The New Importance of Materiality

The materiality threshold in audits refers to the benchmark used to obtain reasonable assurance that an audit does not detect any material misstatement that can significantly impact the usability of financial statements. The concept of materiality was originally used for financial reporting, but with the rising demand of sustainability, it is now being used for sustainability reporting. Materiality assessment helps in deciding which issues should be included and focussed on while preparing an effective sustainability report.

• As
  Staff Accounting Bulletin no. 99 explains, a material
  misrepresentation is not tied to the amount of the misrepresentation
  but rather occurs whenever there was intent to misrepresent the
  registrant’s financial position and results of operations and such a
  misrepresentation occurred.
• Estimating financial events and balances is a necessary evil, given
  management’s need to report on the income and state of assets at
  artificial points in time.
• Since the concept of materiality is focused on the total mix of information from the perspective of a reasonable investor, those who assess the materiality of errors, including registrants, auditors, audit committees, and others, should do so through the lens of the reasonable investor.
• Rather, registrants, auditors, and audit committees need to thoroughly and objectively evaluate the total mix of information.

Nor is it appropriate for information that should be considered together to provide a more complete picture of an aspect of the business to be presented as if it is not related. Part of the materiality decision therefore relates to identifying which matters should be given particular emphasis and which matters should be presented together, or at least related to each other by way of cross-reference. Whether information is material is a matter of judgement based on a range of factors and entity-specific circumstances. Currently, there is a lack of guidance to help management understand how to apply the concept of materiality when preparing financial statements, and in particular, in the notes. In other words, information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. Most importantly, materiality is an entity-specific aspect of relevance based on the nature and/or magnitude of the items to which the information relates in the context of an entity’s financial report.

Report

While auditing the financial reports of ASD Inc. for the year 2019 the auditor discovered an understatement of revenue by $1 million that occurred due to some operational error However, later the auditor realized that it was deliberately done to evade taxes. Determine the materiality of the misstatement if the revenue of ASD Inc. is $200 million. Since a company’s independent auditor usually accumulates
uncorrected/unrecorded misstatements and presents them to management
and the audit committee quarterly, these misstatements become
consequential when the auditor includes them on this schedule and
reports them to the committee. Having these errors and not adjusting
the financial statement means the statements are misstated by the
amount of the errors.

Materiality assessment is the stepping stone in a company’s path towards sustainable development. The process of materiality assessment shapes a company’s sustainability strategy and defines its reporting. It helps a company analyse risk factors and upgrade its business process for future prospects. Materiality assessment is also an important tool to meet the expectations The New Importance Of Materiality of stakeholders. In order to reinforce the role materiality plays in the preparation of financial statements and help companies exercise judgement, we have published the IFRS Practice Statement 2, Making Materiality Judgements. It provides companies with guidance on making materiality judgements when preparing financial statements in accordance with IFRS Standards.

– Time to build Sustainability Ambitions in organizations

On the contrary, preparers should consider whether there is any information that could be removed, or summarised further, to reduce clutter or to make sure the information known to be important to the primary users is more accessible. They should also consider whether there are any gaps in the information that need to be remedied, whether the report is structured in a way that gives appropriate emphasis to the matters they know were important to the entity during the period, etc. Financial statements are meant to be a means of communication, and should not be viewed as a mere compliance exercise. Management needs to take a step back and consider whether they are providing the right level of information in the financial statements and whether it is useful. In the case of financial reporting, the issue is the influence that a particular piece of information would have on a decision being made, when included or omitted from the financial statements. Using different means to quantify materiality causes inconsistency in materiality thresholds.

Therefore, while the existence of a material accounting error is an indicator of the existence of a material weakness, a material weakness may also exist without the existence of a material error. Management’s assessment of the effectiveness of ICFR should therefore be focused on a holistic, objective analysis of what could happen in the context of current and evolving financial reporting risks. As already mentioned above, there is no steadfast framework available for the determination of audit materiality of any transaction within the financial statements. However, auditors often rely either on their professional judgment or certain guidelines (discussed later in the article under “Audit Materiality guidelines”). Consequently, it is important the auditor has a thorough knowledge of how to apply the concept of materiality as it is all relative and is significantly impacted by the size and surrounding circumstances.

Considering Materiality in Planning and Performing an Audit

GAAP.[6] In either case, such errors should be transparently disclosed to investors. This type of restatement is sometimes referred to colloquially as a revision restatement or a “little r” restatement. The concept of sustainability has gained tremendous popularity over the past few decades and continues to take over organizational strategy in various sectors. Many companies have successfully incorporated the environmental, social and governance factors in their business process to attain sustainability and many more are willing to follow sustainable practices. Changing the entire business process of a company in order to incorporate sustainable practices, puts the company’s performance and profitability at stake.

