What Makes an Audit Issue “Material”?

One of the most important terms in financial auditing may get a redefinition — or at least a clarification. The AICPA’s Auditing Standards Board (ASB) has been discussing whether to amend its definition of the term “materiality,” and the board plans to vote on an exposure draft in May.

Note that the Financial Accounting Standards Board (FASB) considered redefining materiality back in November 2017, but dropped the project without making changes.)

Different authorities, different answers

Currently, under U.S. generally accepted auditing standards (GAAS), misstatements and omissions are considered material if they, individually or together, could “reasonably be expected to influence the economic decisions of users made on the basis of the financial statements.”

The ASB decided in January to revise its definition of materiality in order to reduce inconsistencies among various authorities in the U.S. Currently, there are subtle differences among definitions from the AICPA, the U.S. Supreme Court, the Securities and Exchange Commission (SEC), the FASB and the Public Company Accounting Oversight Board (PCAOB).

FASB: Is it “probable” the information would affect a judgment?

While the ASB reconsiders what makes an item material, the FASB has decided to return to the definition it used from 1980 to 2010. Since August 2018, this is its definition: “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.”

This definition no longer syncs with the International Accounting Standards Board’s definition — or the GAAS definition.

If GAAS were changed to use the FASB’s language, it would read: “Misstatements, including omissions, are considered to be material if, in light of surrounding circumstances, it is probable [emphasis added] that the judgment of a reasonable person relying on the financial statements would be influenced or changed by the misstatements, individually or in the aggregate.”

PCAOB: Is there a “substantial likelihood” the data would influence a judgment?

On the other hand, PCAOB Auditing Standard (AS) 2105, Consideration of Materiality in Planning and Performing an Audit, doesn’t define materiality. Instead, it describes materiality by quoting a Supreme Court decision in TSC Industries v. Northway, Inc. That opinion concludes, “In interpreting the federal securities laws, the Supreme Court of the United States has held that a fact is material if there is ‘a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.’ ”

The AS 2105 states that “the auditor should evaluate whether, in light of the surrounding circumstances, there are particular accounts or disclosures for which there is a substantial likelihood that misstatements of lesser amounts than the materiality level established for the financial statements as a whole would influence the judgment of a reasonable investor. If so, the auditor should establish separate materiality levels for those accounts for disclosures.”

If the AICPA changes its definition to use PCAOB wording, the GAAS would read: “Misstatements, including omissions, are considered to be material if there is substantial likelihood [emphasis added] that, individually or in the aggregate, they would influence the judgment of a reasonable user made on the basis of the financial statements.”

Among other things, the ASB must decide whether the definition of materiality under GAAS should use language from FASB or from PCAOB. The ASB task force has recommended the PCAOB’s language because it comes closest to the Supreme Court wording. Moreover, it will eliminate differences between audits of public and private companies.

Still no hard-and-fast rules

Materiality will remain one of the gray areas in financial reporting. No matter how various auditing standards define it, there are no bright line rules. Instead, auditors must rely on their professional judgment to determine what’s material for each company, based on its size, industry, internal controls, financial performance and other factors.

Looking for more clarity? To discuss how Weaver might determine an appropriate materiality threshold for your next audit, contact us.

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