Question

How does the SEC define "materiality"? how does that definition differ, if at all, form the definition of materiality included in accounting and auditing standards?

Answer 1

The SEC has changed its definition of materiality over the period to make it in line with the Supreme Court. According to the SEC, information is material if:

Definition as per SEC:when used to qualify a requirement for the furnishing of information as to any subject, [materiality] limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.

Now materiality in audit:

Auditors make a preliminary assessment of materiality of the financial statements as a whole by determining the amount by which the believe the financial statements could be misstated without affecting user’s decisions. This amount is called “Preliminary judgment about materiality” or “planning materiality”. This judgment need not be quantified but often is. It is called a preliminary judgment about materiality because it is a professional judgment and may change during the engagement if circumstances change. The reason for determining “planning materiality” is to help the auditor plan the appropriate evidence to accumulate. If the auditor set a low peso amount, more evidence is required than for a high amount.

Materiality can be seen as the concept or the convention used in accounting and auditing in which the significance of any transaction, amount or discrepancy is estimated. The main objective of conducting the audit of any financial statements is to ensure that the auditor can express his views related to the preparation of financial statements of all material respect as per the recognized financial reporting guidelines formulated by GAAP.

materiality in accouts:

The materiality principle states that an accounting standard can be ignored if the net impact of doing so has such a small impact on the financial statements that a reader of the financial statements would not be mislead. Under generally accepted accounting principles (GAAP), you do not have to implement the provisions of an accounting standard if an item is immaterial. This definition does not provide definitive guidance in distinguishing material information from immaterial information, so it is necessary to exercise judgment in deciding if a transaction is material.

The SEC has recommended for presentation purposes that an item representing at least 5% of total assets should be separately disclosed in the balance sheet. However, much smaller items may be considered material. For example, if a minor item would have changed a net profit to a net loss, that item could be considered material, no matter how small it might be. Similarly, a transaction would be considered material if its inclusion in the financial statements would change a ratio sufficiently to bring an entity out of compliance with its lender covenants.

As an example of a clearly immaterial item, you may have prepaid $100 of rent on a post office box that covers the next six months; under the matching principle, you should charge the rent to expense over six months. However, the amount of the expense is so small that no reader of the financial statements will be misled if you charge the entire $100 to expense in the current period, rather than spreading it over the usage period. In fact, if the financial statements are rounded to the nearest thousand or million dollars, this transaction would not alter the financial statements at all.

The materiality concept varies based on the size of the entity. A massive multi-national company may consider a $1 million transaction to be immaterial in proportion to its total activity, but $1 million could exceed the revenues of a small local firm, and so would be very material for that smaller company.

The materiality principle is especially important when deciding whether a transaction should be recorded as part of the closing process, since eliminating some transactions can significantly reduce the amount of time required to issue financial statements. It is useful to discuss with the company's auditors what constitutes a material item, so that there will be no issues with these items when the financial statements are audited.