What is meant by materiality in accounting?
3. Application of materiality in accounting
The materiality concept is widely applied for the preparation and presentation of financial statements and may help to overcome the following types of omissions or misstatements:
- An actual misstatement or error (those that can be precisely determined).
- An internal control deficiency caused by the failure in design or operation of a control.
- A large variance in an accounting estimate compared with the actual figures.
- Management or other employees’ fraudulent activities.
An error or aggregation of errors that meet the definition of a material misstatement must be recorded in the books in order for the independent auditor to give an unqualified audit opinion.
Moreover, the Sarbanes-Oxley Act of 2002 demands the entity’s management to detect and prevent material control weaknesses in a timely manner, hence determine whether financial statements are materially impacted by those deficiencies.
It is remarkable that auditors also perform their procedures on the basis of the materiality concept (otherwise auditors would need to test all transactions and balances). However, the materiality levels set for their work would typically differ from those set by a company’s internal policy. For instance, the company may investigate intercompany discrepancies if they exceed $5 million as prescribed by the company’s financial reporting instructions set for a number of years in advance. The auditors, on contrary, would typically define materially levels separately for each audited period.
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