Materiality, in accounting and financial reporting, is the threshold at which an item left out of a financial report, or reported wrongly, would change what a reasonable person relying on that report concludes from it. 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 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 (FASB, Concepts Statement No. 8, Chapter 3, Qualitative Characteristics of Useful Financial Information, QC11). Materiality is entity specific, so one dollar amount can be material in one entity’s report and immaterial in another’s.
Materiality Is Not a Percentage
Nothing in that concepts statement turns the materiality judgment into arithmetic. A decision not to disclose certain information or recognize an economic phenomenon may be made because the amounts involved are too small to make a difference to an investor or other decision maker, but magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, generally is not a sufficient basis for a materiality judgment (FASB, Concepts Statement No. 8, QC11A).
The reason is stated plainly. No general standards of materiality could be formulated to take into account all the considerations that enter into judgments made by an experienced, reasonable provider of financial information, because materiality judgments can properly be made only by those that understand the reporting entity’s pertinent facts and circumstances (FASB, Concepts Statement No. 8, QC11B).
The SEC staff put the same limit on benchmarks for registrants. Exclusive reliance on certain quantitative benchmarks to assess materiality in preparing financial statements and performing audits of those financial statements is inappropriate, and misstatements are not immaterial simply because they fall beneath a numerical threshold (SEC Staff Accounting Bulletin No. 99, Materiality).
The Same Amount Against Two Benchmarks
Say a client’s year closes on the figures below, and one unrecorded expense is measured against two benchmarks taken from the same income statement.
Pretax income 400,000
Revenue 12,000,000
Unrecorded expense 20,000
Against pretax income 20,000 / 400,000 = 5.0%
Against revenue 20,000 / 12,000,000 = 0.17%One amount, two readings, and neither percentage settles the question by itself. What the item is, and the circumstances the judgment is made in, still carry the decision.
What Materiality Is Confused With
The word is used for more than one thing. Sustainability reporting in particular runs its own materiality assessment, which is a separate question from the financial reporting threshold. Two closer confusions are worth pulling apart.
The Auditor’s Materiality
The preparer’s threshold and the auditor’s amounts are different things. Materiality as financial reporting defines it governs what the entity reports, while the auditor separately determines and documents planning amounts to assess risk and scope procedures, and those amounts, including performance materiality and the benchmark and percentage behind them, are worked through in materiality in auditing. Audits of SEC issuers run on a further rulebook, where the test is stated through the reasonable investor and the total mix of information made available (PCAOB, AS 2105, Consideration of Materiality in Planning and Performing an Audit, .02).
The International Definition
The US definition and the international one no longer match, though both were identical when first issued. FASB records that the discussion of materiality as amended is no longer identical to the definition in the International Accounting Standards Board’s Conceptual Framework for Financial Reporting, and that convergence is not possible because the IASB’s definitions of materiality are not consistent with the definition used in the United States and because the IASB is working to further amend its definitions of materiality (FASB, Concepts Statement No. 8, BC3.18D). A definition lifted from the international framework and quoted for a US financial report names the wrong standard setter. Which framework a set of statements is prepared under in the first place is a separate question, worked through in GAAP vs IFRS.
Common Questions
The accounting meaning and the one US federal securities law runs on are in substance the same. The definition FASB carried into its framework comes from Concepts Statement 2, and SEC Staff Accounting Bulletin No. 99 notes that this definition is in substance identical to the definition of the U.S. Supreme Court, which in turn makes the framework’s definition in substance identical to the definition in the auditing standards of the AICPA and the PCAOB (FASB, Concepts Statement No. 8, BC3.18B).
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