Materiality: Whose Business Is It?

By Edward A. Weinstein

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The financial statements are supposed to be representations of what has transpired in the business and of its financial condition as of a certain date. The assignment of this responsibility to management is also set forth in engagement letters, representation letters, and in the auditor’s opinion for each audit engagement.

Auditors have a secondary responsibility for clients’ financial statements: obtaining reasonable assurance as to their fairness, as expressed in the auditor’s opinion. This is done after an examination of records, review and test of transactions, and outside verification of both balances and transactions. The audit also requires many estimates and judgments. In this process, auditors are required to evaluate evidence and to determine the materiality of information uncovered by the audit. The process of assessing materiality is not precisely defined in professional literature, although the responsibility for this judgment is clearly the auditor’s.

What happens, however, when the responsibilities of management and the auditor conflict or are confused?

A company’s management, having primary responsibility for the financial statements, knows of the auditor’s responsibility to express his opinion and make materiality judgments. Suppose management decides to “game” the system. What are the consequences?

After a 40-year auditing career, and having served as an expert witness in several legal controversies (including engagements on behalf of the SEC Enforcement Division), the author has seen the consequences. The distortion of financial statements can be subtle or substantial. The results can be damaging to those who must rely upon financial statements that are flawed as a result of a system gone awry.

Materiality decisions involve the following issues:

• Mechanical errors found during the course of an audit or review. These are mispostings, or computational or similar errors.
• Deliberate “mistakes” caused by management that produce distortion in the financial statements.
• Disagreements regarding an estimate (e.g., adequacy of bad-debt reserves) or the application of GAAP (e.g., whether cash flow is generated by operations or financing).
• Management design of the extent and breadth of systems of internal control.
• Auditor scope determinations. These are affected by risk tolerance and are often expressed as a materiality percentage.

This article will discuss the first two issues in greater depth.

Historical Perspective

In 1958, when this author entered the auditing profession, financial systems were at the beginning of the computer age. Even in 1963, the treasurer of one large client expressed dismay that the leather-bound ledgers that his company had been using for decades were no longer available. While filing deadlines in those years were more lenient (120 days for 10-Ks; 60 days for 10-Qs), the pressure to complete an audit within the filing timeframe was severe.

To expedite completion of adjusted trial balances, consolidations, financial statements, and audits, and ultimately publish the financial statements, auditors developed a protocol to avoid posting late, but arguably unimportant, entries to financial statements. This protocol evolved into what has for at least the last 50 years been referred to as “materiality.” Accountants and auditors always recognized that financial statements, which summarized thousands and, in many instances, millions of transactions, were bound to contain small errors.

Inherent in the protocol was the understanding that the errors were inadvertent, the result of an incorrect posting, an omission, a mathematical error, or a faulty judgment. The protocol did not encompass deliberate error. Most auditors viewed materiality in quantitative terms; that is, in relation to the amounts in the financial statements, principally net income or earnings per share.

Although the professional literature never explicitly defined a “normal” materiality limit, many auditors considered it to be 5% of net income. For higher-risk situations or clients, the limit was reduced to 3%. In situations judged as low-risk, the materiality tolerance could be as high as 10%.

The Evolution

Materiality, which originated as a protocol to enable auditors to complete audits of financial statements, has evolved in unintended ways. It has been used by management to excuse inadvertent errors as well as those deliberately made, both of which can alter reported financial results. This evolution has not been particularly good for the auditing profession.

In the 1960s, ’70s, and ’80s, auditors made materiality decisions. Then, gradually, management began to assert that it too could make such decisions. Instead of focusing on the need for all transactions to be recorded properly and in the right period, company management encroached on the auditors’ domain. In doing this, management began to lose focus regarding its own responsibilities and to limit auditor judgmental responsibility. Many auditors did not resist.

Other Factors

Materiality has not been thought of only in quantitative terms. Nor were individual errors to be measured only separately; they were to be grouped and measured. Certain errors were to be considered in terms of their qualitative effect on financial statements. These concepts are discussed in accounting and auditing literature published by the SEC, FASB, and the auditing profession itself, most recently in SEC Staff Accounting Bulletins (SAB) 108 and 99, the latter of which identifies some qualitative misstatements.

In practice, these concepts are expressed in the auditing guidelines and programs published internally and used by accounting and auditing firms. These guidelines also define how the auditor is to assess risk, and the relationship of this assessment to the quantitative materiality.

