Materiality (auditing)

Materiality (auditing)

Materiality is a concept or convention within auditing and accounting relating to the importance/significance of an amount, transaction, or discrepancy. 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). The assessment of what is material is a matter of professional judgment.

"Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful."

The Financial Accounting Standards Board (FASB) has refrained from giving quantitative guidelines for determining materiality. This has resulted in confusion in the use of Auditing Standards No 47, "Audit Risk and Materiality in Conducting the Audit". Several common rules that have appeared in practice and academia to quantify materiality include:

  • Percentage of pre-tax income or net income (i.e., 5% of average pre-tax income (using a 3-year average));
  • Percentage of gross profit;
  • Percentage of total assets; (i.e.,1/3% of total assets);
  • Percentage of total revenue; (1/2% of total revenues);
  • Percentage of equity; (i.e.,1% of total equity);
  • Blended methods involving some or all of these definitions (e.g., use a mix of the above and to find an average);
  • "Sliding scale" methods which vary with the size of the entity. (i.e., 5% of gross profit if between $0 and $20,000; 2% if between $20,000 and $1,000,000; 1% if between $1,000,000 and $100,000,000; 1/2% if over $100,000,000)
  • 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: 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.

Read more about Materiality (auditing):  Materiality As An Empirically Discovered Amount, Materiality in Governmental Auditing