MATERIALITY: WHOSE BUSINESS IS IT?

Implications: Elaboration on the materiality protocol auditors of financial statements employ. 

Analysis: Most analysts and other users of financial statements understand that financial statements are based on compilations of thousands, millions and even billions of transactions. They also understand that many estimates are used in preparation of these statements (For example: provisions for bad debts, effective tax rates and future interest rates). But are these users aware that preparers and auditors of financial statements also employ a materiality protocol in their work?

Two articles which have appeared in the Wall Street Journal recently have mentioned what one described as “the widely accepted practice” of determining materiality quantitatively as being “5% of a company’s net income for the relevant period.” These articles incorrectly suggested that any error or aggregate of errors of a lesser amount than 5% is disregarded by both management and auditors in determining whether to make a correction.

Materiality decisions by auditors were never intended to be rote determinations utilizing a single milestone integer. The decision whether an error or accumulation of errors was material had always involved judgment, including not only the quantitative amount but its relation to potentially several metrics in financial statements. In addition, the nature of the error and even the intent of the maker of the error were to be considered (if the error was intentionally caused).

While 5% is a customary level of acceptable error for a company having a normal risk profile, auditors typically draw a finer line (3%) when dealing with high risk clients and may exceed 5% when dealing with a low risk client. Thus users of financial statements should be aware that those statements may contain some level of acceptable error.

Some managements have abused this protocol and convinced auditors to accept a strictly numerical measurement which was just under the so-called “5% standard”. Some have refused to accept auditor correcting entries (and the auditor still issued an unqualified opinion). Others have made deliberate small errors, which created numerical and ratio distortions, knowing that these would fly under auditor’s quantitative materiality radar.

Financial statement users should be aware of the materiality protocol and its potential abuses. More on this subject can be found in the SEC’s Staff Accounting Bulletin #99 and in a forthcoming article I have written which will be published in the August issue of The CPA Journal.