Materiality is closely related to risk management and decision-making in the face of uncertainty…
This raises the criteria of probability and magnitude of anticipated events as applied in risk management. Both probability and magnitude call for the application of thresholds in making materiality judgments. In financial accounting, preparers and auditors would independently decide what thresholds they wish to apply. While quantitative thresholds are the most practical, this can also involve qualitative expressions. As an example, the IFRS literature includes over 30 different expressions of probability thresholds. These range from ‘remote’ to ‘probable’ to ‘virtually certain’.
“A typical financial threshold is
5–10 percent of earnings… between 5 and 10 percent requires judgement.”
At stake in conventional financial accounting is the possibility of misrepresentations or misstatements, which can involve errors or omissions from financial statements and annual reports. The question is in how far the statements and reports are accurate and reliable for usage by for example the provider of financial capital. In addition to human error and bounded rationality, an ever-present possibility to consider is the willful misrepresentation of information due to fraud.A related factor is the timely disclosure of misstatements once they have been discovered. In for example the USA, Section 409 of the Sarbanes-Oxley Act of 2002 requires the disclosure of a material event in Form 8-K within four days. In Canada, the TSX Timely Disclosure Policy of 2004 requires listed companies to immediately disclose material information that could significantly affect the market price or value of their securities. It specifies that this includes information related to environmental and social issues.
In financial accounting and auditing, determining the threshold level of materiality requires that an appropriate base level and percentage be decided on. Traditionally the financial community refers to accounting variables such as net income (before taxes) or earnings, revenue, total assets and total debt/equity as benchmarks. The materiality threshold is defined as a percentage of that base. The most commonly used base in auditing is net income (earnings / profits). Most commonly percentages are in the range of 5 – 10 percent (for example an amount <5% = immaterial, > 10% material and 5-10% requires judgment).
A more conservative approach and lower percentages would tend to be applied in the case of enterprises that are from high-risk industries, that face high risk of fraud, that have high accounting risk (history of deficient accounting and controls), that have high staff turnover and operate in various locations (e.g. multinational). When profit before tax from continuing 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 organization‘s operating results are so poor that liquidity or solvency is a real concern, basing overall materiality on financial position (e.g. equity) may be more appropriate to use (e.g. 1 – 2 percent of owners equity).
While thresholds tend to be applied to the year being reported on, the cumulative impact of misstatements over years and its impact on the earnings trend (over e.g. 3–5 years) are also important. This is significant considering the interest of sustainability experts and the IIRC in the ability to create and sustain value in the longer term.
Standard international guidance on calculating materiality, considering agreed thresholds, does not exist. Individual auditing firms provide guidance to their managers on what thresholds to apply. Research to date has examined in how far for example more experienced auditors and ones working for bigger firms with reputational risks tend to be more conservative in applying (e.g. a lower percentage) thresholds.
As far as preparers are concerned, their judgment tend to be influenced by factors such as whether their industry 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. At stake therefore is not just the absolute magnitude of the event involved, but also the 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 cost of debt capital reactions. Typically negative information is expected to have greater impact than positive information.