How do you determine materiality for business transactions and other disclosures?

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business combination materiality threshold

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A common rule of thumb is amounts of 3% or more of net income are material, with some variation if if the topic is primarily balance sheet related. Unusual items with a "negative taint" have a lower threshold. Be wary of systematic errors from controls issues.

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I respectfully disagree with Mr. Peterson. ML should be driven by the risk the users of the financial will be impacted by an unrecorded item. For example, 3% of NI may be appropriate for x situation, but what if your NI is zero or negative?

Look at what could impact the users the most. If a bank is involved with covenants, how close are they to failure? Is the business looking to sell in the near term - EBITDA could be impact many times over.

On a strong company, without issues pointed out, I would expect to see a ML at about 2% of the total assets. So, if I have a company with $50m in total assets, my ML would be about $1m. Add a twist to that and say they are $250,000 from failing x covenant. The $1m ML really won't work anymore. Remember, this is based on audit approach, not a M&A deal or business combination. The threshold would be lower when multiples of EBITDA are involved as that is going to affect the purchase price.

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I have been a CFO for entities with no income, or losses, for which nearly everything is material as survival becomes much more of an issue and the "margin for error" starts to vanish. A threat to covenant compliance is one of many "negative taint" items not specified and should certainly be carefully monitored. I am not sure that 2% of total assets will be accepted for financial reporting and disclosure as most strong companies often have net income of 5% or less of total assets...auditors will not accept a risk of 40% of reported income or any amount close to that.

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Definition (I used as a College Prof teaching Accounting 101):

"Materiality principle. Accountants follow the materiality principle, which states that the requirements of any accounting principle may be ignored when there is no effect on the users of financial information. Certainly, tracking individual paper clips or pieces of paper is immaterial and excessively burdensome to any company's accounting department. Although there is no definitive measure of materiality, the accountant's judgment on such matters must be sound. Several thousand dollars may not be material to an entity such as General Motors, but that same figure is quite material to a small, family-owned business."

Taken from www.cliffnotes.com but similar to the texts that were in use.

This is the basis of materiality. So if the error is such that it could effect the financial picture of the company it is material. Placing a percentage limitation as the example shows is meaningless, since the overriding concern is the effect.

Remember, materiality plays into relevance, reliability, and consistency principles of GAAP as well.

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Like Wayne commented, "Materiality principle. Accountants follow the materiality principle, which states that the requirements of any accounting principle may be ignored when there is no effect on the users of financial information". - Simply, at what point would a user of the financial statement be driven to change their decision making.

That is the basis for ML and why I have the disagreement with the net income based agrument. If you follow the guidance in PPC Guide's Materiality Planning Worksheet, as well as many other national firm guidelines, barring issues of covenant failures, etc... the drivers are total revenue or total assets. I can tell you as an audit partner (both with a national firm and regional firm) that those are the currently accepted drivers of materiality.

Under that argument, assume you have a company with $50m in assets, $300m in revenue and $2.5m in net income. ML based on assets would be $1m. Compared to NI, that would be 40%. The NI approach at even 10% would be $250k. Now, assume you are a lender of the Company. At what point would an unrecorded item impact your decision making ability on to lend them money, give them an interest rate, etc...

I will tell that from an audit firm stand point, assuming a ML of $1m, if you have a $700k entry, that will get recorded and not passed on as each firm has their own risk threshold for undiscovered errors. That said, risk is further involved. Lets assume this is a low risk entity, a common level is 60% of ML. So, that means up to 60% of the ML is acceptable for misstatements, or $600k. If it was a high risk engagement, that number will drop to maybe 20% which definately puts it in line with a net income driven ML. Those are, however, firm policies and vary from firm to firm.

As you can see, materiality is highly subjective and you need to know your audience. If you are on the audit side, ML is definately different than on the private side, as detailed by Mr. Peterson arguments. But, for financial reporting purposes based on your original question, I am leaning on the auditor's side (since you mentioned disclosures), and ML would be discussed and prepared as I stated barring negative taint issues.

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