what does “materiality” really mean?

The infamousEnron case willno doubt force

auditors to review therigor of companyfinancial statements.What should beincluded? What is“material”? We believe that it’stime to re-examine guidelinesissued over the past few years.

For example, in August1999, the Securities andExchange Commission (SEC)announced new materialityguidelines in SEC StaffAccounting Bulletin (SAB) No.99. Perceived abuses in theapplication of materiality tofinancial disclosure led the SECto issue the new bulletin, whichdelineates qualitative factors thatneed to be considered by audi-tors and management in assess-ing materiality. Over the pastfew years, events have broughtrenewed regulators’ interest inthe application of materiality tofinancial statement disclosureand the audits of financial state-ments. The SEC, the AmericanInstitute of Certified PublicAccountants (AICPA), and theFinancial Accounting StandardsBoard (FASB) have each calledfor changes in the application of

materiality to financial account-ing and auditing.

First, there is former SECChairman Arthur Levitt’s famouscriticism of recently criticizedcorporate managements and theirexternal auditors for the “abuseof materiality” in the creation ofaccounting “illusions” and“trickery” (Levitt, 1998). Thefocus of his criticism was the(sometimes intentional) misstate-ments of earnings and misappli-cations of generally acceptedaccounting principles (GAAP)that were justified by referenceto the materiality concept.

Second, the Statement onAuditing Standards (SAS) No.82, Consideration of Fraud in aFinancial Statement Audit(AICPA, 1997) provides guid-ance to auditors on their respon-sibilities related to fraudulentacts that create material mis-statements of financial state-ments. This standard directs theauditor to assess the risk that the

financial statementsare materially misstat-ed due to fraud or mis-appropriation of assetsand, if so, the auditoris to communicatesuch discoveries tomanagement, the audit

committee, and outside parties.Over the past few years, the

FASB has also expressed arenewed interest in materiality,although for a different reason.The FASB is concerned with theeffectiveness of financial disclo-sure and disclosure overload.The ultimate objective is toeliminate disclosures that are notuseful to the decision maker. Tothat end, the FASB is interestedin understanding the applicationof materiality to disclosureissues and states that conven-tional rules of thumb “may nottranslate well to disclosure.”

In this article, we briefly dis-cuss the historical developmentof the concept of materiality andhow materiality decisions aremade. Our discussion includes asummary of the materialityguidelines available in account-ing standards, and a summary ofthe rich body of research onmateriality. An important impli-cation of the research literature

These days, auditors are more concerned thanever about what is “material.” SEC Staff BulletinNo. 99 listed qualitative factors to consider whendetermining materiality. It’s worth re-examining.

© 2002 Wiley Periodicals, Inc.

Eugene G. Chewning Jr. and Julia L. Higgs

What Does “Materiality” Really Mean?

featu

reartic

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61© 2002 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.10071

is that in situations in whichmandated materiality guidelinesdo not exist, materiality judg-ments exhibit considerable diver-sity and remain primarily a mat-ter of professional judgment.While most auditing firms pro-vide materiality guidelines to theauditors in the field, the qualita-tive and quantitative guidancediffers substantially across firms(Friedberg, Strawser, & Cassidy,1989). Because the actual mate-riality thresholds employed infinancial statements are notrequired to be disclosed, thediversity in materiality judg-ments undoubtedly contributesto confusion among financialstatement users. The actuallevel of disclosure maydiffer from the level pre-sumed to exist. Finally, wediscuss how some materi-ality guidance may affectauditors and managers.

THE DEVELOPMENT OFTHE MATERIALITY CONCEPT

Materiality has been vaguelydefined, though the Securitiesand Exchange Commission(SEC), the courts, the FASB, theAICPA, and academicresearchers have all grappledwith the issue at one time oranother. Let’s look at a brief his-tory of how the concept of mate-riality has been defined. The his-tory sets the stage for themanner in which materiality-based practices have developed.

