The New Importance of Materiality
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FeatureAUDITING /SARBANES-OXLEY
The New Importance of Materiality
CPAs can use this familiar concept to identify key control exceptions.
BY JAMES BRADY VORHIES
EXECUTIVE SUMMARY
THE SARBANES-OXLEY REQUIREMENT FOR COMPANIES
to develop key control processes has brought new
attention to the well-known concept of materiality. CPAs need
to be able to identify key control exceptions and apply
materiality to determine their financial impact.
MATERIALITY IS BASED ON THE ASSUMPTION
a reasonable investor would not be influenced in
investment decisions by a fluctuation in net income less
than or equal to 5%. This “5% rule” remains the fundamental
basis for working materiality estimates.
WHEN REVIEWING THE MATERIALITY OF FINANCIAL
statement misstatements that are
uncorrected/unrecorded, an error can fall into three
ranges—inconsequential, consequential and material.
Companies must record errors that fall within the material
misstatement range for the independent auditor to give an
unqualified opinion.
COMPANIES SHOULD BASE WORKING MATERIALITY
levels for control deficiencies on PCAOB Auditing
Standard no. 2, which says consequential control
deficiencies must be reported to the registrant’s audit
committee under Sarbanes-Oxley section 302.
ACCOUNTING ESTIMATION PROCESSES GENERALLY
do not result in control deficiencies or
uncorrected/unrecorded misstatements if they are reasonable.
If the estimation process is flawed, broken or unreasonable,
then a related control deficiency exists.
JAMES BRADY VORHIES, CPA, CIA, CISA, is
manager of risk monitoring and Sarbanes-Oxley compliance for a
Fortune 500 company in Dallas. He is the author of
Key Controls: The Solution for Sarbanes-Oxley Internal
Control Compliance. His e-mail address is .
f you think you understand materiality and its uses,
think again. The Sarbanes-Oxley Act of 2002 has put demands on
management to detect and prevent material control weaknesses in a
timely manner. To help management fulfill this responsibility, CPAs
are creating monthly key control processes to assess and report on
risk. When management finds a key control does not meet the required
minimum quality standard, it must classify the result as a key control
exception.
To develop the controls Sarbanes-Oxley requires, CPAs need to be
able to identify key control exceptions. They also must correctly
apply a familiar concept—materiality—to determine the financial impact
of such exceptions. This article explains the four types of key
control exceptions CPAs may encounter as well as how to apply
materiality to evaluate each one.
THE 5% RULE For many years
accountants have used quantitative estimates to help them identify
potentially material transactions and events. Working materiality
levels or quantitative estimates of materiality generally are based on
the 5% rule, which holds that reasonable investors would not be
influenced in their investment decisions by a fluctuation in net
income of 5% or less. Nor would the investor be swayed by a
fluctuation or series of fluctuations of less than 5% in income
statement line items, as long as the net change was less than 5%. This
theory has been and remains the fundamental concept behind working
materiality estimates today.
Materiality is not
a simple calculation. Because the qualitative analysis is
very complex, almost everyone—including CPAs—uses
quantitative estimates to identify potential materiality
Materiality is not a simple calculation. Rather it is a
determination of what will vs. what will not affect the decision of a
knowledgeable investor given a specific set of circumstances related
to the fair presentation of a company’s financial statements and
disclosures concerning existing or future debt and equity instruments.
However, because such a qualitative analysis is very complex, almost
everyone—including CPAs—uses quantitative estimates to identify
potential materiality issues.
But this approach does not provide the entire solution. The summary
to Staff Accounting Bulletin no. 99, Materiality (available
on the SEC Web site at ), said, “This bulletin expresses the views of the staff that
exclusive reliance on certain quantitative benchmarks to assess
materiality in preparing financial statements and performing audits of
the financial stateme misstatements are not
immaterial simply because they fall beneath a numerical threshold.”
