As auditors, we are often asked: What is materiality and how is it determined?
Although the calculation is not set in stone, materiality is generally defined as a judgmental threshold used to assess what amount would impact a reasonable user of financial statements.
In determining materiality, both qualitative and quantitative factors are considered. Conceptually, by how much could an amount be misstated in order to alter the opinion of the users of the financial statements?
Materiality isn’t only for auditors; company management applies the concept of materiality in their decision-making very frequently, whether they realize it or not. For example, let’s look at an example of a routine transaction, such as purchasing a $100 office chair for use in your business. GAAP would suggest that you capitalize and record the chair as an asset and depreciate it over 7-10 years (for simplicity, let’s assume 10 years at $10 per year). However, the threshold for capitalization under your company’s policy is $5,000, and therefore the cost of the chair may be expensed immediately.
By adhering to your company’s capitalization policy, you are not misleading the users of your financial statements, but rather creating efficiencies in your operations. This is materiality in action.
Do not assume immateriality — instead, analyze it
So then, what is considered material? The answer, of course, is: It depends. You cannot assume a transaction or series of transactions is immaterial until you analyze it.
In the example above, we knew that the $100 chair was well below the capitalization threshold, and therefore materially reasonable to expense. But what if this $100 was a weekly expense totaling $5,200 annually? In this instance, the total borders on your materiality threshold, and therefore more consideration must be given to its impact. While subject to professional judgment, it would likely be best to capitalize the item under these circumstances.
When reconciling significant account balances, any variances should be researched and resolved, as they may be indicative of an omission or error. Significant areas such as fixed assets (in this example) should be reconciled regularly in order to prevent material discrepancies. It is important to implement internal control procedures such as balance checks and reviews to ensure transactions are being properly recorded and company policies are being followed.
As external auditors, we review these variances both individually and in the aggregate in order to ensure that, collectively, the discrepancies are not significant enough to impact the financial statements as a whole. Often, when significant accounts such as fixed assets cannot be adequately reconciled, we will recommend suggestions for process improvements to our clients with the goal of improving accuracy and minimizing discrepancies, which have potential to add up and create more issues.
Other materiality considerations
Another important area to consider is the nature of the account. For example, is it subject to management’s estimate and interpretation? Items such as the allowance for doubtful accounts, warranty estimates and intangible asset impairment are highly subject to estimate and, typically, historical data. Due to the subjectivity of these accounts, materiality is more difficult to pinpoint, and, as such, these accounts should be analyzed for reasonableness, and sufficient documentation for the calculation should be maintained.
Materiality is considered not only on the face of the financials, but also throughout the footnotes. Users must be made aware of significant concentrations, such as in relation to sales and receivables. The readers of the financial statements could be greatly influenced upon learning that a majority of sales and the related receivables were from a single customer, leading them to consider the related risks when making financial and operational decisions going forward.
Not all materiality is created equally
Additionally, auditors must always consider fraud risk. For example, if it was discovered that the chair we discussed in the previous example was purchased for the CFO’s spouse’s home office, that would be considered asset misappropriation, a form of fraud. Any fraudulent activity is considered material, as it would impact the stakeholders’ view of the company, and should therefore be brought to the attention of management immediately, regardless of the amount. Even though a $100 fraudulent transaction may seem trivial to a multi-million-dollar company, it could just be the tip of the iceberg, a symptom of a much deeper issue within the company.
Another area in which the materiality calculation may be further complicated and often lower than the amount used in other financial statement areas is related party transactions. The disclosure of related party transactions can often provide valuable insight to readers of the financial statements, and, as such, a more conservative threshold is typically utilized.
Don’t waste time — when in doubt, record it out
Ironically, sometimes in an effort to reduce labor and complexity, we spend more time debating whether a transaction is immaterial than the time and effort we’d expend simply recording it.
So, the next time you’re deciding whether to book a transaction that doesn’t seem very influential, consider the impact and time you may squander arguing against recording the transaction. It is usually much more efficient to address the situation in the moment than it is to go back and try to recall the specific circumstances and scenarios that led to the situation in the first place. And always remember to evaluate the cumulative effect of the transaction(s). As we saw earlier, an individual transaction may not be material, but when analyzed in the aggregate, you could very well see a different result.
While applying the concept of materiality may help create efficiencies, it is important to examine each account and transaction on a case-by-case basis. And most importantly, always approach this analysis keeping the users of your financial statements at the forefront.