Holmes (1972) argues thatthe concept of materiality proba-bly arose in English common law.Holmes cited a 1867 case, tried13 years before the establishmentof the Institute of CharteredAccountants in England, in whichthe judge concluded that “no mis-statement or concealment of anymaterial fact ought to be permit-ted” (p. 46). Deliberations on the

1895 British Companies Act alsoindicate a user orientation indefining materiality: “Every con-tract or fact is material whichwould influence the judgment ofa prudent investor in determiningwhether he would subscribe forthe share or debenture offered bythe prospectus” (p. 46).

In the United States, thecourts also have defined the con-cept of materiality, albeit indis-tinctly.1 For instance, in Escott etal. v. BarChris ConstructionCorporation et al. (1968) thecourt defined a material item asone that “if it had been correctlystated or disclosed would havedeterred or tended to deter the

average prudent investor frompurchasing the securities in ques-tion.” Later, in Mitchell v. TexasGulf Sulphur Co. (1971), thecourt described material informa-tion as that which “the tradingjudgment of reasonable investorswould not have been leftuntouched upon receipt of suchinformation.” In TSC Industries.v. Northway, Inc. (1976), theSupreme Court elaborated on thedefinition stating that somethingis material if there is “substantiallikelihood that the disclosure ofthe omitted fact would have beenviewed by the reasonable investoras having significantly alteredthe ‘total mix’ of informationmade available.”

Although the responsibilityfor standard setting has been del-egated to the accounting profes-sion, the SEC maintains the legalauthority to set accounting stan-dards. The 1933 and 1934 Secu-

rities Acts do not address materi-ality. The SEC has over the yearsdefined materiality on a rule-by-rule basis (Jennings, Kneer, &Reckers, 1985). However, giventhe historical development ofmateriality in English commonlaw, and its later application inU.S. case law, accounting stan-dard setters have, not surprising-ly, adopted a strong user orienta-tion. For example, SECRegulation S-X describes materi-ality as follows:

The term “material,”when used to qualify arequirement for the fur-nishing of information asto any subject, limits theinformation required tothose matters as towhich an average pru-dent investor ought tobe reasonably informedbefore purchasing thesecurity registered (Rule1-02).

Like the SEC, the FASB’sdefinition of materiality revealsan orientation toward the finan-cial statement user:

The magnitude of anomission or misstate-ment of accountinginformation that, in thelight of surrounding cir-cumstances, makes itprobable that the judg-ment of a reasonableperson relying on theinformation would havebeen changed or influ-enced by the omission ormisstatement (Statementof Financial AccountingConcepts [SFAC] No. 2,FASB, 1980).

SAB No. 99 does notsupercede any of the guidancepreviously issued by any authori-

62 The Journal of Corporate Accounting & Finance


…the diversity in materiality judg-ments undoubtedly contributes to con-fusion among financial statement users.

tative body. Instead, the documentreminds financial statement pre-parers of the importance of the“total mix” of factors that theSupreme Court described in TSCIndustries v. Northway (1976).The SEC points out that blindlyfollowing a numerical rule ofthumb is clearly not acceptable inmateriality decisions because ofthe many qualitative factors thatneed to go into the judgment.Although qualitative factors havebeen addressed in the materialityliterature, the bulletin delineatessituations regarding misstate-ments that should receive particu-lar consideration. These situationsinclude whether misstatements(1) arise from impreciseestimates, (2) mask changesin earnings trends, (3) causefinancial results to meetanalysts’ expectations, (4)would change a loss toincome and vice versa, (5)affect compliance with reg-ulations or contracts, (6)affect management compen-sation, (7) arise from illegalacts, and (8) affect reportingfor significant segments(SAB No. 99, 4). The documentalso lists concerns about whethermateriality decisions mask earn-ings management or volatility, areintentional misstatements, andhave an effect on prior periods.The bulletin did not set general,concrete rules on materiality suchas what numerical amount wouldconstitute a material item. Insteadit reminds preparers of the quali-tative factors that should be con-sidered together with and apartfrom quantitative thresholds.

HOW ARE MATERIALITYDECISIONS MADE?

