Magazine article The CPA Journal

Assessing Materiality

Magazine article The CPA Journal

Assessing Materiality

Article excerpt

A New 'Fuzzy Logic' Approach

Two difficulties that auditors face in assessing materiality are the need to make a binary decision (material versus not material) and the need to weigh certain qualitative factors in doing so. This article shows how a "fuzzy logic" expert system permits auditors to assess materiality on a continuous scale from O to 1, and allows for explicit consideration of important qualitative factors relevant to materiality.

In practice, an auditor must make an oversimplified, binary decision for each omission and misstatement, both individually and in the aggiegate: It is either material, or it is not A fuzzy logic model allows omissions and misstatements to possess a degree of value-that is, each omission or misstatement is material to a greater or lesser degree, measured on a scale from 0 to 1.

Auditors tend to view materiality as a quantitative concept; the larger the fluctuation, the more likely the auditor is to consider it material. This is natural, because size is easier to measure and analyze than nonquantitative factors. Both the sec and FASB, however, recognize that although such thresholds and rules of thumb can be useful starting points, exclusive reliance on numerical thresholds has no basis in accounting literature or law. Indeed, materiality assessment requires the consideration of many qualitative factors beyond the size of the misstatement or omission. (The authors consider errors, which may or may not be material, to include misstatements, in which a numerical or textual item is reported incorrectly, and omissions, in which a required item is absent from the financial statement) sec Staff Accounting Bulletin (SAB) 99 lists qualitative factors that "render material a quantitatively small misstatement of a financial statement item." These factors ask whether the misstatement does the following:

* Arises from an item capable of precise measurement, or arises from an estimate and, if so, the degree of imprecision inherent in the estimate;

* Masks a change in earnings or other trends;

* Hides a failure to meet analysts' expectations;

* Changes a loss into income, or vice versa;

* Concerns a portion of the business that has been identified as playing a significant role in the company's operations or profitability;

* Affects compliance with regulatory requirements;

* Affects compliance with loan covenants or other contractual requirements;

* Increases management's compensation by, for example, satisfying requirements for the award of bonuses or other forms of incentive compensation; or

* Involves concealment of an unlawful transaction.

FASB has also emphasized that materiality is not strictly a quantitative concept (Statement of Financial Accounting Concepts 2). In fact, FASB rejected a formulaic approach for determining materiality in favor of one that incorporates all relevant circumstances.

Typically, qualitative factors are more difficult to assess than the size of a misstatement or omission. Qualitative factors often require subjective judgment and evaluation in light of other information that may not be readily available to the auditor during the audit.

Consequently, auditors tend to rely on quantitative evaluations and to do so using simplistic numerical thresholds and rules of thumb. The authors reviewed the materiality worksheets of three national public accounting firms and found no specific guidance regarding how to evaluate the qualitative factors in the materiality assessment process. One worksheet made no mention of qualitative factors. A second worksheet reminded the auditor to consider such factors but provided only one example, that of an illegal payment. The third worksheet listed the qualitative factors from SAB 99 but provided no methodology for incorporating such factors into the overall materiality assessment. In practice, qualitative factors, while recognized as important, are likely to be overlooked. …

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