How to Determine What Is Material in an Audit
Auditors refer to financial statement information that’s not 100 percent correct as a misstatement. You’ll probably never see a set of financial statements that’s completely accurate. But misstatements aren’t the issue in an audit — whether they’re material is what matters.
With respect to materiality, everything is relative. What may be material for one company may be immaterial for another. It’s impossible for an audit firm to establish absolute guidelines because of the different size, complexity, and type of business entity of each company you audit.
Stated very broadly, you must consider the potential of the incorrect information to affect the overall accuracy of the financial statements. Here are some factors you consider when deciding if a misstatement is material:
The comparative size of the misstatement: An expense difference of $10,000 is material if the total expense amount is $40,000, but it’s immaterial if the total expense amount is $400,000.
The nature of the misstatement: The type of misstatement may make it material even if the comparative size is immaterial. For example, $10,000 incorrectly excluded from income may be material even though it’s a small percentage of overall income, if the omission was deceptive in nature.
The relationship to other misstatements: An immaterial misstatement in one financial statement account may relate to a material misstatement in another. For example, there could be an immaterial difference in interest expense but a material difference in the dollar amount of the note payable on the balance sheet.
The inherent character of the mistake: The amount of the item may be small, but the type of the item is significant. For example, you may find expenses that you don’t normally associate with the type of business. You should be concerned if you find aircraft and boat expenses in the financial statements of a company whose clients are all in the same geographic landlocked area.