After the FASB was createdin 1973, one of its first tasks wasan examination of the concept ofmateriality. The Board issued a

discussion memorandum, Crite-ria for Determining Materiality,in 1975, but the exposure draftthat typically follows was neverissued. Eventually, the FASBconcluded that “materiality judg-ments can properly be made onlyby those who have all the facts.The Board’s present position isthat no general standards ofmateriality could be formulatedto take into account all the con-siderations that enter into anexperienced human judgment”(SFAC No. 2, FASB 1980).

In the descriptions of materi-ality from the SEC and the FASB,the focus clearly is on the actionsof a reasonable person or prudent

investor. Financial statementsshould disclose the informationthat can have an impact oninvestor decisions. However, thisrather vague guidance has result-ed in materiality judgments beingapplied in a variety of ways. Toget a better understanding of howmateriality judgments are made,we discuss below the guidancefound in the accounting standardsand in the research literature.

Guidance from AccountingStandards

Both the SEC and the FASBhave been reluctant to provideoperational guidance to thosewho must make materiality deci-sions. In fact, as noted earlier inSFAC No. 2, the FASB conclud-

ed that a general standard ofmateriality could not be formu-lated. The FASB is, no doubt,concerned about the possiblelegal implications of very specif-ic guidelines. Thus, materiality isgenerally considered to be amatter of professional judgment.

The materiality decision isprimarily a quantitative one; how-ever, the nature of the item ortransaction also must be consid-ered (SFAC No. 2, SAB No. 99).For example, the disclosure ofnon-arm’s-length transactionsbetween a corporation and itsemployees or subsidiaries are nec-essary even though the amountswould not ordinarily be consid-

ered material. Therefore, aloan made by the corpora-tion to one of its directorsshould be disclosed, eventhough the amount is small.The materiality of an item isalso a relative conceptrather than a matter ofabsolute size. For example,an omitted expense of$500,000 would certainly bematerial to a company withincome of $1 million but

not material to a company withincome of $500 million.

Despite reluctance to set gen-eral materiality guidelines, theSEC, the FASB, and its predeces-sors in very specific and limitedcircumstances have prescribedquantitative accounting and dis-closure guidelines that can beinterpreted as materiality thresh-olds. Exhibit 1 contains examplesof the quantitative guidance givento financial statement preparersin FASB standards and examplesof similar guidance from Regula-tion S-X (see Exhibit 2). In situa-tions where quantitative guidanceis provided, thresholds of 5 per-cent and 10 percent appear mostoften.2 However, disclosurethresholds range from a low of 1percent up to 90 percent. Because

May/June 2002 63


Despite reluctance to set generalmateriality guidelines, the SEC, theFASB, and its predecessors in veryspecific and limited circumstances haveprescribed quantitative accounting anddisclosure guidelines that can beinterpreted as materiality thresholds.



Examples of Quantitative Materiality Measures Issued by the FASB Topic Authority Materiality Guidelines Segment Reporting SFAS 131 ¶ 18 Report separate information for any segment if segment

a. Revenues exceed 10 percent of combined revenue of reportedsegments

b. Income/loss is 10 percent of combined income of profitablesegments

c. Income/loss is 10 percent of combined loss of unprofitablesegments

d. Assets are 10 percent of combined assets of all operating seg-ments

SFAS 131 ¶ 20 Report additional segments until 75 percent of total revenue is included in reportable segments.

SFAS 131 ¶ 39 Report on extent of reliance on any customer if revenue from thatrelationship exceed 10 percent of total revenues.

Employee Stock Options SFAS 123 ¶ 23 A discount on the market price of up to 5 percent is deemed tobe a safe harbor for meeting part of the criteria of a noncompen-satory stock plan.

Postemployment Benefits SFAS 106 ¶ 59 Any unrecognized gain or loss that exceeds 10 percent of thegreater of the market value of assets or the accumulatedpostemployment benefit obligation should be amortized.

SFAS 106 ¶ 74 Employers with defined benefit postemployment plans must dis-close the effects of a 1 percent increase in assumed health carecost trend rates on various cost components of the plan.

Pension Plans SFAS 87 ¶ 32 Any unrecognized gain or loss that exceeds 10 percent of thegreater of the market value of pension assets or the projectedbenefit obligation should be amortized.

