Materiality (auditing)

Materiality is a concept or convention within auditing and accounting relating to the importance/significance of an amount,
transaction, or discrepancy.[1] The objective of an audit of financial statements is to enable the auditor to express an opinion whether
the financial statements are prepared, in all material respects, in conformity with an identified financial reporting framework such as
Generally Accepted Accounting Principles(GAAP).

As a simple example, an expenditure of ten cents on paper is generally immaterial, and, if it were forgotten or recorded incorrectly,
then no practical difference would result, even for a very small business. However, a transaction of many millions of dollars is almost
always material, and if it were forgotten or recorded incorrectly, then financial managers, investors, and others would make incorrect
decisions as a result of this error. The assessment of what is material – where to draw the line between a transaction that is big enough
to matter or small enough to be immaterial – depends upon factors such as the size of the ganization's
or revenues and expenses, and is
ultimately a matter of professional judgment.[2]

Contents
Definitions of Materiality
Materiality in accounting
Materiality in auditing
Materiality in securities regulation
Methods of calculating materiality
Methods from a study funded by the Norwegian Research Council
Methods from Discussion Paper 6: Audit Risk and Materiality
, as issued in July 1984
Other, unverified methods
Materiality in governmental auditing
References
External links

Definitions of Materiality

Materiality in accounting
The IFRS Foundation has as its mission to develop a single set of high quality, understandable, enforceable and globally accepted
[3]
financial reporting standards based upon clearly articulated principles.

These reporting standards consist of a growing number of individual standards. The Conceptual Framework is not an International
Financial Reporting Standard(IFRS) itself and nothing in the Framework overrides any specific IFRS. However, the Framework has
as its purpose to, inter alia, assist the International Accounting Standards Board (IASB) and individual national standard-setting
bodies in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial
[4]
statements by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs.

Chapter 3 of the Conceptual Framework deals specifically with the quantitative characteristics of financial information that make it
useful to the users of the financial statements. Paragraphs QC6 to QC11 provides guidance to determine when information is relevant
and when it is not. In determining the relevance of financial information, regard needs to be given to its materiality. Information is
said to be material if omitting it or misstating it could influence decisions that users make on the basis of an entity's financial
statements. Put differently, "materiality is an entity-specific aspect of relevance, based on the size, or magnitude, or both," of the
items to which financial information relates. The IASB has declined to specify a uniform quantitative threshold for materiality, or to
.[5]
predetermine what could be material in a particular situation, because of this entity-specific nature of materiality

On 31 October 2018, the International Accounting Standards Board amended the definition of materiality in IFRS Standards by
amending IAS 1 and IAS 8. The amended definition of materiality is ef
fective from 1 January 2020:

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions
that the primary users of general purpose financial statements make on the basis of those financial statements, which
.[6]
provide financial information about a specific reporting entity

Materiality in auditing
The International Auditing and Assurance Standards Board (IAASB) is an independent standard-setting body that serves the public
interest by setting high-quality international standards for auditing, assurance, and other related standards.[7] The IAASB issues the
International Standards on Auditing, which consists of a growing number of individual standards.

In terms of ISA 200, the purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. The
auditor expresses an opinion on whether the financial statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework, such as IFRS.[8] ISA 320, paragraph A3, states that this assessment of what is material is a
matter of professional judgement.

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of
identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion
in the auditor’s report.[9]

ISA 320, paragraph 10, requires that "planning materiality" be set prior to the commencement of detailed testing. ISA 320, paragraph
12 requires that materiality be revised as the audit progresses, if (and only if) information is revealed that, if known at the onset of the
audit, would have caused the auditor to set a lower materiality. In practice, materiality is re-assessed at least once, during the
conclusion of the audit, prior to the issuing of the audit report. This materiality is referred to as "final materiality".

ISA 320, paragraph 11, requires the auditor to set "performance materiality". ISA 320, paragraph 9, defines performance materiality
as an amount or amounts that is less than the materiality for the financial statements as a whole ("overall materiality"). It includes
materiality that is applied to particular transactions, account balances or disclosures. Paragraph 9 also states that the purpose of
setting performance materiality is to reduce the risk that the aggregate total of uncorrected misstatements could be material to the
financial statements.

