Question

. Discuss materiality, different levels of materiality, and bases for setting materiality.

Answer 1

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 different decisions as a result of this error than they would have had the error not been made. 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 organization's revenues and expenses, and is ultimately a matter of professional judgment.^[2]

Level of materiality at different sectors.........

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 which qualitative 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 a cash accounting environment, total expenditures is often used as a benchmark.

Determining Materiality

No steadfast rule exists for determining the materiality of transactions within financial statements. Auditors must rely on certain principles and professional judgment. The amount and type of misstatement are taken into consideration when determining materiality.

In the example above, there are two transactions of absolute dollar amounts. However, in practice, determining materiality is more effective on a relative basis.

For example, instead of looking at whether a transaction of $1.00 or $1,000,000 is considered to be material, the auditor will refer to the percentage impact that the misstatement may have on the financial statements.

So, for a company with $5 million in revenue, the $1 million misstatement can represent a 20% margin impact, which is very material.

However, if the company has $5 billion in revenue, the $1 million misstatement will only result in a 0.02% margin impact, which, on a relative basis, is not material to the overall financial performance of the company.

If the $1 million error was due to fraudulent behavior – perhaps an executive employee embezzling money from the company – this misstatement can be considered material since it involves potential criminal activity.

Therefore, it is crucial to consider not only the absolute and relative amounts of the misstatements but also the qualitative impacts of the misstatements.

Methods of Calculating Materiality

The International Accounting Standards Board (IASB) has refrained from giving quantitative guidance and standards regarding the calculation of materiality. Since there is no benchmark or formula, it is very subjective at the discretion of the auditor.

However, some academic bodies have developed calculation methods.

Norwegian Research Council Materiality Calculation Methods

The Norwegian Research Council funded a study on the calculation of materiality that includes single rule methods in addition to variable size rule methods.

Single Rule Methods:

• 5% of pre-tax income
• 5% of total assets
• 1% of shareholders’ equity
• 1% of total revenue

Variable Size Rule 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)
• 5% to 1% of gross profit (if gross profit is more than $1,000,000 but less than $100,000,000
• 5% of gross profit (if gross profit is more than $100,000,000)

There are also blended methods that combine some of the methods and using appropriate weighting for each element.