SFAS 35 ¶ 28 Any investment that exceeds 5 percent of the net assets avail-able for benefits should be identified in the disclosures fordefined benefit pension plans.

Related-Party Transactions SFAS 57 ¶ 24 Principal Owner is defined as one who owns more than 10 per-cent of the voting interests of the firm.

Leases SFAS 13 ¶ 7 Lease must be treated as a capital lease if the lease term is 75percent or more of the life of the asset except when the leasebegins in the last 25 percent of the life of the asset.Lease must be treated as a capital lease if the present value ofthe minimum lease payments is equal to 90 percent or more ofthe FMV of the leased asset at the inception of the lease.

Investments in Common APB 18 ¶ 17 Defines ownership levels between 20 percent and 50 percent of theStock voting stock as guidelines for appropriate use of the equity method.

ARB 51 ¶ 2 Defines a controlling financial interest as the direct or indirectownership of 50 percent of the outstanding voting shares.

Exhibit 1

May/June 2002 65


Examples of Quantitative Materiality Measures from Regulation S-X Application of Regulation S-X

Rule Number Rule Topic Specific Guidance Offered by the Rule Rule 1-02 Definition of terms used Defines terms based on percentages

in Regulation S-X 50-percent-owned person—owns approximately 50 percent ofvoting sharesPrincipal holder of equity security—beneficial owner of morethan 10 percent of any class of equity securitiesPromoter—Any person that receives 10 percent of any class ofsecurities of the issuer upon founding and organizing a businessForeign business—any business that has 50 percent of assetsoutside of the United States Significant subsidiary—investment in the subsidiary exceeds 10percent of the total assets or income of the registrant and itssubsidiaries

Commercial and Industrial Companies Rule 5-02 Balance sheets • Give separate disclosure for each of the following:

—current asset that exceeds 5 percent of total current assets—notes receivable that exceed 10 percent of total receivables—class of intangible asset in excess of 5 percent of total assets—current liability that exceeds 5 percent of total current liabilities—other liabilities in excess of 5 percent of total liabilities

Rule 5-03 Income statements • Certain revenue and income captions can be combined if thecombination does not exceed 10 percent of the total of allrelated classes

• Excise taxes that exceed 1 percent of total revenues for publicutility companies shall be shown parenthetically or separatelyon the face of the statement

• State the dividends received by 50 percent or less owned persons Rule 5-04 What schedules are to • Certain schedules are required to be filed when the restricted net

be filed assets of consolidated subsidiaries exceed 25 percent of consoli-dated net assets at the end of the most recent fiscal year

Interim Financial Statements Rule 10-01 Interim financial statements • Any balance sheet item that is less than 10 percent of total

assets and has not changed by more than 25 percent since thelast fiscal year may be combined with others

• Any income statement item that is less than 15 percent of theaverage income over the past three fiscal years and has notchanged by more than 20 percent since the last fiscal yearmay be combined with others

• The statement of cash flows may be abbreviated when cashflows from investing and financing activities exceed 10 percentof the average of net cash flows from operating activities forthe most recent three years

(continued)

Exhibit 2

these quantitative guidelinesapply to very specific situations,accounting professionals must becareful not to interpret them asgeneral guidelines for materialitydecisions.

In most instances, accountingstandards provide less well-defined guidance in the form ofsuggested comparisons withinfinancial statements. For instance,Accounting Principles BoardOpinion No. 20 recommendsgauging the materiality of achange in accounting principle byevaluating the change’s effect on“income before extraordinaryitems or on net income” or on the“trend of earnings” (par. 38). Andin other cases, a standard may

require that the nature of the itembe the basis for disclosure. Forexample SFAS No. 105, Disclo-sure of Information about Finan-cial Instruments with Off-BalanceSheet Risk, requires disclosure ofinformation about all such finan-cial instruments either in thebody of the financial statementsor in the notes to the financialstatements. SFAS No. 105 doesnot carry the standard exceptionthat provisions of the standard donot apply to immaterial items.