The Conundrum Created

If the quantitative total of the errors discovered by the audit exceeds the auditor’s planned limit, the auditor should first consider the appropriateness of planning materiality in relation to the final financial statements. The auditor should then consider whether his scope was sufficient to flush out all errors. Assuming that the auditor concludes positively on both, or makes appropriate adjustment to scope while the gross error still exceeds limits, what happens next?

In theory, the auditor cannot express an opinion on the financial statements absent correction of the errors. In practice, one of two scenarios develops, only rarely leading to the theoretical result: In scenario one, auditor and management have an iterative discussion resulting in the client accepting all or some of the auditor’s suggested error corrections. In scenario two, management rejects all suggested corrections and the auditor is left to again reassess the original planning limit of materiality, taking into consideration the financial and operational circumstances of the client and other matters revealed by the audit. These may affect the materiality metrics originally scoped or modified. This additional modification is considered an acceptable result in an audit.

Such was the case in audits of Waste Management Corporation (WM) from 1992 through 1996. Each year, the total of errors exceeded the planning limit (many times by a multiple of it). Each year, management and the auditor discussed the result and management “passed” the auditor’s proposed adjusting journal entries (PAJEs); that is, rejected them. The auditor then reconsidered the 3% limit, and issued an unqualified opinion on WM’s financial statements.

The proposed entries were not recorded in the first period of the succeeding year. (In the author’s experience, virtually every audit client had posted passed adjusting journal entries in the first quarter of the succeeding year because they were deemed immaterial to either period.) Instead, the entries at WM were suspended.

Within months of the publication of WM’s financial statements, a new audit planning cycle began and the same risk-assessment and materiality limits were adopted. This pattern continued each year, from 1992 to 1996. The auditor had been prevented from making the appropriate correcting entries because management asserted primacy regarding the financial statements. The auditor could have refused to provide assurance on these financial statements through his opinion, but did not choose this course of action.

Presumably due to increasing auditor discomfort, WM management adopted strategies for eliminating the errors, including netting them against nonrecurring gains on the disposition of subsidiaries or divisions. Although this practice had the salutary effect of reducing the carryover amount of these entries, it was not in accordance with GAAP. Thus, one error was fixed with another.

Qualitative Materiality

During the same five-year period, WM management caused a series of entries to be made in 14 consecutive quarters. These entries reclassified amounts that were accumulated in certain expense categories to other, presumably less-significant expense categories. With one exception, these entries distorted the relationship between selling and administrative expenses, or operating expenses, and total revenue. These entries had no effect on net income, because the offsetting debits or credits were to interest, taxes, or other expense accounts. None of these entries reflected any business transaction. No support or audit evidence could be found for any of them.

The distortions created by these entries were for amounts as small as 0.7% of the related line item. Obvious questions included the following: Were these items “errors” as contemplated by materiality protocols? How should they have been viewed by the auditor? How should they be viewed in terms of qualitative materiality?

These entries were clearly material (qualitatively). Otherwise, why were they made? Not entered in the transactional record of WM, their only purpose could have been to affect the financial statements. They were designed to deceive readers of the financial statements. And they effectively destroyed the representational faithfulness of the financial statement in which they were made. These were not inadvertent errors as contemplated by materiality protocols. They were deliberately created “errors.” It appeared that the auditor, considering solely the quantitative effect, ignored management’s actions in creating these entries.

These entries present an interesting perspective on the entire WM matter. On the one hand, WM management was consistently refusing to correct errors found by its auditor in five successive years, the amounts of which significantly exceeded the auditor’s judgment of what was quantitatively material. On the other hand, WM management was simultaneously and deliberately altering the results produced by the transactional record in amounts that were, by comparison, infinitesimal. Taken together, these two positions are contradictory and chimerical.

Both FASB and SEC pronouncements address this kind of deception. FASB’s Statement of Financial Concepts 2 states that a misstatement is material if “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.” SAB 99 states that auditors “should not assume that even small intentional misstatements in financial statements … are immaterial. While the intent of management does not render a misstatement material, it may provide significant evidence of materiality.”

Another Distortion

In another case known to the author, a company’s management created entries that had no substance to serve its purposes. These entries were justified to the auditor as immaterial.