The “normal” calculation of the 5% working materiality level takes
an SEC registrant’s pretax net income from continuing operations and
normalizies it by adjusting for unusual events not anticipated in the
current year. CPAs then adjust the estimate for unusual events
expected in the current year and use 5% of the year’s adjusted net
income estimate as the basic working materiality threshold. Errors in
the company’s books and records that are less than this amount are
considered immaterial and do not require financial statement
adjustments to obtain an unqualified audit opinion. Errors equal to or
greater than this amount require adjustments.
THE FOUR PERSPECTIVES
To assist CPAs in helping management meet its
responsibilities under Sarbanes-Oxley, there are four perspectives of
working materiality, each with its own distinct quantitative
calculations and limits. To know which materiality level to apply,
CPAs must determine the type of financial statement effect or
“exception” at hand. The first is familiar to most CPAs—the actual
financial statement misstatement or error. It generally is a dollar
error that can be calculated exactly. The second exception is an
internal control deficiency caused by the failure in design or
operation of a control. The third actually is not
it is a large variance in an accounting estimate compared with the
actual determined amount. The fourth exception is financial fraud by
management or other employees to enhance a company’s reported
financial position and operations results.
Under section 302 of Sarbanes-Oxley, companies must review their
disclosure controls and procedures quarterly, identify all key control
exceptions and
Determine which are internal control deficiencies.
Assess each deficiency’s impact on the fair presentation
of their financial statements.
Identify and report significant control deficiencies or
material weaknesses to the board of directors’ audit committee and to
the company’s independent auditor.
EXCEPTION 1: MISSTATEMENTS OR ERRORS
Many CPAs call actual financial statement
misstatements or errors uncorrected/unrecorded misstatements. Under
the normal financial audit process, auditors accumulate and report
these dollar errors on a similarly named schedule that usually lists
two types of financial statement errors:
Incorrectly recorded financial statement amounts.
These transactions generally were recorded incorrectly
because they were in the wrong amount or the wrong account. The latter
is tantamount to being improperly accounted for in accordance with
Financial statement amounts that should have been recorded
but were not. In almost all cases CPAs can calculate
uncorrected/unrecorded misstatements to an exact dollar amount. If the
error is based on a needed adjustment that was estimated, then
generally it resulted from an internal control weakness or a control
deficiency. The normal materiality evaluation process is to review
each item individually and then all items in the aggregate based on
the working materiality levels for each company to determine whether
to adjust the financial statements.
Generally, the solution to uncorrected/unrecorded misstatements is
very easy—management simply adjusts the financial statements. However,
when these errors are discovered and whether the company can determine
the correct accounting in a timely manner affect its ability to record
these entries for the correct reporting period.
In determining working materiality levels for uncorrected/unrecorded
misstatements, there are several generally used methods. Each is based
on the 5% rule as a calculated percentage of that materiality limit.
Any uncorrected/unrecorded misstatement that approaches 5% would, in
theory, cause a “material misstatement” in the company’s financial
statements. CPAs must undertake appropriate qualitative analysis to
determine whether a material misstatement actually occurred. If so,
the solu management only needs to appropriately
record the uncorrected/unrecorded misstatement for the financial
statements to be considered fairly stated in all material respects.
In reviewing the materiality of uncorrected/unrecorded
misstatements, errors can fall in one of three ranges—inconsequential,
consequential or material misstatements. Very small
uncorrected/unrecorded misstatements have no consequence on the
financial statements and need not be identified or considered. This is
based on the theory there are only a small number of these items. CPAs
should accumulate a large number of like errors and consider them as a
single error. Items that are singularly or in the aggregate small
enough that they don’t need to be reported on the schedule of
uncorrected/unrecorded misstatements may be “inconsequential” from a
materiality perspective. As a general practice management should
attempt to limit these mistakes and search for and record identified
Since a company’s independent auditor usually accumulates
uncorrected/unrecorded misstatements and presents them to management
and the audit committee quarterly, these misstatements become
consequential when the auditor includes them on this schedule and
reports them to the committee. Having these errors and not adjusting
the financial statement means the statements are misstated by the
amount of the errors.
