Question

Forensic Accounting and Fraud Examination - Second Edition: Chapter 8

How is materiality determined?

Answer 1

Forensic Accounting and Fraud Examination

Determination of Materiality:

How often have you heard auditee management say something like,"I know it's a fraud,but it's so small; it's not even material to our financial statements." Auditees, and sometime auditors themselves, have dismissed possible detected irregularities by concluding that they are not material to the financial statements. I would argue that,when it comes to a proven fraud,no matter how small, the concept of Materiality does not apply; from an ethical point of view,the theft of a penny is the same as the theft of a million dollars.

The issue of Materiality draws on both legal and accounting principles. Guidence to the practicing forensic accountant or fraud examiner can be found from the U.S. supreme court, the American SEC,the FASB and academic literature. The supreme court has defined something as material if "there is substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investors having significantly altered the mix of information made available". The SEC ,in regulation S-X,defines material items as "those matter about which an average prudent investor ought reasonably to be informed" before purchasing the registered security. The FASB has defined materiality to be"the magnitude of an omission or misstatement of accounting information that in light of surrounding circumstances, makes it probable that the judgement of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement."