How materiality is established in an audit or a review

When audit season gets underway for calendar-year entities, materiality will be the subject of many discussions – but as a business owner, how familiar are you with materiality and how it’s determined?

Simply put, materiality determines what’s important enough to be included in the financial statements and what can be omitted. It may also affect the nature, timing, and extent of audit procedures.

What’s materiality?

The Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA) voted in 2019 to align the definition of materiality in the auditing standards with the definition used in financial reporting under U.S. Generally Accepted Accounting Principles (GAAP).

The current definition of materiality is: “The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, 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.”

Under current rules, there are no longer inconsistencies between the AICPA standards and the definition of materiality used by the U.S. judicial system and other U.S. standard-setters and regulators. This definition was also the original definition in effect from 1980 until 2010.

However, the move to align the definitions in the United States has created inconsistencies with the international interpretation of this concept. According to the definition set by the International Accounting Standards Board, misstatements and omissions are considered material if they, individually or in the aggregate, could “reasonably be expected to influence the economic decisions of users made on the basis of the financial statements.”

How auditors set the threshold

No prescribed materiality threshold applies to all entities. Instead, the AICPA instructs auditors to rely on their professional judgment to determine what is material for each company based on such factors as:

• Size
• Industry
• Internal controls
• Financial performance

During fieldwork, auditors may ask about line items on the financial statements that have changed materially from the prior year. A “materiality” rule of thumb for small businesses might be to inquire about items that change by more than, say, 10% or $10,000. For example, if marketing expenses or labor costs increased by 25% in 2024, it may raise a red flag, especially if the increase didn’t correlate with an increase in revenue. Businesses should be ready to explain why the cost went up and provide supporting documents (such as invoices) for auditors to review.