Question

Although materiality is ultimately a matter of professional judgment, two types of criteria are taken into consideration when determining materiality thresholds. Provide the two types of criteria

Answer 1

Ans: Materiality is considered as a key concept in the theory and practice of accounting and auduting . It is a significant factor in the planning of the audit procedures, performing the panned audit procedures, evaluating the results of the audit procedures and issuing an audit report.

The American Institute of certifies Public accountants(AICPA) and the International Auditing and Assurance standards Board(IAASB)vpointed out that the auditor's determination of materiality is a matter of professional judgement.

The concept of materiality is directly linked to the decission making requirements of financial statement users. Materiality has been defined by the Financial Accounting Standards Board in statement of Accounting concepts" "Qualitative characteristics of Accounting Information" as follows

"The omission or misstatement of an item is material in financial report, if in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a resonable person relying upon the report would have been changed or influnced by the influsion or correction of an item.

Thus the accounting concept of materiality address decission usefulness of the financial statements users.The finacial statements -which are the responsibilities of the management -are prepared using accounting estimates and the management has to make those estimates accurately.

The MAteriality threshold is defined as a percentage of the base. The most commonly used base in auditing is net income(earnings/profit). Most commonly percentages are in the range of 5-10 percent (for example an amount <5%= immaterial, >10% material and 5-10% requires judgemnet).

The more conservative approach and lower percentages would tend to be applied in case of enterprises that are from High-Risk industries, that face high risk of fraud, that have high accounting risk(history of deficiat accounting and controls), that have high staff turnover ane operate in various locations(e.g. multinational). When Profit before tax from contining operations is volatile, other benchmarks such as total revenues(Sales) may be more appropriate to use(e.g. 0.2-2 percent of total revenue). Also where the oraganization's operating results are so poor that liquidity or solvency is a real concern, basing overall materiality on finacial position (e.g. equity) may be more appropriate to use(e.g. 1-2 percent of owner's equity)

While threshold tend to be applied to the year being reported on, the cumulative impact of misstatememt over years and its impact on the earnings trend (over e.g. 3-5 years) are also important. This is the significant considering the interest of sustainability experts and the IIRC in the ability to create and sustain value in the longer term.

Standard international guidence on calculating materiality considering agreed thresholdd, does not exist. Individual auditing firms provide guidence to their managers on what threshold to apply. Research to date has examined in how far for example more experienced auditors and one working for bigger firms with reputational risk tend to be more conservative in applying(e.g. a lower percentage) thresholds.

As far as prepares are concerned , their judgement tend to be influnced by factors such as whether their industryu is more exposed to litigation. The closer the reporting organization is to break-even results(small profit/loss) the more sensitive the threshold applied becomes. As stake therefore is not just the absolute magnitude of the event involved but also severity of its implications the positive/negative nature(direction) of the information, the sensitivity of the firm's equity returns to the information (the stock price reaction) and the impact of the information on the firm's default risk(importance to debt holders). The extent to which investors or lenders(dis)agree with the materiality judgments made by preparers or auditors would be seen , among others, in stock market price or cose of debt capital reactions. Typically negative information is expected to have greater impact than positive information.

Although the concept of materiality underlines the prononcements of AICPA and the SEC Apporach.