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Home / 2005 / April 2005 / Materiality and Misstatements

Materiality is a concept which is pervasive in the context of financial reporting and auditing, though its precise meaning and application is often quite difficult to communicate. It is particularly fundamental in the evaluation of misstatements, and the appearance of a new draft international auditing standard on this topic is very significant.

A Matter of Judgement

A priority for the accounting profession, particularly in Ireland and the UK, has been to preserve the primacy of professional judgement, and to strive for a principles-based, rather than a rules-driven, environment. This has been particularly relevant in considering materiality, where guidance has sought to avoid percentage or absolute numerical benchmarks, instead preferring to define the concept by reference to the relative significance of the matter under review. Thus, the definition provided in Auditing Standards “'Materiality' is an expression of the relative significance or importance of a particular matter in the context of financial statements as a whole. A matter is material if its omission would reasonably influence the decisions of an addressee of the auditors' report; likewise a misstatement is material if it would have a similar influence. Materiality may also be considered in the context of any individual primary statement within the financial statements or of individual items included in them. Materiality is not capable of general mathematical definition as it has both qualitative and quantitative aspects.”

The standard goes on to explain that differing levels of materiality may be considered appropriate in relation to particular circumstances;

“Materiality is considered at both the overall financial statement level and in relation to individual account balances, classes of transactions and disclosures. Materiality may be influenced by considerations such as legal and regulatory requirements and considerations relating to individual financial statement account balances and relationships. This process may result in different materiality considerations being applied depending on the aspect of the financial statements being considered. For example, the expected degree of accuracy of certain statutory disclosures, such as directors' emoluments, may make normal materiality considerations irrelevant.” The Statement of Principles for Financial Reporting issued by the ASB in 1999 provided further guidance on the matter.

“Materiality is the final test of what information should be given in a particular set of financial statements……the materiality test asks whether the resulting information content is of such significance as to require its inclusion in the financial statements.”

“An item of information is material to the financial statements if its misstatement or omission might reasonably be expected to influence the economic decisions of users of those financial statements, including their assessments of management's stewardship.”

So it’s very much for the preparer of financial statements, or the auditor, to use their professional judgement to determine whether in the particular circumstances, a misstatement should be considered material.

Hard to quantify ?

Despite the statement in the SAS 220 quoted above in relation to “general mathematical definition”, it is hard to resist the temptation to resort to benchmarks, such as percentages or sliding scales. Indeed, as an aid to judgement, audit practice manuals do provide indicators of the likely ranges of percentages which may be applied to the relevant critical components of financial statements. For example, profit after tax might be considered the appropriate critical component in many circumstances. A percentage of between 5 and 10 of this critical component might normally be considered appropriate in determining materiality.

However, such guidelines come with multiple caveats. The choice of critical component as the base for calculation will vary according to circumstances. A stable base is required, so volatility can pose problems with suitability of possible critical components. The appropriate percentage will also vary, e.g. depending on the critical component chosen, and on the nature of the entity, or the sensitivity of the item under consideration.

What action is required?

From the point of view of the preparer of financial statements, once an item has been determined to be material, the position should be relatively straightforward – make any necessary adjustment to reflect the item appropriately in the financial statements. To quote the ASB’s Statement of Principles again;

“If an item of information is material, it will need to be included and if it is not, it need not be included.”

The debate really arises when a misstatement has been identified, and not corrected. Materiality is a key tool in the evaluation of misstatements. To quote SAS 200 again, “The auditors plan and perform the audit to be able to provide reasonable assurance that the financial statements are free of material misstatement and give a true and fair view”.

If a misstatement which is considered material is identified during the audit, a correcting adjustment will be required; otherwise the auditor will have to consider whether the audit opinion is affected by the error. Auditors will accumulate known and likely misstatements identified during the audit, and request management to adjust for those not considered very small in the context of materiality. New Guidance for Auditors

In drafting the proposed new auditing standard, the IAASB considered the following key elements;

• Definition; • Quantitative guidelines; • Communication of misstatements to management, and • Management bias.

Definition

The definition adopted is the same as in IAS 1 ,

“Omissions or misstatements are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.”

This definition requires an assessment of the likely reaction of users of the financial statements. The draft standard explains that for general purpose financial statements, this is intended to cover the generality of well-informed users as a group, not individual users whose needs may vary widely. For a commercial entity, the needs of investors will be a good indicator of the needs of users in general.

While materiality is determined in relation to financial statements as a whole, the proposed standard emphasises that this “does not establish a threshold below which identified misstatements are always considered to be immaterial” as the particular significance of an item may dictate a lower level of materiality in considering that item. Quantitative guidelines

As would be expected, the draft standard repeats the maxim that “the determination of materiality is a matter of professional judgement”. However, it does elaborate on the approach of applying a percentage to a chosen benchmark. This is useful, and as noted above reflects current best practice among auditors. There is some discussion on the selection of an appropriate benchmark, and also on the range of percentages which might be applied. Three examples are given, being;

• For a profit oriented entity, five percent of profit before tax from continuing operations, or one half of one percent of total revenues; • For a not-for-profit entity, one half of one percent of total expenses or total revenues; • For an entity in the mutual fund industry, one half of one percent of net asset value.

There is a concern on the part of IAASB that these might be interpreted as rules, and so dilute the role of judgement, so they have included the following caveat;

“The auditor may consider higher or lower percentages than those illustrated above to be appropriate.”

Communication of misstatements to management

The proposed standard reflects current best practice in requiring that “the auditor should accumulate all known and likely misstatements identified during the audit, other than those that the auditor believes are clearly trivial, and communicate them to the appropriate level of management on a timely basis.”

The standard goes beyond this requirement for mere communication, however, and states further that the auditor should request management to correct all non-trivial misstatements. It discusses the appropriate further audit review process required in the event that management refuse to make the correcting adjustments. Reference is then made to the guidance in ISA 260 “Communication of audit matters to those charged with governance” which calls for the auditor to repeat the request for correction to the board of directors or equivalent body.

Thus there is a clear onus in the auditor to request (obviously not demand, as the making of adjustments to the financial statements is not his responsibility) correction of all non-trivial misstatements, even where they do not exceed the materiality level determined.

Management bias

The draft standard requires that consideration be given by the auditor to possible bias in management’s judgements. The auditor may conclude that a combination of lack of neutrality with uncorrected misstatements causes the financial statements as a whole to be materially misstated. In this it echoes, and refers to the other draft standard currently exposed for comment, ISA 540 (revised) “The audit of accounting estimates and related disclosures” which was the subject of an article in the last issue of Accountancy Ireland . Conclusion

The primacy of professional judgement is underlined by the standard, which clarifies the responsibilities of auditors in seeking correction of non-trivial misstatements, and in working towards an absence of excessive bias in financial statements.

Ronan Nolan is Chairman of the ICAI’s Auditing Standards Committee, and is an audit partner in the Financial Services group of Deloitte, based in Dublin.

2009_AC512: Materiality and Misstatement - Accountancy Ireland, 2005, Ronan Nolan