Auditing: Concept of Materiality

The materiality concept is the principle that

trivial / insignificant matters are to be
disregarded in accounting, and all important
matters are to be disclosed. Items that are
large enough to matter are material items.

The materiality concept is an established,

recognized accounting convention.
 Materiality
• Applying the materiality concept may
call for more subjective judgment.
Moreover, the subjective judgments of
senior management, accountants,
auditors, board of directors,
stockholders, and potential business
partners, can differ, especially when
competing interests are involved.
 Why materiality concept is
important?
• Why is the materiality concept
important and necessary in financial
accounting?

• Please follow that some of the reasons

explained in the following slides shows
that materiality is necessary and inevitable
in business case analysis, as well. 
 Materiality

• What is Material? What is Not?

• The materiality concept addresses
omissions and misstatements in
accounting reports and in business case
analysis. The central question is: Do
They matter?
 Materiality

Some omissions are inevitable and desirable

in both cases.

• An income statement, for instance, is meant

to help stockholders, management, and
boards of directors make judgments—
judgments about investing, managing, and
evaluating management performance.
 components of Internal Control
A statement with too much detail could
Obscure/unclear the "larger picture," could be
difficult to prepare, and difficult to read
and use.

• Similarly, a business case analysis is a tool

for decision support and planning. Non
material details are can be simply distracting
and pointless.
 components of Internal Control
On the other hand, omission or misstatement of
material items would work against the purpose in
either case. In the US, the
predominant approach to deciding what is
material and what is not, is the view written in
the GAAP (Generally Accepted Accounting
principles) that items are material if they could
individually or collectively influence the
economic decisions of users, taken on the basis
of financial statements.
 Materiality

This definition is consistent with a more

formal statement from the board
responsible for GAAP, the United States
Financial Accounting Standards Board
(FASB).  
 Materiality
• Materiality refers to ... "the magnitude of
an omission or misstatement of accounting
information that, in the light of surrounding
circumstances, makes it probable that the
judgment of a reasonable person relying
on the information would have been
changed or influenced by the omission or
misstatement.
 Materiality :
• Here the auditors responsibility is
to determine whether the financial
information / statements are
materially misstated .
 Materiality : Auditor What to do
• If the auditor determines that there is a
material misstatement , he or she will bring
it to the client’s attention so that correction
could be made.
 Materiality : Facts
• Facts
– Accounting and auditing are business
functions relating to the proper recording and
reporting of financial information. Accounting
is the specific function of taking a company's
financial information and presenting to
internal and external users for business and
investment decisions. Auditing is the process
of reviewing the information prepared by
company accountants and ensuring it is in
accord with GAAP, the leading accounting
authority in the United States.
 Materiality : facts

– According to GAAP, accountants are to

use professional judgment when
assessing material errors and how these
errors might influence economic
decisions made by users of the financial
statements.
 Materiality : Types
• Types
– While GAAP is silent on specifically
determining the materiality of financial errors
or misstatements, a few common standards
have developed in the accounting industry
and public accounting practice.
• Types:
– These professional judgments include errors
or misstatements equal to 5 percent of pre-tax
net income or gross profit, 33 percent of total
company assets, 50 percent of total revenues
in an accounting period, 1 percent of total
equity or a blend of consistent errors and
misstatements in the company's financial
statements.
 Materiality : Effects
• Effects
– Material errors or findings usually mean
companies must go back and correct any
previous accounting or financial statements
that may be affected. These corrections may
have devastating effects on companies,
particularly on public companies.
 Materiality: Effects
• Effects
• Corrected financial statements for
previous accounting periods may lead
investors to sell the company's stock or
investment analysts to negatively rate the
company's stock. This leads the company
to lose equity financing, limiting its ability
to grow and expand in the marketplace.
 Materiality: Prevention & Solution

• Prevention/Solution
• Implementing proper accounting policies
or internal controls can help companies
avoid material misstatements in its
financial statements. Employing educated
or professionally licensed accountants can
also help companies improve their overall
accounting process.
Materiality : Prevention/Solution
• Prevention / Solution
• Although these preventive measures can
be time-consuming and expensive to
develop and implement, they usually pay
for themselves by limiting the number of
errors or misstatements found during the
audit process
 Materiality: Expert Insight
• Expert Insight
– Using a public accounting firm to develop
accounting policies and internal controls helps
companies understand current accounting
practices. The accounting industry is well
versed in technical accounting rules and the
changing business environment.
 Materiality: Expert Insight
– Accounting professionals may also be able to
advise companies on the highest risk areas of
their operations and explain the importance of
accounting policies or internal controls for
these operations.
 Materiality: In Summary
• Materiality is a concept or convention within
auditing and accounting relating to the
importance/significance of an amount,
transaction, or discrepancy. 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). The
assessment of what is material is a matter of
professional judgment.
 Materiality : Summary
• "Information is material if its omission or
misstatement could influence the economic
decision of users taken on the basis of the
financial statements. Materiality depends on the
size of the item or error judged in the particular
circumstances of its omission or misstatement.
Thus, materiality provides a threshold or cut-off
point rather than being a primary qualitative
characteristic which information must have if it is
to be useful."
 Materiality: quantitative guidelines

