Understanding materiality is key to performing accurate audits. We understand this is a challenging concept, so we’re looking at the definition of the term, the history of how materiality came to be in its current iteration, and how to apply this when completing financial statement audits.
What is materiality?
Materiality refers to the significance of an amount, transaction, or discrepancy in financial statements. Something is considered material if its omission or error could influence the economic decisions of those who rely on the financial statements.
To fully understand this concept, we need to consider the history.
The definition of materiality currently used in financial statement audits is converged among relevant U.S. standard-setting, regulatory, and judicial bodies, including:
- Financial Accounting Standards Board (FASB)
- Public Company Oversight Board (PCAOB)
- Securities Exchange Commission (SEC)
- AICPA’s Auditing Standards Board (ASB).
The foundation of the most recent materiality definition lies in the 1976 U.S. Supreme Court decision TSC Industries, Inc. v. Northway, Inc. which opined that an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would (not simply could) consider it important in deciding how to vote. In other words, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.
In August 2018, FASB issued amendments to chapter 3, Qualitative Characteristics of Useful Financial Information, of Concepts Statement No. 8. The amended definition of materiality states, “the omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”
In general, the focus of materiality over time has moved from “reasonable expectations of influence over economic decisions on the basis of information in the financial statements” to “substantial likelihood of influence over reasonable judgements based on the information in the financial statements”.
Applying Materiality: Focus on Generally Accepted Auditing Standards
The current definition in generally accepted auditing standards Section 320 defines material misstatements as: “Misstatements, including omissions, are considered to be material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements”.
The financial statement auditor’s determination of materiality is a matter of professional judgment and is affected by the auditor’s perception of the financial information needs of users of the financial statements.
Factors related to materiality
Judgments about materiality must be made considering the following:
- Surrounding circumstances affected by the size or nature of a misstatement, or a combination of both.
- Both qualitative and quantitative considerations.
- Consideration of the common financial information needs of users as a group. (Note: The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered.)
For purposes of determining materiality, the auditor may assume that reasonable users have the following characteristics:
- Have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with reasonable diligence.
- Understand that financial statements are prepared, presented, and audited to levels of materiality.
- Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events.
- Make reasonable judgments based on the information in the financial statements.
The concept of materiality is applied by the auditor when both planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and uncorrected misstatements, if any, on the financial statements.
When establishing the overall audit strategy, the auditor should determine materiality for the financial statements as a whole. If, in the specific circumstances of the entity, one or more particular classes of transactions, account balances, or disclosures exist for which there is a substantial likelihood that misstatements of lesser amounts than materiality for the financial statements as a whole would influence the judgment made by a reasonable user based on the basis of the financial statements, the auditor also should determine the materiality level or levels to be applied to those particular classes of transactions, account balances, or disclosures.
Examples include:
- Whether law, regulation, or the applicable financial reporting framework affect expectations about measurement or disclosure of certain items (e.g., related party transactions).
- Key disclosures relating the industry in which the entity operates (e.g., research and development costs for a pharmaceutical company).
- Whether attention is focused on a specific aspect of something separately disclosed in the financial statements (e.g., a newly acquired business).
- The extent to which a misstatement affects other information that will be communicated in documents containing the audited financial statements (e.g., information to be included in a "Management Discussion and Analysis" or an "Operating and Financial Review").
Learn more about materiality with Becker CPE
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