• Even though this sounds straightforward, applying the concept in practice is not always easy.
• Using different means to quantify materiality causes inconsistency in materiality thresholds.
• As already mentioned above, there is no steadfast framework available for the determination of audit materiality of any transaction within the financial statements.
• For example, a restatement of previously-issued financial statements may result in the clawback of executive compensation, reputational harm, a decrease in the registrant’s share price, increased scrutiny by investors or regulators, litigation, or other impacts.
• THE FOUR PERSPECTIVES
  To assist CPAs in helping management meet its
  responsibilities under Sarbanes-Oxley, there are four perspectives of
  working materiality, each with its own distinct quantitative
  calculations and limits.

Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. We further note that registrants often argue that an error is not material because its effect is offset by other errors. As noted in SAB No. 99, https://kelleysbookkeeping.com/how-to-calculate-bad-debt-expenses-with-the/ registrants and their auditors first should consider whether each misstatement is material, irrespective of its effect when combined with other misstatements. The aggregated effects should then also be considered to determine whether an otherwise immaterial error, when aggregated with other misstatements, renders the financial statements taken as a whole to be materially misleading. However, we do not believe this analysis of the aggregate effects should serve as the basis for a conclusion that individual errors are immaterial.

The New Importance of Materiality

We continue to emphasize the importance of identifying and communicating material weaknesses to investors promptly. Consequently, rather than exercising judgement about what to include in financial statements, they use the requirements in the International Financial Reporting Standards (IFRS) as if they are a checklist. This results in financial statements that comply with the accounting requirements but do not communicate information effectively to investors. MINIMIZING EXCEPTIONS
CPAs must understand each of the four perspectives of
materiality to be able to estimate the effect of key control
exceptions on an SEC registrant’s fair presentation of its financial
statements in compliance with sections 302 and 404. But it’s equally
important to develop an ongoing key control risk reporting process
that ensures the timely identification of these issues. The right
processes will minimize key control exceptions and meet every
accountant’s goal of providing fair and complete financial
information.

The focus on company-specific information should further discourage boilerplate disclosure. One area where the staff in OCA have observed an increased need for objectivity is in the assessment of qualitative factors. The interpretive guidance on materiality in SAB No. 99 speaks to circumstances where a quantitatively small error could, nevertheless, be material because of qualitative factors.

Importance of Materiality in Accounting

CPAs must undertake appropriate qualitative analysis to
determine whether a material misstatement actually occurred. If so,
the solution again is simple; management only needs to appropriately
record the uncorrected/unrecorded misstatement for the financial
statements to be considered fairly stated in all material respects. Materiality is a subjective concept that enables a company to measure and disclose only those transactions that are of a sufficiently large dollar amount to be of concern to the users of a particular company’s financial statements. A company must account for these substantive amounts in a way that complies with financial accounting principles. However, materiality – the significance of an item – is measured in terms of the item’s dollar amount and the nature of the misstatement that results if accounting principles aren’t followed. Therefore, each company has the ability to determine what items are material in the context of its operations and justify the labor cost of adhering to accounting principles when accounting for the items.

There is a widely acknowledged uncertainty about how the concept of materiality should be applied, resulting in a somewhat overly cautious approach to disclosure, preparers being reluctant to ‘filter out’ information which is not relevant and auditors and regulators being reluctant to accept omissions. Also, the drafting of some Standards could be read to suggest the specific requirements of those Standards override the general statement in IAS 1 Presentation of Financial Statements that an entity need not provide information that is not material. 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). This benchmark is used to obtain reasonable assurance in an audit — or limited assurance in a review — of detecting misstatements that could be large enough, individually or in the aggregate, to be material to the financial statements. We also note that the qualitative factors that may be relevant in the assessment of materiality of a quantitatively significant error would not necessarily be the same qualitative factors noted in SAB No. 99 when considering whether a quantitatively small error is material. So it might be inappropriate for a registrant to simply assess those qualitative factors in reverse when evaluating the materiality of a quantitatively significant error.

Materiality survey and matrix

This means that, even if a misstatement is not material in “Dollar” (or other denomination) terms, it may still be material because of its nature. The concept of materiality in accounting is strongly correlated[7] with the concept of Stakeholder Engagement. The main guidelines on the preparation of non-financial statements (GRI Standards and IIRC Framework) underline the centrality of the principle of materiality and the involvement of stakeholders in this process. 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.