Materiality in Auditing: Concepts, Standards, and Practice

Introduction to Materiality in Auditing

With respect to the field of auditing, materiality is a critically important concept addressing the significance of discrepancies, amounts, and transactions. Specific materiality guidelines are required in accounting practices to avoid judgmental (legal) decisions. Materiality is applied in most, if not all, economic decisions, and it is by no means a new issue. Disclosures regarding financial statements have been emphasized by courts in the United Kingdom since the 1800s, while materiality first rose to prominence in the United States following the Securities Act of 1933. The significance of the materiality concept and its implications are pertinent to business decisions, as well as to the analysis and preparation of financial statements and the application of generally accepted accounting principles (GAAP).

For the accounting field, as well as for all areas of management, the concept of materiality is central to decision making. If something is considered immaterial — such as certain events, transactions, or specific items — it does not have to be separately reported in financial statements. This means that anything deemed immaterial is not accessible in the financial statements to creditors or investors. For this reason, stakeholders are often particularly interested in "non-mandatory" information, since these data are not required to be made available yet may be of considerable significance. Indeed, investors are more likely to focus on non-mandatory information than mandatory information in many cases (Juma'h, 2009).

Defining Materiality: Regulatory and Standard-Setting Perspectives

The materiality concept has been addressed by the International Accounting Standards Committee (IASC), as well as by accounting bodies in the United States such as the American Institute of Certified Public Accountants (AICPA), the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), and the General Accounting Office (GAO). Materiality was defined by FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information (Para. 132, 1980), as follows:

"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" (Juma'h, 2009).

Classification and Application of Materiality

What a company releases or discloses on the face of its financial statements is a decision involving limitations on the amount or extent of information to be disclosed; this also applies to accompanying notes. A comprehensive inclusion of all economic events affecting a particular business would result in an enormous volume of unnecessary material that is likely to present a misleading impression of the company to the stakeholders reading the financial statements. At the same time, the professional accountant is aware that the choice of an inadequate presentation method for economic information, or failure to fully disclose certain economically significant events, might mislead financial statement users. An obvious point is that the materiality purview of stakeholders and users of financial statements is potentially distinct from that of accountants (Juma'h, 2009).

When materiality guidance is discussed, specific language addresses implied likelihood — the extent to which information might influence the judgment of a "reasonable person" — using terms such as probable, likely to influence, reasonably influence, possible, extremely unlikely, and remote (Price and Wallace, 2001, 2002). In considering the materiality of an event, an accountant's judgment is of critical importance. When an accountant weighs these factors, both qualitative and quantitative measurements must take into account the aggregate base, type, and circumstances of the matter at hand (Juma'h, 2009).

Relevance of Materiality to Professional Accounting Practice

Precisely what will be disclosed in a financial statement is determined by materiality; consequently, the judgments exercised concerning materiality determine the content of financial statements. Materiality becomes relevant when evaluating whether financial statements are in compliance with general accounting principles and are fairly presented, as well as during the design and planning of auditing protocols. The act of auditing involves assessing and detecting misstatements at an acceptable level, which is accomplished by testing sample items or transactions. The chosen materiality level determines the extent of testing in auditory application (Brennan & Gray, 2005).

The materiality level to be used in auditing and presenting financial statements is selected at the start of the annual reporting cycle for financial audits. Auditors and company management select the materiality level independently, with upper management generally making the primary decision. Ideally, the materiality decision by management is independent of the materiality choice made by auditors; this management-determined level is then used to prepare the financial statements. Some have argued that the precise order of this process is important in order to avoid "materiality shopping," whereby management attempts to determine how far it can go regarding transparency in materiality reporting. After management has prepared the statements in accordance with its selected materiality level, the auditors then apply the organization's chosen position to their audits. The central principle is that an organization's position on materiality must be decided by management rather than by the auditor or auditors.

In Ireland and the United Kingdom, ISA 700 has recently been revised, and auditors must now report the manner in which the materiality concept was applied during an audit, as well as the potential effects on the scope of the audit. This revision allows audit committees and stakeholders to interact directly with respect to materiality (Financial Reporting Council, 2013).

Conclusion

Both generic and accounting materiality share the property of flexibility, which is fundamental to the ability of professional accountants to reshape the concept as needed through a professional lens. This alignment may coincide with the necessity to respond to or meet professional challenges, whether they originate internally or are imposed externally — perhaps from actual or symbolic legal impetus. The professional accountant must at all times seek to balance economic viability (practical utility) with uncertainty in the auditing process, and must exercise sound judgment in addressing professional challenges, objectives, and priorities.

The capitalist ethos is the fundamental foundation of the materiality concept — one that is legalistic and inherently qualitative, yet bound to the accountant's professional objectives. These frameworks powerfully impact systems of control and organizational behavior, yet originate from perceptions of materiality that are both historically derived and informed by interdisciplinary studies. From within the habitus of the professional accountant, the full scope of materiality may remain elusive unless it is more thoroughly explored as a still-developing field of inquiry. Attempts to move beyond the bounds of the present materiality construct may provide further direction for empirical studies of materiality and its impact upon the living center of the professional habitus (Edgley, n.d.).