In terms of ISA 320, paragraph A1, a relationship exists between audit risk and materiality. This relationship is inverse. The higher
the audit risk, the lower the materiality will be set. The lower the audit risk, the higher the materiality will be set.

In terms of the Conceptual Framework (see "materiality in accounting" above), materiality also has a qualitative aspect. This means
that, even if a misstatement is not material in "Dollar" (or other denomination) terms, it may still be material because of its nature. An
example is if a disclosure is omitted from the financial statements.

Materiality in securities regulation

Materiality is also a concept used in securities regulation. However, some experts regard the concept as inadequately defined, based
only on the development of case law.[10]

Methods of calculating materiality

The IASB has refrained from giving quantitative guidance for the mathematical calculationof materiality. While ISA 320, paragraph
A3, does provide for the use of benchmarks to calculate materiality [11] Several
, it does not suggest a particular benchmark or formula.
common rules to quantify materiality have been developed by academia.

Methods from a study funded by the Norwegian Research Council

[12]
These include single-rule methods and variable size rule methods.

Single rule methods:

5% of pre-tax income;
0.5% of total assets;
1% of equity;
1% of total revenue.
"Sliding scale" or variable-size methods:

2% to 5% of gross profit if less than $20,000;

1% to 2% of gross profit, if gross profit is more than $20,000 but less than $1,000,000;
0.5% to 1% of gross profit, if gross profit is more than $1,000,000 but less than $100,000,000;
0.5% of gross profit, if gross profit is more than $100,000,000.
Blended methods involve combining some or all of these methods, by using an appropriate weighting for each element.

2/3 .
The research study also cites KPMG's formula-based method: Materiality = 1.84 times (the greater of assets or revenues)

Methods from Discussion Paper 6: Audit Risk and Materiality

, as issued in July 1984
These methods offer a suggested range for the calculation of materiality. Based on the audit risk, the auditor will select a value inside
this range.[13]

0.5% to 1% of gross revenue;

1% to 2% of total assets;
1% to 2% of gross profit;
2% to 5% of shareholders' equity;
5% to 10% of net profit.
These ranges can also be combined into blended methods.

Other, unverified methods

A concave function, such as the "gauge" formula. Gauge is a measure of materiality that experiences a decreasing returns to scale as
opposed to the other traditional quantitative metrics aforementioned. The concave nature of the function leads to a lower materiality
threshold (which implies less tolerance for misstatement) as the company becomes larger because more users are relying on the
financial statements. Although the formula varies, a typical structure is as follows:

where... a non-zero, non-negative constant; usually

a constant that is between zero and one, i.e.

for each asset or revenue account, transaction, etc.

Materiality, if quantified in any of the above ways, is a function of company size as measured by assets and revenues: the larger the
company, the larger materiality limit.
Using different means to quantify materiality causes inconsistency in materiality thresholds. Since "planning materiality" should
affect the scope of both tests of controls and substantive tests, such differences might be of importance. Two different auditors
auditing even the same entity might generate differing scopes of audit procedures, solely based on the "planning materiality"
definition used.

Materiality in governmental auditing

Materiality in governmental auditing is different from materiality in private sector auditing for several reasons.

Most importantly, due to the format of state and local government financial statements under GAAP, the AICPA Audit Guide for
State and Local Governments requires auditors to consider materiality by "opinion unit" rather than for the financial statements taken
as a whole. The Guide defines opinion units as follows:

Government-wide level (three units):

1. Governmental activities;
2. Business type activities; and
3. Discretely presented component units in the aggregate.
Fund level (at least two): Talatech Inc

1. General fund (always a major fund);

2. Other major funds determined for government funds or enterprise funds. Each major fund is an opinion unit. If there
are no major funds, then there will be only two opinion units—the general fund and the remaining fund information;
and
3. Remaining fund information, consisting of all other nonmajor governmental and enterprise funds, internal service
fund type, and fiduciary fund type. (This will generally always be present, although the individual components and
size will change between governmental entities.)
This functionally decreases materiality for state and local government financial statements by an order of magnitude compared to
materiality for private company financial statements. Due to the unique concept of materiality, the auditor's report expresses an
opinion in relation to each opinion unit.

