If you are a local auditee, you may have heard the term materiality used by the CPA who performs your audit.
- "The purpose of the audit is to determine whether the financial statements are materially correct."
- "These are some material adjustments that I believe you need to make to the financial statements."
- "I found an error, but it is not material to the financial statements."
Materiality is a dollar threshold that an auditor calculates in order to help him or her determine the quantitative and qualitative aspects of errors or findings that would cause an agency’s financial statements to be misstated or incorrect to such an extent that they would be misleading.
If material mistakes in financial statements are not corrected, the CPA is required to modify or add qualifying language to the auditor’s opinion, or the accountant’s review or compilation report.
The concept of materiality is referenced in the third paragraph of the standard auditor’s opinion:
Our (the CPA’s) responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.
Similar language regarding materiality of financial statements is included in an accountant’s review report.
A CPA calculates a materiality threshold (or materiality thresholds, for various components of the financial statements) during the planning and performance of the audit. The materiality threshold is based on a formula that the CPA feels is appropriate for the audit.
Quantitative and qualitative factors go into the calculation of materiality. Problems observed by the auditor in his or her tests of transaction types that may not necessarily be of a high dollar amount (such as travel expenditures) may indicate overall problems in the way that a local auditee’s management is administering the public funds it receives; and may require that the auditor expand his or her procedures (in other words, perform more tests) to determine whether there are problems in the agency’s other processes.
The materiality threshold is one of the tools that the CPA uses to:
- Determine which of the local auditee’s processes and transactions to test
- Determine whether the exceptions noted in the processes and transactions tested will trigger findings that will be included in the audit report
- Assess and evaluate the changes in account balances between years
- Determine whether uncorrected errors in the financial statements or the notes to the financial statements are significant enough to warrant an opinion modification
The calculation of materiality is the judgment of the auditor, and may vary from auditor to auditor, and from engagement to engagement. It also may change as the engagement progresses.
The dollar threshold of materiality is not something an auditor usually shares with the agency he or she is auditing.
- Why wouldn’t a CPA share the materiality threshold with the auditee? Why is it such a big secret?
- The CPA firm that is performing my agency’s audit is proposing an adjustment to the financial statements that I don’t think is material. Can I use this as support for not making the adjustment?
- The CPA firm performing my agency’s audit shared his materiality threshold with me. He proposed that we disclose a related party transaction in the notes to the financial statements. The amount of the transaction is below the materiality threshold. I don’t want to make the adjustment, but the CPA said he will need to modify his opinion if I don’t. Is he correct?
- Since the materiality threshold is subjective, wouldn’t that also make it a flawed measurement?