An error or aggregation of errors that reaches the 5% rule is a
“material misstatement” of the financial statements and must be
recorded in order for the independent auditor to give an unqualified
audit opinion. CPAs usually record these amounts and many smaller
consequential ones to adjust the financial statements and eliminate
uncorrected/unrecorded misstatements.
EXCEPTION 2: INTERNAL CONTROL DEFICIENCIES The
second perspective on working materiality levels, an internal control
deficiency caused by the failure of a control, is required by sections
302 and 404. PCAOB Auditing Standard no. 2, An Audit of Internal
Control Over Financial Reporting Performed in Conjunction With an
Audit of Financial Statements, defines the materiality levels
SEC registrants should use to determine the materiality of control
deficiencies.
Any internal control failure could be a control deficiency. Such
deficiencies usually are the result of a failure in control design or
operation. A design failure results when management has not
established a sufficient amount of internal control or control
activities to achieve an operation failure occurs
when an adequately designed control does not operate properly.
According to Auditing Standard no. 2, such failures can be significant
deficiencies or material weaknesses if they result in a large enough
impact on the financial statements.
CPAs should recommend companies base working materiality levels for
control deficiencies on Standard no. 2, resulting in a three-part
materiality range. Control deficiencies are considered consequential
if they would result in “more than a remote likelihood that a
misstatement of the company’s annual or interim financial statements
that is more than inconsequential will not be prevented or detected.”
Inconsequential control deficiencies obviously fall short of the
consequential range, but consequential control deficiencies must be
reported to the registrant’s audit committee under Sarbanes-Oxley
section 302 paragraph 5(a).
When a significant deficiency causes a material misstatement—as
defined again by the 5% rule—it becomes a material weakness. According
to the PCAOB definition, “a material weakness is a significant
deficiency or combination of significant deficiencies that result in
more than a remote likelihood that a material misstatement of the
annual or interim financial statements will not be prevented or
detected.”
The working materiality ranges for both uncorrected/unrecorded
misstatements and for control deficiencies thus range from
inconsequential to consequential to material misstatements. However,
the actual materiality levels for the ranges are different. What is
material and considered a material misstatement or material weakness
based on the 5% rule calculation is, of course, the same.
Uncorrected/unrecorded misstatements generally are related to
control deficiencies. Whenever such a misstatement exists, CPAs must
ask whether the actual dollar misstatement is the result of a control
deficiency. However, the amount of the uncorrected/unrecorded
misstatement is not necessarily the amount of the deficiency. For
example, a trader may fail to record a trade and the error may go
unnoticed for several reporting periods. While the amount of the
uncorrected/unrecorded misstatement is exactly the amount of the
unrecorded trade, the control deficiency is based on the dollar volume
of trades that could have gone unrecorded before such an error was
found, based on the mitigating controls that eventually would have
discovered and prevented such mistakes. This emphasizes the importance
of designing adequate mitigating controls in a company’s overall
internal control plan. Any time a key control fails, management must
have effective mitigating controls that will prevent the resulting
potential financial statement error from becoming material.
CPAs must understand that control deficiencies can exist whenever
there is an internal control failure or design deficiency—whether or
not an actual financial statement misstatement occurred. The
materiality of the control deficiency must be determined based on the
potential financial statement misstatement that could have occurred,
regardless of whether one actually happened and irrespective of the
dollar error of any actual financial statement mistake.
Quantitative factors play a large role in determining the potential
misstatement that could have resulted from an existing control
deficiency. The PCAOB focused specifically on the likelihood of a
misstatement occurring. For example, an employee may have committed a
fraud by overriding an internal control and stealing an actual dollar
amount. This amount would be the uncorrected/unrecorded misstatement.
