Friday, January 28, 2011

Auditor Jargon Part 6 - Material and Immaterial

The terms "material" and "immaterial" are part of the accounting lexicon. Accountants and auditors use these terms with hardly a passing thought but in a way that is readily understood among themselves. The terms represent well established concepts used to assess the significance of whatever cost is being examined at a particular moment. Materiality enters into risk assessments, in deciding whether to pursue a "finding", or whether to report an internal control deficiency. If something is determined to be immaterial, its not going to be pursued, quantified, or reported upon.

To illustrate, suppose you buy a $10 waste basket that will last 10 years. The accounting matching principle requires that you record the asset and depreciate it over those 10 years at $1 per year. The materiality principle allows you to expense the entire $10 in the year it is purchased. No one is going to get excited about $1 per year. Likewise, an auditor reviewing costs charged to Government contracts will focus on large dollar items because low cost resistors, capacitors, machine screws, or lubricating oil isn't going to significantly affect costs charged to the Government.

In financial reporting (e.g. a company's audited financial statements) the auditor issues an opinion on the financial statements as a whole. The opinion does not state that the financial statements are accurate down to the nickle. The opinion states that the financial statements present fairly in all material respects the financial position of the company. Determining what is material or immaterial therefore requires the exercise of professional judgment.

While the Financial Accounting Standards Board (FASB) and the Cost Accounting Standards Board (CASB) have refrained from giving quantitative guidelines for determining materiality, a few common standards have developed in the accounting industry and public accounting practice. One of those is the five percent rule; an error or misstatement equal to 5 percent of pretax net income or gross profit, or amount proposed.

While avoiding definitive guidelines, the Government, through the CAS Board, has issued some guidelines for assessing materiality (see CAS 9903.305)

In determining whether amounts of cost are material or immaterial, the following criteria shall be considered where appropriate; no one criterion is necessarily determinative:
  • The absolute dollar amount involved. The larger the dollar amount, the more likely that it will be material.
  • The amount of contract cost compared with the amount under consideration. The larger the proportion of the amount under consideration to contract cost, the more likely it is to be material.
  • The relationship between a cost item and a cost objective. Direct cost items, especially if the amounts are themselves part of a base for allocation of indirect costs, will normally have more impact than the same amount of indirect costs.
  • The impact on Government funding. Change3s in accounting treatment will have more impact if they influence the distribution of costs between Government and non-Government cost objectives than if all cost objectives have Government financial support.
  • The cumulative impact of individually immaterial items. It is appropriate to consider whether such impacts:
    • Tend to offset one another, or
    • Tend to be in the same direction and hence to accumulate into a material amount.
  •  The cost of administrative processing of the price adjustment modification shall be considered. If the cost to process exceeds the amount to be recovered, it is less likely the amount will be material.

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