Determining Materiality: Relativity and Professional Judgment

E-mail Story Print Story

Judgment and Expectations

Materiality is a concept that has caused much frustration and angst in the public accounting profession, primarily because it requires a substantial degree of auditor judgment regarding what’s important to users of the financial statements when making economic decisions. To understand how any piece of information may influence an investor, supplier, creditor, or lender’s decision-making process, an auditor needs to anticipate who the potential readers of the information may be and the range of decisions they may make. Although the number of possible decisions and assessments is endless, an auditor’s judgment may be questioned and sometimes litigated in a court of law.

Although public accountants have been charged with stewardship in the financial reporting process, some in our profession still look for ways to avoid making the tough decisions that responsibility entails. One CPA wrote to me (see page 17) that when he was working for a major accounting firm in the 1960s, the ability to technically comply with financial statement disclosure requirements—while actually saying nothing—was a prized quality. So what has changed? In the past, many issues were overlooked with the excuse that they were immaterial. Yet some issues that an auditor deems to be immaterial may be very material to investors and others. The Sarbanes-Oxley Act made clear that the public expects the CPA to be a financial cop.

So CPAs are looking for guidance on the meaning of materiality. But despite accounting regulators’ attempts to avoid bright-line rules and develop principles-based accounting standards, many in the profession consistently seek “definitions” and “examples” when it comes to materiality. This guidance inevitably turns into the detailed rules and checklists that we purport to disparage. The fundamental meaning of materiality continues to haunt regulators and practitioners.

The Problem with Quantification

The PCAOB recently adopted Auditing Standard No. 5 (AS5), An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements. This new standard, pending SEC approval, will replace AS2, which many critics contend was overly costly because it caused auditors to focus on minutiae when assessing risk, and ignored the big picture that would be revealed by a top-down approach. AS5 encourages auditors to be consistent in the materiality measures they use for planning and performing audits of financial statements and internal controls. However, the standard stops short of providing a quantitative value.

But will anything other than a specific materiality number satisfy some auditors and business groups? Quantitative measures provide a deceptive sense of comfort, especially for those accustomed to dealing with numbers. In the past, a common practice was for audit firms to base the scope of their work on a numerical materiality threshold, such as 5% of net income. An auditor would then use this number to determine whether a misstatement should be reported. The profession has historically recognized that certain circumstances can render these strictly quantitative measures invalid. For example, is a 2% misstatement acceptable if it was caused by management fraud? The answer is that there is no such thing as “immaterial” fraud when it is committed by top executives.

The qualitative aspects of a misstatement cannot be disregarded or excused for merely quantitative reasons. The issues behind the numbers often tell us more than the numbers alone. If CPAs ignore these clues, if they set aside their professional judgment, they do so at their own peril.

Materiality is relative. As a result of that 40-minute flight delay, I missed my connecting flight and spent an additional eight hours in the airport waiting on stand-by for another flight home. Put in this context, was the initial 40-minute delay really immaterial? I’ll leave that to your judgment.

As always, I welcome your comments.

Mary-Jo Kranacher, MBA, CPA, CFE
Editor-in-Chief
mkranacher@nysscpa.org

©2009 The New York State Society of CPAs. Legal Notices