• The Financial Accounting Standards

Board (FASB) has refrained from giving
quantitative guidelines for determining
materiality. This has resulted in confusion
in the use of Auditing Standards No 47,
"Audit Risk and Materiality in Conducting
the Audit". Several common rules that
have appeared in practice and academia
to quantify materiality include:
 Materiality: Quantitative guidelines
• Percentage of pre-tax income or net income
(i.e., 5% of average pre-tax income (using a 3-
year average));
• Percentage of gross profit;
• Percentage of total assets; (i.e.,1/3% of total
assets);
• Percentage of total revenue; (1/2% of total
revenues);
• Percentage of equity; (i.e.,1% of total equity);
Materiality: Quantitative guidelines
• Blended methods involving some or all of
these definitions (e.g., use a mix of the
above and to find an average);
• "Sliding scale" methods which vary with
the size of the entity. (i.e., 5% of gross
profit if between $0 and $20,000; 2% if
between $20,000 and $1,000,000; 1% if
between $1,000,000 and $100,000,000;
1/2% if over $100,000,000)
Materiality:
 What Constitutes Abuse of the
Materiality Concept?
• Abuses of the materiality concept are more likely
to have serious legal consequences in
accounting, than in business case analysis.
• For accountants, GAAP and FASB have resisted
putting precise quantitative value on the size of
misstatement or omission that qualifies as an
error in materiality. Nevertheless, in reaching
judgment on specific cases, auditors and courts
have utilized several "rules of thumb."
 Materiality : Abuse


1. On an income statement, an omission or error
greater than 5% of Profit (before tax), or greater
than 0.5% of sales revenues is more likely to be
considered "large enough to matter."


2. On a balance sheet, a questionable entry
more than 0.3 to 0.5% of total assets or more
than 1% of total equity, is more likely to be
viewed suspiciously.
 Materiality
• The final judgment on a suspected
materiality abuse, however, will also
consider factors besides the magnitude
of the error. Auditors and courts will
also consider 

• Please go to next page

 Materiality : Abuse
1. Motivation and intent behind the error 

If the intent is to keep stock prices

inappropriately high, inflate reported
earnings, or inappropriately influence
merger / acquisition decisions, for
instance, an abuse judgment is more
likely.
 Materiality: Abuse
• 2. The likely effect on user perceptions and
judgment.

• An accounting statement with large indirect

manufacturing labor& expenses misclassified as direct
manufacturing labor might not be seen as materiality
abuse, since both kinds of labor contribute to cost of
goods sold and the gross profit / gross margin result is
the same regardless of which category has the labor in
question.
Materiality: Abuse
 Steps of applying Materiality
• There are 5-steps in applying materiality
Step-1. Set preliminary judgment about
materiality :

Step-2. Allocate preliminary judgment about

materiality to segments
 Steps of applying Materiality

• Step-3. Estimate total misstatement in

segments

• Step-4. Estimate combined misstatement

in segments
• Step-5. Compare combined estimate with
preliminary or revised judgement about
materiality
 Steps of applying Materiality
Step-1. Set preliminary judgment about materiality :
Ideally an Auditor decides early in the audit the combined
amount of misstatement in the financial statements that
would be considered material. SAS 47 defines the
amount as the preliminary judgment about
materiality. This judgment need not be quantified
but often is. It is called preliminary judgment about
materiality because it is a professional judgment and may
change during the engagement if circumstance changes.
 Steps of applying Materiality
• The reason for setting a preliminary
judgment about materiality is to help
the auditor plan the appropriate evidence
to accumulate. If an Auditors sets a low
dollar amount , more evidence is required
than high amount. (Please follow the
example of the text - Page 252)
Steps of applying Materiality
 Audit Risk
• Audit risk (also referred to as residual
risk) refers to acceptable audit risk, i.e. it
indicates the auditor's willingness to
accept that the financial statements may
be materially misstated after the audit is
completed and an unqualified (clean)
opinion was issued. If the auditor decides
to lower audit risk, it means that he wants
to be more certain that the financial
statements are not materially misstated.
 Audit Risk
• In Formula, Audit Risk can be explained
• As follows:

• AR = CR*IR*DR
• where... IR is inherent risk, CR is control
risk and DR , detection risk is the
conditional probability that the auditor
does not detect a material misstatement in
the F/S, given that one exists.
 Audit Risk Model
• The audit risk model expresses the relationships
among the audit risk components as follows:

• AR = IR x CR x DR

• To illustrate the use of the model , assume that

an auditor has made the following risk
assesment for a particular assertion , such as
the completeness assertion for investors :

• go to next page
 Audit Risk
• AR + 5% , IR = 75% , CR = 50%
• Detection Risk ( DR) can be determined as follows:
• AR .05
• DR = ---------------------- = 13%
• IR (.75) x CR (.50)

• A 13% detection Risk means the auditor needs to plan

sustentative test in such a way that there is an
acceptable risk that they will have approximately a 13%
of failing to detect material misstatement. This level of
risk is acceptable if the auditor has assurance from other
sources to support inherent and control risk assesment.