Materiality - What Is It Good For?

No, the answer is not “absolutely nothing.” Materiality is something that we come across in our everyday lives whether we recognize it or not. For example, if the speed limit is 65 miles an hour, and you are driving 66 miles an hour, would you be surprised if you were pulled over and issued a citation? Probably so. You might argue that you were not “materially” exceeding the speed limit, right?

What is Materiality?

So what is “material”? To answer this question, I will defer to the answer that single-handedly got me through my college tax class: “It depends.” There are many fancy definitions of materiality out there; however, I like to sum it up with one question:  Had you known about it, would your opinion have changed?

Materiality is in the eye of the beholder. Size does matter; however, in the end it is a judgmental assessment that we make, and hopefully we have factored in many different qualitative and quantitative inputs. Our assessment of materiality is the basis for our answer to this fundamental question:  “Do I care?” In other words, I suspect or know that something is omitted or misstated. Will it make a difference if I spend additional time to verify or correct it?

The answer to this question will vary significantly based on perspective. For example, let’s say that inventory is “off” by $1,950, meaning I run the detailed reports, and when I add them up they differ from the trial balance total by that amount. From an auditor’s perspective, if this is a large company, we could potentially “pass” on that difference, meaning that we would not investigate it any further.

Now, what if you were the employee responsible for balancing the inventory reports at your company? To that person, the $1,950 would probably be considered material.

How about outside investors? They see inventory of $500,000 on the financial statements. If someone told them that this amount was off by $1,950, would they care? In other words, would their decision to invest change based on this difference? Again, likely not.

What if the reason for the $1,950 was related to fraud? Fraud is the one instance in which materiality does not apply. We take the position that fraud of $1 is material. Fraud is fraud, and if you allow “immaterial” fraud, you are opening the door to material fraud.

Another factor that may impact our materiality assessment is context. For example, if we are estimating something (an allowance for doubtful accounts, inventory obsolescence reserve, etc.), it would be more “acceptable” to come materially close to the exact number than, say, depreciation, which is a simple calculation. With a simple calculation like straight-line depreciation, there is really no excuse to be “close enough.”

Calculating and Using Materiality

So how do auditors calculate and use materiality? Well, I cannot disclose all of our secrets, but there are some standard practices in the auditing world that all auditors adhere to. When auditors calculate materiality for our audit, we take into account the users of the financial statements:  investors, bankers, owners, etc. As mentioned before, we try to incorporate not only financial data, but also qualitative data (debt covenants, intended use of the financials, etc.).

Our audit procedures are then designed based on this premise of materiality. If Company A goes through its annual audit and comes away with an unmodified opinion and no adjusting journal entries, that doesn’t necessarily mean Company A is perfect.

There could have been some immaterial variances that the auditor simply “passed” on correcting. Depending on the size of the “passed adjustments,” they may be required to be communicated to management. Auditors look at these adjustments on a cumulative basis, so at the end of the audit they will be analyzed in the aggregate in order to make the final assessment that they are still considered immaterial.

Another area where materiality comes into play is in the footnotes to the financial statements. Many of these footnotes are descriptions or narratives, and if our materiality assessment is purely quantitative, how do we determine whether a footnote itself is material? This is when you have to go back to the question at the beginning of this article. Had you known about it, would your opinion have changed?

Furthermore, we could have a footnote that has significant qualitative data—for example, a situation in which we have a client that has violated debt covenants. This disclosure itself may only be a few sentences among 20+ pages of numbers, but it could be a real deal breaker. That, by definition, makes it material.

In other words, if a company had decided to entirely close a large geographic region that accounted for a large portion of its revenue, this is something that should definitely be disclosed in the notes to the financial statements.

On the other hand, if a large company is deciding whether or not to disclose the fact that they had $1,950 in advertising costs, which is technically required by GAAP, they might argue that the presence of this note does not add any value to the decision-making process of a reader.

Conclusion

Materiality can be your friend or foe. While you can use it to your favor to gain efficiencies and streamline your financial reporting, you don’t want to abuse it or use it to intentionally mislead users of the financial statements. Remember, with great power comes great responsibility.