However, the control deficiency amount is based on how much could
have been stolen because of the internal control weaknesses
weighted by the likelihood of someone stealing this amount.
EXCEPTION 3: ACCOUNTING ESTIMATES
The third perspective on working materiality levels
concerns variances from original estimates. Because estimation
processes are evaluated based on their adequacy, an accounting
estimation generally would not result in a control deficiency or an
uncorrected/unrecorded misstatement if it was reasonable given
The available technology.
The process was “normal” for the industry.
The company’s independent auditor reviewed and approved
Estimating financial events and balances is a necessary evil, given
management’s need to report on the income and state of assets at
artificial points in time. As long as the estimation process is
reasonable, CPAs can’t conclude a control deficiency exists when the
actual amount is compared with the estimate, regardless of how large
the variance given that a better estimate was not possible.
If the estimation process is flawed, broken or unreasonable, a
control deficiency exists. An uncorrected/unrecorded misstatement also
may exist—the difference between the estimate calculated and recorded
in error vs. what the correct estimate should have been.
EXCEPTION 4: FRAUD
The fourth perspective on working materiality is
financial fraud. Section 303(a), “Improper Influence on Conduct of
Audits,” says it is unlawful for any officer or director of an issuer,
or any other person acting under their direction, to “take any action
to fraudulently influence, coerce, manipulate, or mislead any
independent public or certified accountant engaged in the performance
of an audit of the financial statements of that issuer for the purpose
of rendering such financial statements materially misleading.”
Section 303(a) concerns fraud performed for the company by
management or employees who intended to materially misrepresent the
entity’s financial position and results of operations. How much of a
misrepresentation is required to be material? The answer is twofold.
Fraud generally is not limited by amount but rather by intent. In
other words, if the intent was to defraud someone by $1 or by $1
million it’s still fraud. It’s not the amount that makes it fraud. As
Staff Accounting Bulletin no. 99 explains, a material
misrepresentation is not tied to the amount of the misrepresentation
but rather occurs whenever there was intent to misrepresent the
registrant’s financial position and results of operations and such a
misrepresentation occurred. Therefore, if somebody makes a $10,000
entry giving a company the one cent it needs to meet its earnings
target and the entry was not based on GAAP but rather on management’s
need to meet this target, the entry was a material misrepresentation.
This explains why management’s intent always should be to fairly
present in all material respects the results of operations and
condition of assets when recording any accounting entries into the
company’s books and records.
A fraud on the part of an employee(s) or management that is
against the company follows the normal
uncorrected/unrecorded misstatements and control deficiency
materiality rules and levels. A fraud by management or employee(s)
that is for the company falls under section 303(a).
For example, any fraud where employees attempt to help the company
by artificially enhancing earnings for financial position would be a
fraud for the company. On the other hand a fraud where someone
attempts to harm the company by misusing or misappropriating its
assets for their own benefit would be against the company.
MINIMIZING EXCEPTIONS
CPAs must understand each of the four perspectives of
materiality to be able to estimate the effect of key control
exceptions on an SEC registrant’s fair presentation of its financial
statements in compliance with sections 302 and 404. But it’s equally
important to develop an ongoing key control risk reporting process
that ensures the timely identification of these issues. The right
processes will minimize key control exceptions and meet every
accountant’s goal of providing fair and complete financial
information.
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As you weather the dog days of summer, it’s a good time to make sure your cybersecurity structure can stand up to the heat of external and internal threats. Here are six steps to help shore up your systems.
From The Tax Adviser
From CGMA Magazine
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Be the first to know when the JofA publishes breaking news about tax, financial reporting, auditing, or other topics. Select to receive all alerts or just ones for the topic(s) that interest you most.
