One of the five techniques of earnings management identified by the Securities and Exchange Commission relates to materiality. Independent auditors have traditionally used arbitrary quantitative benchmarks to define how large an amount must be to be

considered material. During the course of auditing the financial statements of a company, an auditor finds some misstatements in the client's financial statements. When combined, the misstatements, result in a 4% overstatement of net income and a $.02 (4%) overstatement of earnings per share. The auditor's materiality threshold is 5%, that is, an item in the financial statements must be misstated by more than 5% to be considered a material deviation from generally accepted accounting principles. On the basis of the established materiality threshold, the auditor concludes that the deviation from GAAP is immaterial and the accounting is permissible. Define the term "materiality" and explain whether the auditor is justified in the conclusion that the accounting proposed by the client is permissible.

Materiality is defined by the FASB in its Statement of Financial Accounting Concepts No. 2 as follows:

The omission or misstatement of an item in a financial report is material if, in light of 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 been influenced by the inclusion or correction of the item.

This definition requires that the auditor consider the facts in the context of the surrounding circumstances. The FASB has never endorsed a quantitative threshold as the sole basis for determining the materiality of an item. The FASB has said that the magnitude of an item by itself, without regard to the nature of the item and the circumstances in which the judgment must be made, is not a sufficient basis for a materiality judgement. Auditors must therefore consider qualitative and quantitative factors in assessing an item's materiality. Among the qualitative factors that might be considered are:

-Intentional misstatements are more important than unintentional misstatements (such as clerical error) since an intentional error reflects on the integrity and reliability of management and employees of the client company.

-Immaterial misstatements may be material if they allow the client to avoid violation of a contractual agreement such as a debt covenant.

-Does an immaterial misstatement affect the trend in earnings?

-Does the immaterial misstatement allow the company to meet financial analysts' expectations for the company?

-Does the immaterial misstatement result in meeting the threshold for management bonuses where the bonus compensation is based on earnings?

If the auditor discovers that any of the situations from the list above apply to the misstatements in question, then the auditor should investigate each misstatement thoroughly. Reliance on a quantitative threshold alone may not be adequate.