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Tax Reform Resource Center

Establishing Materiality in an Audit

4/11/2018

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by H2R CPA Team
​​
When accountants conduct an audit or review, they can’t test every transaction. Instead, they set a “materiality” threshold. This benchmark is used to obtain reasonable assurance in an audit — or limited assurance in a review — of detecting misstatements that could be large enough, individually or in the aggregate, to be material to the financial statements.

What is materiality?
Unfortunately, there’s no specific definition of materiality under U.S. Generally Accepted Accounting Principles (GAAP). But the Conceptual Framework for Financial Reporting under International Financial Reporting Standards (IFRS) says:

Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.

Several definitions of materiality exist. But the universal premise is that a financial misstatement is material if it could influence the decisions of financial statement users.

How do auditors determine materiality?
To establish a level of materiality, auditors rely on rules of thumb and professional judgment. They also consider the amount and type of misstatement.

The materiality threshold is typically stated as a general percentage of a specific financial statement line item. For example, let’s suppose Joe Auditor sets a materiality threshold of 1% of revenue for ABC Company. For 2017, the company reports annual revenue of $190 million, so its materiality threshold is $1.9 million.

During fieldwork, Joe unearths a clerical error that caused ABC to understate revenue by $1 million. Is this error material? Although a $1 million error may seem significant, it’s less than 1% of the company’s annual revenue. So, it’s immaterial to ABC’s overall financial performance.

On the other hand, if the company had overstated its revenue by $1 million due to a fraud scheme involving a senior executive, Joe may deem the misstatement as material because it involved a member of the senior leadership team and potential criminal activity.

Regardless of whether a misstatement of revenue is considered material, it may trigger a material misstatement in accounts receivable. In other words, the balances recorded as due from customers may be materially different from the actual amounts due.

It’s all relative
As these examples demonstrate, materiality is a relative concept. In practice, auditors must evaluate a material misstatement on a standalone basis and within context of a company’s financial statements overall. What constitutes a material misstatement for one company may not reach the materiality threshold for another. Materiality is a matter of professional judgment and your audit team’s experience.

Contact H2R CPA at 412-391-2920 or team@h2rcpa.com to learn more about how we can assist you with your Assurance needs. Our team would be pleased to provide a complimentary consultation. 
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    For additional insight and expertise, please visit the following blogs from some of our CPAAI member firms:

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    Onisko & Scholz
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    Rosenwig McRae Thorpe Toronto, ON


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H2R CPA is a local Pittsburgh CPA firm with a 60-year history of serving businesses, nonprofits and individuals throughout the western Pennsylvania region, including Allegheny, Armstrong, Beaver, Butler, Fayette, Mercer, Washington and Westmoreland counties. Formerly known as Horovitz, Rudoy & Roteman, the H2R CPA team has a reputation for establishing long-term, trusted relationships with clients while delivering tax, assurance, business consulting, automated payroll processing and estate administration services.
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  • Home
  • Who We Are
    • Leadership Team >
      • Paul K. Rudoy
      • Leo A. Hannah
      • Alex M. Kindler
      • Kieran O'Dea
      • Edward G. Scherer
      • Sara Beauseigneur
      • William M. Bodnar
      • Cara M. Colavita
      • Dominic T. Cutuli
      • Joseph M. Delisi
      • Brett Fulesday
      • Stephen A. Silverman
      • Jeff Wolstoncroft
    • Client Satisfaction
    • CPAAI
    • In the Community
    • Video Testimonials
  • What We Do
    • Tax >
      • Tax Planning
      • State and Local Tax
      • International Tax
      • Tax Credit Certification
      • Cost Segregation
    • Assurance >
      • Audits, Reviews and Compilations
      • Due Diligence
      • Employee Benefit Plans
      • Nonprofit Organizations
      • International Financial Reporting Standards (IFRS)
    • Business Consulting >
      • Business Valuation
      • Litigation Support
      • Succession Planning
      • Estate Planning
      • Wealth Management
      • Outsourced CFO
      • Transaction Advisory
    • Automated Payroll Processing
    • Estate Administration
  • Who We Serve
    • Industries >
      • Manufacturing & Distribution
      • Construction
      • Technology
      • Real Estate
      • Professional Services
      • Hospitality
      • Minor League Baseball
    • Closely Held Businesses
    • Nonprofit Organizations
    • High Net Worth Individuals
    • Fraternal Benefit Societies
  • Tools & Resources
    • H2R CPA News
    • Publications
    • Tax Guide Online
    • Client Tax Notebook
    • Client Portal
  • Contact Us
    • Office Location
    • Careers at H2R CPA >
      • Tax Senior Team Member
      • Tax Manager
    • Complimentary Consultation
    • Referrals
    • Submit RFP
  • Blog
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