January marks the start of audit season for calendar-year entities. One important concept that business owners should understand before their audits start is materiality. It’s used to determine what’s important enough to be included in the financial statements — and what can be omitted. It may also affect the nature, timing and extent of audit procedures. Here’s how materiality is determined and used during external audits.
What’s materiality?
The Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA) voted in 2019 to align the definition of materiality in the auditing standards with the definition used in financial reporting under U.S. Generally Accepted Accounting Principles (GAAP).
The current definition of materiality is: “The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable [emphasis added] that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”
Under the current rules, there are no longer inconsistencies between the AICPA standards and the definition of materiality used by the U.S. judicial system and other U.S. standard-setters and regulators. This definition was also the original definition in effect from 1980 until 2010.
However, the move to align the definitions in the United States has created inconsistencies with the international interpretation of this concept. According to the definition set by the International Accounting Standards Board, misstatements and omissions are considered material if they, individually or in the aggregate, could “reasonably [emphasis added] be expected to influence the economic decisions of users made on the basis of the financial statements.”
How do auditors set the materiality threshold?
No prescribed materiality threshold applies to all entities. Rather, the AICPA instructs auditors to rely on their professional judgment to determine what’s material for each company based on such factors as:
- Size,
- Industry,
- Internal controls, and
- Financial performance.
During fieldwork, auditors may ask about line items on the financial statements that have changed materially from the prior year. A “materiality” rule of thumb for small businesses might be to inquire about items that change by more than, say, 10% or $10,000. For example, if marketing expenses or labor costs increased by 25% in 2024, it may raise a red flag, especially if the increase didn’t correlate with an increase in revenue. Businesses should be ready to explain why the cost went up and provide supporting documents (such as invoices) for auditors to review.
However, auditors may consider certain transactions or events to be material despite being relatively small in monetary value. Examples include related-party transactions, loan covenant violations, or misstatements that impact contractual obligations or regulatory compliance.
When CPAs attest to subject matters that can’t be measured — such as sustainability programs, employee education initiatives or fair labor practices — establishing what’s material is less clear. As nonfinancial matters become increasingly important, it’s critical to understand what information will most significantly impact stakeholders’ decision-making process. In this context, “stakeholders” could refer to more than just investors. It also could mean customers, employees, suppliers and communities — many groups to consider when determining materiality.
How does materiality impact audit procedures?
The materiality threshold affects more than audit planning and the audit opinion. It also guides the audit’s scope and procedures. Auditors typically apply more robust procedures in areas with a high risk of material misstatement. For example, high-risk accounts may call for detailed testing, while low-risk accounts may be verified using analytical reviews.
Materiality also guides the sample size auditors use for testing transactions and balances. In high-risk areas, where material misstatements are more probable, auditors may choose larger sample sizes to increase the accuracy of their testing. Smaller samples may be used in low-risk areas with less likelihood of material misstatements.
If misstatements are discovered during fieldwork, auditors apply the materiality threshold to assess whether to adjust the financial statements. If management refuses to make an adjusting journal entry to correct a misstatement, the auditor may issue a qualified or adverse opinion.
Cornerstone of financial statement audits
Materiality helps auditors focus on areas most likely to impact financial statement users’ decisions. Applying this concept throughout an audit balances thoroughness with practicality, thereby enhancing the audit’s effectiveness and efficiency. Likewise, a solid understanding of this concept helps business owners and external stakeholders appreciate the rigor involved in financial audits. Contact your CPA to discuss the appropriate materiality threshold for your company.
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