Materiality Considerations: Audits of Government Financial Statements Just Got More Complex

Few issues involving financial statements in conformity with generally accepted accounting principles (GAAP) have been more elusive and difficult for preparers to address and resolve--or of greater importance--than that of materiality. For auditors too, materiality in planning and conducting financial statement audits in accordance with generally accepted auditing standards (GAAS) has proved challenging. Recent actions by the SEC and the AICPA auditing standards board (ASB) underscore the significance of this topic. In addition, GASB Statement no. 34, Basic Financial Statements--and Management's Discussion and Analysis--for State and Local Governments, compounds the materiality issues for preparers and auditors of state and local government financial statements. The GASB statement represents a substantial change in the information preparers provide in such statements, the manner in which they report many transactions and events and the nature and degree of aggregation and disaggregation contained in them. This article discusses current materiality concepts and standards related to the preparation and audit of the basic financial statements of state and local government entities. MATERIALITY: ACCOUNTING AND AUDITING Materiality in financial reporting is addressed most completely in FASB Statement of Financial Accounting Concepts no. 2, Qualitative Characteristics of Accounting Information. It states, in part: "The essence of the materiality concept is clear. The omission or misstatement of an item in a financial report is material if, in the light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion of correction of the item." This statement goes on to explain that evaluation of a particular item's materiality is complex, involves quantitative as well as qualitative considerations and requires seasoned professional judgment. It also acknowledges that FASB has chosen not to prescribe thresholds because "no general standards of materiality could be formulated to take into account all the considerations that enter into an experienced human judgment." The ASB also has provided guidance to auditors about how the concept of materiality should be applied in financial statement audits. Statement on Auditing Standards (SAS) no. 47, Audit Risk and Materiality in Conducting an Audit, says that auditors should consider "materiality both in (a) planning the audit and designing auditing procedures and (b) evaluating whether the financial statements taken as a whole are presented Fairly, in all material respects, in conformity with generally accepted accounting principles." It also says: "The auditor plans the audit to obtain reasonable assurance of detecting misstatements that he or she believes could be large enough, individually or in the aggregate, to be quantitatively material to the financial statements. Although the auditor should be alert for misstatements that could be qualitatively material, it ordinarily is not practical to design procedures to detect them." Based on the relevant professional literature, certain observations can be made: * The consideration of materiality is complex and requires substantial professional judgment in preparing or auditing financial statements. * Preparers of financial statements must be concerned with both quantitative and qualitative materiality considerations throughout the process. * Auditors generally design the audit to provide reasonable assurance of detecting quantitatively material misstatements but are responsible throughout the audit for considering whether any misstatements that come to their attention are quantitatively or qualitatively material. Given these factors it is evident that both preparers and auditors of state and local government financial statements need to clearly understand how to assess materiality. …