This situation involved the disposition of trade accounts receivable that had arisen from sales of dubious origin. Because the receivables were not collectable, management had to remove them from the accounts. To have written them off as bad debts would have aroused the suspicions of analysts and required response to inevitable questions. What was to be done?

Management determined to establish unrelated “reserves” in connection with the acquisition of purchased companies. The reserves were established at slightly less than 5% of the purchase price of the acquired companies. The company used these reserves as repositories for the bad receivables.

This management also asserted its primacy over the financial statements. The auditor was allegedly told that because the “error” was less than 5%, the amounts were not material. The auditor reluctantly accepted this explanation, ignoring the issue of qualitative materiality.

A Change in Climate

Since 2002, the audit landscape has changed as a result of the Sarbanes-Oxley Act (SOX). Audit committees have begun to assert themselves and are increasingly populated by more knowledgeable, independent individuals. The fact that PAJEs must be disclosed to the audit committee has begun to act as a countervailing force to managements’ reluctance to accept these adjustments. The author has been told that some audit committees, concerned with their own liability, have instructed management to book all PAJEs.

The SOX requirement that CEOs and CFOs sign off on company financial statements has also had a sobering effect on some individuals’ thinking. Executives who might otherwise be inclined to ignore auditor attempts to correct errors, or even to cause such errors, must now think twice. Auditors, facing sharp questioning from audit committees, are more focused and less willing to be malleable. The possibility of being second-guessed by the Public Company Accounting Oversight Board’s (PCAOB) inspection process has also affected the thinking of auditors.

Although much progress has been made, this writer suspects that there remain some companies with executives who haven’t gotten the message, some audit committees whose members are ill suited to the task, and some auditors who still believe that client service means accommodation of bad practices. In other words, the temptations remain. It is important that recent improvements become universal and part of the institutional memory of the financial reporting process.

The confusion of roles regarding materiality decisions and the ceding of responsibility by some auditors must not be allowed to happen again. It is disappointing that SAB 99, an important step forward, does not assign clear responsibility to the auditor for materiality decisions. It perpetuates management’s making materiality decisions having to do with financial statement errors, arguably on a co-equal basis with auditors. SAB 99 thus continues the confusion regarding materiality decision making.

Lessons Learned

In “Assessing Materiality: A New ‘Fuzzy Logic’ Approach” (The CPA Journal, June 2006), authors Rebecca L. Rosner, Christie L. Comunale, and Thomas R. Sexton suggest that the assessment of qualitative materiality factors is difficult and would be furthered by using “fuzzy logic” techniques.

In the author’s experience, such an approach is not necessary. What is necessary is for auditors to use keener judgment and avoid doing what is plainly wrong with an overly quantitative approach. This keener judgment needs to be accompanied by a strong measure of auditor resolve if challenged by management over materiality decisions.

The following is some simple advice for auditors on materiality:

• Client management should not be making materiality decisions having to do with financial statement error.
• Any outright error created deliberately by management is, by definition, qualitatively material and must be corrected.
• In today’s era of computers, there is little justification for any but the most insignificant (note: not “immaterial”) error corrections not to be entered in the books and records before publication of financial statements.
• Any insignificant error not corrected at a closing must be immediately booked into the first quarter of the next year. There should be no reason to carry over such entries from year to year or period to period. (See Lee J. Seidler, “Materiality Decisions in the Computer Age,” The CPA Journal, May 1999.) This requirement will improve the client’s judgment as to what is “insignificant,” providing incentive to record all but truly insignificant corrections in the correct year.

Reclaiming the Auditor’s Role

When a company’s management asserts its primacy regarding financial statements, including the right to make all materiality judgments that also must be evaluated by the auditor, it is time for the auditor to leave. This is especially so when the errors are deliberate, not supported by the transactional record, and acknowledged as such by the client.

Firing a client is never easy. In the Waste Management case, jurors were permitted to ask questions of witnesses after direct examination, cross-examination, and redirect. One juror observed that resigning from a client had to be a very difficult action to take and asked this witness whether he knew of any such resignation. Acknowledging the difficulty of resigning from a client, I described having done so about 30 years ago, with a then–very significant client, over the initial objections of more-senior partners in the office. The reasons for the resignation involved a dispute over materiality and client integrity. That revelation helped the jurors to understand the concept of “materiality.”

©2009 The New York State Society of CPAs. Legal Notices