So let's start off with a definition of materiality. What does it mean when something is material? You probably have a layperson's definition, something is material to you that matters. But within the financial statement context, materiality is the magnitude of the misstatement, that makes it probable that the judgment of a reasonable person, relying on that information, would reach a different conclusion, or that their conclusion would be influenced by that misstatement. So it's interesting, isn't it? It's not only changing their conclusion, but influencing their conclusion. And the person we're talking about here it's not just any investor, but a reasonable person. When it comes right down to who is and is not a reasonable person, that's really beyond the scope of the course, but if I ever were to be a case that's litigated, it would be determined within a court system or outside of a court system sometimes by independent third parties called mediators or arbitrators. So, when the auditor says I'm obtaining reasonable assurance, it's very important for you to realize that they're not obtaining reasonable assurance that the financial statements are free of misstatement period. No, it's that they are free of material misstatement. Let's look a little bit more deeply, audit learners, at material misstatements. I want to share some of the factors that auditors examine when trying to plan the audit or when looking at a misstatement that they have located and trying to get a sense of, is this something that we need to require of management to adjust their books because that's material, or is it something that if management pushes back that we can at least discuss amongst the audit team and realize that it's it's probably not material? So go back to the basics, a material difference is a difference that could affect the decisions of a reasonable decision maker who uses the financial statements. Material to whom, you might ask. And you might also ask, what about small misstatements? And you see an illusion there to PCAOB AS 14. PCAOB, again, is the Public Company Accounting Oversight Board. They are the body that's responsible for both drafting and creating Auditing Standards and also enforcing compliance with those standards for publicly traded companies in the United States. There are other standard setting bodies such as the AICPAS, American Institute of Certified Public Accountants audit standards board, and they would apply to all non-registrants... non-public registrants in the United States. And it's a very similar idea here. But as we talk about what is material, one question is, material to whom? The primary users of financial statements from your financial reporting class, if you remember, are investors and creditors. That's exactly what you said, right? Investors and creditors, but there are other users, right? Such as regulators, suppliers, and customers, maybe members of a professional guild or body. And again, it's not...any decision maker is reasonable decision makers. So let's talk about attributes that can make a misstatement material. In particular, using those attributes to say what might make a small quantitative misstatement, nonetheless material because of qualitative reasoning. The best way to do this would be for the auditor to not assess this based on what they think as an auditor, but what they think these main decision makers, who rely on the financial statements, think. So, what I'm getting at here is that for you to assess materiality, how material is a error that you have found, you need to think about stepping into the shoes of reasonable investors to assess the degree to which a proposed audit adjustment is material. That conceptually is a very good idea. Now, I'll get to some reasons why it is hard, I do have the note to that perspective taking is difficult and I'll go into why, but let's just toggle back to what about small misstatements and then the idea of needing to step into the shoes of a reasonable investor. What do investors think about? Okay, let's just think about what investors look at. Do investors care about just the size of the misstatement, or is the direction of the misstatement also important? Suppose I tell you you have for $100 million of net income, suppose I tell you there is a $10 million misstatement. Now, is your answer about how important that going to be differ, does it differ, if that's a $10 million overstatement. That the income should have been 90 million or $10 million understatement, that the reported income should have been 110 million. If you're like most investors, you care more deeply about areas of overstatement than understatement. So keep that in mind, if you're an audit firm and you say, Well, in guiding our planning of the audit, we're going to say that any misstatement that is greater than 5% of net income is material. Maybe you need to rethink that and say, if 5% understatements of net income are material, maybe a 3% overstatement of net income is material. One thing you would not want to say is that, well, it needs to be a 5% overstatement and a 3% understatement. That would be very unusual. So step back, think about how reasonable investors would react to overstatements versus understatements. And it's easy to do at one level there because if you ask yourself, if management has an incentive to misstate, what direction would a misstatement tend to go, understatements or overstatements? Well when it comes to things like assets and revenues, it's typically going to be overstatements. When it comes to things like liabilities and expenses, it tends to be understatements.
