The Challenge of Materiality

OwlFaceHow often have you heard auditee management say something like, “I know it’s a fraud, but it’s so small; it’s not even material to our financial statements.”  Auditees, and sometime auditors themselves, have dismissed possible detected irregularities by concluding that they are not material to the financial statements.  I would argue that, when it comes to a proven fraud, no matter how small, the concept of materiality does not apply; from an ethical point of view, the theft of a penny is the same as the theft of a million dollars.

The issue of materiality draws on both legal and accounting principles.  Guidance to the practicing forensic accountant or fraud examiner can be found from the U.S. Supreme Court, the American SEC, the FASB and academic literature.  The Supreme Court has defined something as material if  “there is substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.”  The SEC, in Regulation S-X, defines material items as “those matters about which an average prudent investor ought reasonably to be informed” before purchasing the registered security.  The FASB has defined materiality to be “the magnitude of an omission or misstatement of accounting information that in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”

The problem for fraud examiners is that, over time, companies and auditors have developed certain rules of thumb to assist them in determining when a matter might be material.  One familiar to us all is that a misstatement or omission that represents 5 percent or less of some factor (such as net income or assets) is not material.  The SEC sought to settle the issue of materiality and remedy the potential for earnings management abuse with the 1999 release of Staff Accounting Bulletin (SAB) No. 99, Materiality.  SAB 99 provides guidance for preparers and auditors on evaluating the materiality of misstatements in the financial reporting and auditing process by summarizing and analyzing GAAP and Federal Securities laws and offering examples of what is and what is  not acceptable.

Fraud Examiners, in advising our clients, should make them aware that while the SEC does not object to the use of the 5 percent threshold  for a ‘preliminary’ assessment of materiality, it emphasizes that the final determination must be based on an analysis that considers qualitative factors rather than on relying exclusively on a quantitative benchmark.  SAB 99 notes specifically that certain qualitative factors (like the presence of proven fraud) can cause even quantitatively small misstatements to become material.  It suggests that forensic accountants and fraud examiners, in preparation for discussions with our clients,  must determine whether the misstatements:

–arise from illegal acts;
–affect management compensation;
–affect compliance with State of Federal regulations or with contracts;
–mask changes in earnings trends.

Fraud examiners must always question the facts and circumstances of suspicious transactions.  An auditor or examiner might, at some point in the past, have made document requests that give the client information about materiality and scope, such as, “Provide documentation of all transactions in account XX over $5,000.”  As a result, a fraudster presently on staff, may decide to embezzle funds at transaction amounts less than $5,000.   While an individual transaction of less than $5,000 may fall below the auditor’s materiality scope, the total  amount of a number of embezzlements of this size may be material as it relates to the financial statements.   When there is any suspicion of this kind, the auditor should consider consultation with a forensic accounting investigator, who can offer assistance and guidance in the selection of additional procedures and in the performance of those procedures.

When a fraud is determined, or even suspected, the controlling question is, “how long is this piece of string?”  A simple looking, apparently non-material, embezzlement may be only the tip  of an iceberg of schemes which have been going on below management’s radar for a long period of time; no fraud, however small, is ever immaterial.

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