Guidance from the ResearchLiterature

How is the materiality of atransaction or event not covered

by one of these specific stan-dards judged? Generally, whatcauses an item, a transaction, anerror, or an omission to crossover the threshold from immate-rial to material? To answer thesequestions, we turn to the richbody of empirical inquiry on thesubject. Research on materialitycan be divided into two majorareas. The first group of studiesexamines auditors’ judgmentseither through surveys of audi-tors or by using auditors as sub-jects in carefully controlledexperiments. The second groupemploys information containedin financial statements to deriveimplicit materiality thresholds.Below we summarize what can



Examples of Quantitative Materiality Measures from Regulation S-X (continued)Application of Regulation S-X

Rule Number Rule Topic Specific Guidance Offered by the Rule Pro-Forma Financial Information

Rule 11-02 Preparation requirements Balance sheet items may be combined for pro-forma financialstatements if the caption is less than 10 percent of total assets.For the income statement, the caption can be combined if it is lessthan 15 percent of average net income for the past three years

Form and Content of Schedules Rule 12-12 Investments in securities of Investments in securities of unaffiliated issuers must be listed

unaffiliated issuers separately except under certain conditions; securities totalingless than 5 percent of the total value of all securities at the endof the period can be listed as miscellaneous securities

Rule 12-25 Supplementary profit and Any category exceeding 5 percent of total expenses should be loss information stated separately

Rule 12-28 Real estate and Separate information should be given for each investment except accumulated depreciation that an amount not exceeding 5 percent of the ending gross

amount of real estate can be classified as miscellaneous invest-ments

Rule 12-29 Mortgage loans on real Information is to be given for any mortgage that exceed 3 estate percent of the total carrying amount of all mortgages

SEC Rules S-X can be found in 17 CFR 210. The above information represents only a portion of the specific materiality guidance found in SEC Rules S-X.Other significant reporting requirements promulgated by the SEC can be found in the SEC Financial Reporting Releases, Accounting Series Releases, and StaffAccounting Bulletins. See 17 CFR 211 for a list of applicable releases and bulletins.

Exhibit 2

be learned from each group ofstudies.

Survey and Experimental Studies A number of survey and

experimental studies on material-ity have examined auditor judg-ments during the evaluationphase of an audit. The auditormust aggregate and evaluate thequalitative and quantitative char-acteristics of the information pro-vided by management to deter-mine if the financial statementsare materially misstated, whetheradjustments to the financialstatements should be made, andthe type of opinion to issue. Atthis point the auditor should con-sider how errors or omis-sions could affect the usersof financial statements.

Much of the earlierwork of this type has beensummarized by Holstrumand Messier (1982). Theyconclude that the mostimportant factor used inmaking materiality judg-ments is the effect that anitem has on income. They fur-ther conclude that the thresholdfor materiality is somewherebetween 5 percent and 10 per-cent of income from continuingoperations. Leslie (1985) inter-viewed accountants in the UnitedStates and Canada and suggestedother guidelines as follows:

• 5 percent of income beforetax

• 0.5 percent of revenues• 0.5 percent of assets• 1 percent of the book value

of equity

In perhaps the most compre-hensive study of its type, Warrenand Elliott (1986), on behalf ofthe AICPA, surveyed 691accounting professionals from abroad spectrum of U.S.-basedaccounting firms. The respon-

dents were asked to describemateriality thresholds used inaudits. Warren and Elliott’sanalysis and synthesis found thatauditors’ perceptions of material-ity levels were closely related tothree financial statement baseamounts—revenue, pretaxincome, and net income. Theyalso speculate that quantitativemateriality thresholds might becontinuous measures rather thansome fixed percentage of afinancial statement base amount(e.g., the materiality thresholdincreases as income increases,but at a decreasing rate).3 Use ofsuch a measure would also implythat materiality thresholds do not

vary as much as the underlyingbase amount, which could be animportant attribute for compa-nies with highly variable baseamounts such as income.

