Materiality Defined: Differing concepts of materiality can cause confusion among stakeholders.

Author:Fabrizius, Michael P.
Position:REPORTING
 
FREE EXCERPT

Because the term materiality arose within the context of financial reporting and statement assurance, internal auditors have been challenged in adapting or creating a definition that is relevant for themselves and their stakeholders. In the context of financial reporting, materiality is relevant to three stakeholder groups: 1) preparers of financial statements, 2) auditors, and 3) users of financial statements. Although materiality decisions are made by only two of these three groups--preparers and auditors--most internal auditors' conception of materiality likely has a user orientation. The auditor might ask, "How would a reasonably prudent investor react to the magnitude of misstatement (under- or over-reported amounts) or omission of a specific financial statement item in terms of its presentation and disclosure?"

Given this backdrop, the term materiality can be a significant cause of confusion in determining what to audit, how much to audit, what to correspondingly report, and for what matters it is necessary to gain consensus regarding management action. In many situations, stakeholders come to the table with their own concept of materiality--sometimes vaguely defined--that can be at odds with internal audit's definition. Sometimes managers attempt to mitigate or downplay an issue and internal audit's proposed recommendation because it reflects poorly on their performance in their respective areas of responsibility. In such instances, supposed lack of materiality can be used as the basis for an argument to convince internal audit that the issue under discussion has no real merit.

If internal auditors are not well-prepared to articulate and defend what they believe to be the relevant concept of materiality, the discussion of audit issues can easily become contentious or seriously impaired. It is therefore imperative that internal auditors fully understand the meaning and contexts of the term materiality so they are prepared to use it authoritatively and appropriately.

THE OLD RULE OF THUMB

Historically, many stakeholders, and even many internal auditors who began their careers as certified public accountants or chartered accountants, were introduced to the materiality concept from a financial reporting and external audit standpoint. Here, the term referred to the significance of an item to the users of a set of financial statements, and the probability that its omission or misstatement would influence or change a decision by them. Although professional standards never defined the threshold for materiality as a fixed percentage of revenue, equity, or other financial statement value, and it is clear that qualitative factors play an equally important role as quantitative considerations, a widely used rule of thumb was that materiality was reached when a misstatement or omission was at least 5 percent of a given factor--such as net income or net assets. Accordingly, anything less than 5 percent often was considered immaterial for audit scoping or adjustment proposal purposes.

In 1999, the U.S. Securities and Exchange Commission's (SEC's) Staff Accounting Bulletin 99 (SAB 99) rejected the blanket concept that a misstatement or omission of less that 5 percent of a given factor is immaterial. The SEC had no objection to the rule of thumb as a starting point in assessing materiality, but quantifying in percentage terms the magnitude of a financial reporting misstatement was only the beginning of an analysis of materiality.

SAB 99 requires that a determination of materiality for financial reporting consider the quantitative and qualitative aspects of the matter...

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