This quick guide walks you through the process of adding the Journal of Accountancy as a favorite news source in the News app from Apple.UN ‘leaders’ as corrupt as US/UK/Israel: We the People must demand arrests or suffer endless war
UN ‘leaders’ as corrupt as US/UK/Israel: We the People must demand arrests or suffer endless war Posted on
by United Nations Secretary-General Ban Ki-moon’s
about Israel’s most recent armed attack upon Gaza are Orwellian lies of omission because they fail to uphold the one and only legal authority of the UN: to stop Wars of Aggression.Allowing “developed nations” to have unlawful wars is . A recent example is Secretary-General Kofi Annan’s silence for 18 months in official statements over the US/UK’s armed attacks and invasion of Iraq, to finally admit in 2004 :“Yes, if you wish. I have indicated it was not in conformity with the UN Charter. From our point of view and from the Charter point of view it was illegal.”Please note Anan’s timidity of language, failure to act as Chief Administrator in his only area of legal authority, and pretense that clear violation of law is somehow a “point of view” rather than obvious assertion of objective facts. One of the only insights we have of government assessment of Iraq war illegality is the
that disclosed in public testimony in 2010:All the lawyers in the UK’s Foreign Affairs Department concluded the US/UK invasion of Iraq was an unlawful War of Aggression. Their expert advice is the most qualified to make that . This powerful judgment of unlawful war followed the . The
by government illegal unless in response to attack by another nation’s government.In the , this is not even close to lawful. For the UN Secretary-General to be silent rather than uphold UN treaty law in his one and only area of job responsibility is a game-changing revelation that sometime soon will become -obvious evidence of UN “leaders’” criminal conspiracy for Wars of A the Orwellian opposite of its stated purpose.The United Nations is the creation of the winners for the Second World War of Colonial Empire (WW2). This followed
to steal as much of the world as possible.The UN, therefore, was never intended as an instrument for “world peace” by imperialistic nations, but to protect empire with empty rhetoric of “peace.” The
is a powerful tool for We the People to demand arrests of US/UK/Israel “leaders” who commit obvious War Crimes for unlawful and lie-began Wars of Aggression. And that said, official statements of UN Secretary-General Ban Ki-moon minces around
without any apparent interest in upholding UN law. Examples: Israel bombed a UN-protected refugee facility in Gaza after 33 warnings to Israel of its exact location without call to arrest those responsible ( from any power to continue that criminal activity). He also blames “Hamas” without evidence that they launch anything toward Israel. In fact, such reports could be a continuation of
as likely as desperate Palestinians starving under Israel’s unlawful military siege.Ki-moon , but fails to state Israel’s destruction of power and water are War Crimes.He describes , but takes zero action to state the
fact that these unlawful acts of war demand immediate arrests of Israeli government leaders for OBVIOUS War Crimes.Therefore and obviously, the UN Secretary-General is not doing his job of stopping unlawful Wars of Aggression, but shedding
in pretense of caring about somebody else somewhere, somehow doing the job he’s sworn to do.Our world of the present under US/UK/Israel Wars of Aggression with UN criminal complicity is the same as described powerfully from a victim of :It is no use trying to escape their arrogance by submission or good behavior. Robbers of the world, having by universal plunder exhausted the land, their drive is greed. If the enemy be rich, if poor, they lust for domination. Neither rule of the East nor West satisfies them. Alone among men, they crave with equal eagerness poverty and riches. To plunder, slaughter, seize with false pretenses, they give the lying name ‘empire.’ And where nothing remains but a desert, they call that ‘peace.’
– Tacitus, The Agricola and the GermaniaToday’s United Nations will uphold peace just as well as the ancient Roman Senate. This will continue until US/UK/Israel/UN “leaders” are arrested for
(among many categories of crime) centering in war and .Citizen: Are you
for US/UK/Israel wars covered by UN Orwellian rhetoric, or must you have more suffering and death? If you , for whatever strategic reason, what is your better idea???And please remember your role as a guest on E do what you can in peace (, ) ?&
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