A question that naturallyarises concerns the internal con-sistency of these measures ofmateriality. Do the variousguidelines yield comparablemateriality thresholds? Pany andWheeler (1989) test the sensitiv-ity of five common rules ofthumb, including those suggest-ed by Leslie (1985) and a fifththat they call a sliding scalemeasure, similar to the continu-ous measures described above.4

They found very significant dif-ferences in the size of the mate-riality threshold across materiali-ty definitions and acrossindustries. In one industry, thelargest threshold was more than

18 times larger than the smallestthreshold. Differences of thismagnitude could imply very realdisparities in the levels of report-ing in financial statements andin the scope of the work per-formed by the auditor. Such dif-ferences also serve to emphasizethe importance of consideringqualitative factors in making themateriality judgment.

Another question that arisesis the comparison of auditors’views regarding materiality withthose of financial statementusers. If users’ views differ fromauditors’ views, then users maypresume a level of disclosurethat does not exist. Jennings,

Kneer, and Reckers (1987)compare auditors’ material-ity judgments with those ofchartered financial ana-lysts, bank loan officers,and credit managers. Mem-bers of these groups indi-vidually provided the dol-lar amount at which anitem became material foreach of five different

cases. The cases included thetiming of the write-off of obso-lete inventory, the appropriatefinancial statement recognitionof an extraordinary gain, disclo-sure of a lawsuit, disclosure of abribe, and a discontinued prod-uct line. The results indicatedthat financial analysts and creditmanagers had the most conser-vative materiality thresholds.Auditors’ thresholds were higherthan analysts and credit man-agers, and bankers’ thresholdswere higher than any othergroup. These results suggest thatauditors’ materiality thresholdsmay not coincide with those offinancial statement users.

Studies of Financial StatementDisclosure

Research of this kind utilizespublicly available information to

May/June 2002 67


In one industry, the largest thresholdwas more than 18 times larger thanthe smallest threshold. Differences ofthis magnitude could imply very realdisparities in the levels of reportingin financial statements…

infer materiality thresholdsinherent in financial statementdisclosures. The idea behindthese studies is that the actualmateriality thresholds applied invery specific circumstances canbe estimated by reviewing finan-cial statement disclosures oraudit opinions of various firms.Because immaterial amounts ortransactions typically are not dis-closed in financial statements,this kind of study is only possi-ble in limited circumstances.

The most common study ofthis type is an examination ofauditors’ actual materiality judg-ments when a firm changes fromone generally accepted account-ing principle to another.The changes may be dis-cretionary or mandated bythe FASB. Accountingstandards require firms todisclose all changes inaccounting principles andto report the effect of achange in the financialstatements, including the effectof the change on income. Audit-ing standards require the auditorto modify the standard languageof the audit report to disclose amaterial change in accountingprinciples. Thus, all changes inaccounting principles arerequired to be reported, andthose that are deemed materialreceive modified audit opinions.

In a study of the adoption ofSFAS No. 34, Capitalization ofInterest Cost, Morris andNichols (1988) find an averageeffect on income for modifiedaudit opinions (that is, materialchanges) of 17 percent and foraudit opinions not modified (thatis, immaterial changes) of 5 per-cent. Chewning, Pany, andWheeler (1989) examine threedifferent accounting principleschanges. Two of them were pro-fessionally mandated (SFAS No.43, Accounting for Compensated

Absences, and SFAS No. 52,Foreign Currency Translation),and the third change was discre-tionary (LIFO adoption). Resultsshowed that the standard auditreport was modified at muchlower percentages of incomethan either conventional wisdomor prior survey and laboratoryresearch would suggest. Approx-imately 60 percent were modi-fied when the change inaccounting principles increasedor decreased income by 4 per-cent or less. Auditing standardsevidently did not discourageauditors from modifying auditopinions for seemingly immate-rial changes. Nevertheless, the

research of Morris and Nichols(1988) and Chewning et al.(1989) implies considerable vari-ation in materiality thresholdsinvolving changes in accountingprinciples.