Moreover, the primary users of government financial statements are different: the citizenry and the parliament in the public sector
versus investors in the private sector. It is important to identify the primary users since materiality reflects the auditor’s judgment of
the needs of users in relation to the information in the financial statements.

Finally, in government auditing, the political sensitivity to adverse media exposure often concerns the nature rather than the size of an
amount, such as illegal acts, bribery, corruption and related-party transactions. Qualitative considerations of materiality are therefore
different from in private-sector auditing, in whichqualitative considerations are focused on the effect on earnings per share, executive
bonuses or other risks that are not applicable to governments. Qualitative materiality refers to the nature of a transaction or amount
and includes many financial and non-financial items that, independent of the amount, may influence the decisions of a user of the
financial statements.

While rules of thumb mentioned in the section above are commonly applied to state and local government financial statements,
government auditors may also use different means to quantify materiality such as total cost or net cost (expenses less revenues or
expenditure less receipts). In acash accounting environment, total expenditures is often used as a benchmark.

References
1. Reasonable Investor(s), Boston University Law Review
, available at: http://ssrn.com/abstract=2579510
2. SEC Staff Accounting Bulletin 99 - Materiality, available at: https://www.sec.gov/interps/account/sab99.htm
3. IFRS Foundation, International Accounting Standards Board (IASB) (2015).
Who we are and what we do.
http://www.ifrs.org/The-organisation/Documents/2015/WhoWeAre_ENGLISH_July%202015.pdf: IFRS Foundation e-
Book. p. 1.
 4. IFRS Foundation, International Accounting Standards Board (IASB) (September 2010). Conceptual Framework.
http://eifrs.ifrs.org/eifrs/bnstandards/en/2015/framework.pdf
: IFRS Foundation. pp.A23.
5. IFRS Foundation, International Accounting Standards Board (IASB) (September 2010). Conceptual Framework.
http://eifrs.ifrs.org/eifrs/bnstandards/en/2015/framework.pdf
: IFRS Foundation. pp.A31, A32.
6. "IASB clarifies its definition of 'material'" (https://www.ifrs.org/news-and-events/2018/10/iasb-clarifies-its-definition-of-
material/). 31 October 2018. Retrieved 2018-11-03.
7. "About IAASB" (http://www.iaasb.org/about-iaasb). IFAC. International Federation of Accountants. Retrieved
4 November 2015.
8. IAASB (Effective for periods beginning on orafter December 15, 2009).ISA 200: Overall objectives of the
independent auditor and the conduct of an audit in accordance with the International Standards on Auditing
.
http://www.ifac.org/system/files/downloads/a008-2010-iaasb-handbook-isa-200.pdf: IFAC. p. 72. Check date values
in: |date= (help)
9. IAASB (Effective for audits of financial statements for periods beginning on or after December 15, 2009).ISA 320:
Materiality in planning and performing an audit . http://www.ifac.org/system/files/downloads/a018-2010-iaasb-
handbook-isa-320.pdf: IFAC. p. 315. Check date values in: |date= (help)
10. Oesterle, Dale (2011).The overused and under-defined notion of "material" in securities law.
https://www.law.upenn.edu/live/files/157-oesterle14upajbusl1672011pdf
: Penn Law. p. 207.
11. "South African Institute of Chartered Accountants Frequently Asked Questions"
(http://www.saica.co.za/faqs/showAn
swer.asp?FaqQuestionId=306&FaqSectionId=8&FaqSubSectionId=34). SAICA. South African Institute of Chartered
Accountants. Retrieved 4 November 2015.
12. McKee, Thomas E.; et al. (2000). Working paper no. 51/00: Current materiality guidance for auditors(http://brage.bib
sys.no/xmlui/bitstream/handle/11250/166032/A51_00.pdf?sequence=1) (PDF). Foundation for Research in
Economic and Business Administration. p. 4.ISSN 0803-4028 (https://www.worldcat.org/issn/0803-4028).
13. "Materiality in a financial statement audit"(https://www.pastel.co.za/Other-Pastel-Products-Software/Pastel-Auditor/
Materiality-in-a-financial-statement-audit.asp). Pastel. Sage Pastel. Retrieved 4 November 2015.

External links
Accounting Terminology Guide (New York Society of CPAs)

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