Wednesday, July 14, 2010

The Ever Elusive Materiality

Just what is materiality and why is it so elusive? It is somewhat like pass interference; difficult to describe, but I know it when I see it. Materiality is elusive partly because it requires the use of professional judgment to determine it. Your professional judgment is not always the same as mine, so is my determination of materiality better than yours; certainly not. When using your professional judgment in determining materiality, the number you arrive at will depend upon which variables you choose when making your estimate. Materiality is measured in several different ways, such as:

· in relation to something else (financial statements, account balance, compliance requirement)
· by size or as a percentage of something
· a threshold or cutoff point

Also materiality is not a constant. It changes from one entity to another or from one year to another. So how do the standard setting bodies define materiality? Here are the definitions from the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC) and the International Accounting Standards Board (IASB):

FASB – US GAAP – “…the magnitude of an omission or misstatement of accounting information that, in 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.”

SEC – uses the same information the courts do in interpreting the federal securities laws. The Supreme Court 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.”

IASB – International GAAP – “Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cutoff point rather than being a primary qualitative characteristic which information must have if it is to be useful.”

Based on these definitions then can we say that materiality is calculated by applying multiple variables to unknown conditions to arrive at the magical number; “materiality?” Well at least it is a logical approach to determining this threshold or cut off point but after all isn’t the most important part of this equation your professional judgment? What do you think?

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