In a recent study, Chewning,Wheeler, and Chan (1998) exam-ine a different kind of financialstatement disclosure, the disclo-sure of gains from equity-for-debtswaps. Accounting standards(SFAS No. 4) require gains andlosses from the extinguishment ofdebt to be classified as extraordi-nary items if material in amount.Immaterial gains and losses arereported in “other income.”Therefore, the judged materialityof the reported gains and lossescould be inferred through the dis-closure option chosen.5 Note thatthis method overcomes the diffi-culty in precisely identifyingmaterial transactions associatedwith changes in accounting prin-

ciples. The results suggest thatmateriality thresholds followclosely a percentage-of-incomemateriality guideline. Swap gainsless than 5 percent of operatingincome were infrequently judgedto be material, while gains greaterthan 10 percent of income werefrequently deemed material. Agray area existed between 5 and10 percent. Sensitivity analysisindicated that 6 percent of incomeprovided the best cutoff betweenmaterial and immaterial gains.Further, the authors found thatthe disclosure option chosen(materiality) was closely associat-ed with the equity market’s stockprice reaction to the announce-

ment of the swap. Thesefindings imply similaritybetween the materialitythreshold used and equityinvestors’ assessment of theinformation contained in theannouncement of the swap.

The research on materi-ality finds that many finan-

cial statement items have beenused to develop materialitythresholds.6 Thus, a question thatarises is which measures arebest. That is, which financialstatement items are most closelyassociated with the materialitydecision? Chewning and Higgs(1998) summarize the findingsof a number of empirical studieson materiality using a quantita-tive method known as meta-analysis. They combined resultsfrom 26 studies that investigate11 different but often-used mate-riality measures. Four financialstatement items, two related toincome and two related to finan-cial position, were found to bestrongly associated with materi-ality across a wide variety ofdecisions and research methods.The financial statement itemsare income, revenue, assets, andequity. Materiality thresholdsbased on revenue or assets are



…many financial statement itemshave been used to develop materiali-ty thresholds. Thus, a question thatarises is which measures are best.

more stable from period to peri-od because assets and revenuestend to fluctuate less thanincome or equity. Also, material-ity decisions based on revenueand assets are much less likely tobe affected by a small denomina-tor. For example, if income isnear zero, a small amount willappear large relative to income.

The FASB (1995) hasexpressed a renewed interest indisclosure-related materiality.Their interest is related ultimate-ly to the elimination of immate-rial disclosures, thus increasingthe effectiveness of the remain-ing disclosures and reducing thecosts of disclosure. However, theFASB questions whetherexisting materiality guid-ance, whether prescribed inaccounting standards orprovided through rules ofthumb, is appropriate toapply to disclosure issues.Chewning and Higgs(1998) examine separatelythe existing disclosure-relatedmateriality studies (those studiesthat examine auditors’ actualmateriality decisions involvingaccounting principles changes).They find that materialitythresholds based on revenue andassets are strongly associatedwith the auditor’s decision todisclose the accounting changein the audit report. Thus, materi-ality guidelines based on tradi-tional income or balance sheetamounts may translate well todisclosure issues.

Implications of SEC StaffAccounting Bulletin 99

As stated previously, SECSAB 99 did not substantivelychange the previous rules. Fur-ther, it is unlikely that auditingfirms and financial statementpreparers will abandon numeri-cal rules of thumb. For the audi-

tor, these rules of thumb are use-ful in assessing the risk of thefirm and in determining sam-pling strategies. Numerical rulesof thumb continue to be usefulguidelines in making materialityjudgements. However, the SECbulletin let it be known thatusing a typical numerical thresh-old will not be a safe harbor formateriality decisions. It appearsthat the SEC was letting finan-cial statement preparers andauditors know that they mayhave a greater burden to justifyany errors or misstatements thatare not corrected in the issuedstatements. The bulletin alsoseemed to reflect the growing

recognition that preparers andauditors need to understand theenvironment and the risks facedby the firm and that these factorsare qualitative considerations in reporting and disclosuredecisions.

WHAT CONCLUSIONS CAN WEDRAW?

Collectively, the literature onmateriality leads us to some gen-eral conclusions.

• Materiality decisions areoften based on informationfrom both the income state-ment and statement of finan-cial position.

• Revenue, assets, income, andthe book value of equity arecommon bases for judgingmateriality. Materialitythresholds based on incomeappear to be in the 4 to 6

percent range but are notstrictly linear. Evidence alsosuggests that materialitythresholds increase asincome increases, but at adecreasing rate.

