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.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