• Thresholds based on totalassets or revenue may bemore stable from year toyear than income-basedthresholds. The researchfindings imply a materialitythreshold of approximately0.5 to 1 percent of assets orrevenue and 1 to 2 percentof equity.

Accounting professionalsmust determine what is separate-

ly disclosed in the financialstatements. Materialityplays an important role indetermining the informa-tion available to others foranalysis and the form inwhich that information iscommunicated. Auditorsset materiality levels for

detecting errors and irregulari-ties. The conventional thought isthat only material items requireadjustments to the financialstatements; however, the SEC hasindicated that careful considera-tion should be given when con-cluding not to adjust statementsfor known errors because of themyriad of qualitative factors thatshould influence the decision.Footnote disclosures pertain onlyto material items. New account-ing standards need only beapplied if their effects aredeemed material. The auditor’sstandard report asserts that thefinancial statements are free ofmaterial errors, misstatements, oromissions. However, only in verylimited circumstances doaccounting standards actuallyprescribe materiality guidelines.In many disclosure situationswhere accounting standards donot provide guidelines, the mate-

May/June 2002 69


Thresholds based on total assets orrevenue may be more stable fromyear to year than income-basedthresholds.

riality decision may, in fact, be ajoint and negotiated decisionbetween management and theauditor. Considering the guid-ance given in SAB No. 99, andrecent corporate fraud, the nego-tiation of adjustments may comeunder greater scrutiny, particular-ly if evidence exists that theitems in question present infor-mation in a more favorable light.

Accordingly, research hasfound considerable variance inmateriality judgments acrossdecisions (e.g., reporting onaccounting principles changes)and across decision makers (e.g.,financial analysts and bank loanofficers). Financial statementusers need to know the materiali-ty rules used by managementand the auditor in order to betterinterpret the information pre-sented in financial statements.Thus, the situation over the pastfew years seems to beg for somegeneral materiality standard. Ageneral standard, even one witha threshold different from auser’s preference, would promotecross-sectional comparison andimproved disclosure forinvestors. Up until the Enroncase, it seemed that neither theFASB nor the SEC was likely topromulgate a general materialitystandard soon, although SAB 99did highlight the problems withmateriality decisions and thelack of general rules. However,an alternative that is both simpleand feasible is for managementor the auditor to simply reportthe materiality threshold used.

NOTES

1. For an excellent discussion of judicialstandards of materiality, see Jennings,Reckers, and Kneer (1985).

2. Situations where quantitative guidancehas been given have sometimes result-ed in financial statement users beingable to circumvent the spirit in whichaccounting standards were issued. For

example, the qualitative criteria onwhen to apply capital lease criteria hasgiven rise to some rather innovativelease contracts whereby the lessormeets and the lessee does not meet thecriteria for a capital lease (Kieso &Weygandt, 1998).

3. Elliot (1983) reported that the thenaudit firm of Peat Marwick Main useda continuous materiality measure foraudit planning purposes called the“audit gauge.”

4. The sliding scale measure wasdefined as 5 percent of gross profitbetween $0 and $20,000, 2 percentbetween $20,000 and $1,000,000, 1percent between $1,000,000 and$100,000,000, and 0.5 percent over$100,000,000.

5. This is a very important materialitydecision. Hand (1989) finds an earn-ings motivation for equity-for-debtswaps occurring in the mid-1980s.Earnings including swap gains wereinsignificantly different from analysts’expectations, but without the swapgains, earnings fell significantly shortof analyst’s expectations. Only if thegain were deemed material, would it beseparately disclosed in the financialstatements, and only then could thegain’s effect on earnings be easily eval-uated.

6. Chewning and Higgs (1998) identifymore than 50 quantitative materialitymeasures that have been examined inthe research literature.

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May/June 2002 71


Eugene G. Chewning Jr. is an associate professor of accounting at the Darla Moore School of Businessat the University of South Carolina. Julia L. Higgs is an assistant professor of accounting at the College ofBusiness at Florida Atlantic University. The authors would like to thank Maribeth Coller and Earl Spiller forcomments on an earlier draft of this article.

what does “materiality” really mean?

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