|EXECUTIVE SUMMARY |
| FEW ISSUES INVOLVING THE PREPARATION of financial statements in conformity with generally accepted accounting principles have been more elusive and difficult to address and resolve—or of greater importance—than materiality. It also has proved challenging in planning and conducting financial statement audits in accordance with generally accepted auditing standards.
THE ISSUANCE OF GASB STATEMENT NO. 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments, which introduced substantial changes in the basic financial statements of state and local governments, makes it even more critical that preparers and auditors of such entities understand the applications of materiality and related standards.
GUIDANCE IS CONTAINED IN NUMEROUS DOCUMENTS: Among them are GASB’s recently issued Statement no. 34 and Comprehensive Implementation Guide—2003, as well as the AICPA’s SAS no. 47, Audit Risk and Materiality in Conducting an Audit, and its new audit and accounting guide, Audits of State and Local Governments (GASB 34 Edition), which provides materiality guidance to auditors that introduces a new opinion unit concept. It requires auditors to make separate materiality determinations for purposes of planning, performing, evaluating the results of and reporting on the audit of a government’s financial statements for each opinion unit.
PRACTITIONERS WORKING IN STATE and local governments or who audit such entities should relate the financial accounting and reporting literature to the authoritative auditing literature in order to appropriately prepare and audit financial statements.
|William W. Holder is the Ernst and Young Professor of Accounting at the University of Southern California, Los Angeles, and a member of the Governmental Accounting Standards Board. His e-mail address is email@example.com . Kenneth R. Schermann is a senior project manager at GASB. His e-mail address is firstname.lastname@example.org . Ray Whittington is director and a professor at DePaul University School of Accountancy and MIS, Chicago. His e-mail address is email@example.com . |
ew 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 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.”
In state and local governments, because of recent profound changes in accounting standards and auditing guidance, professional obligations related to materiality considerations have changed significantly and become more complex.
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. Considering the quality of the internal control, selecting the nature and extent of audit procedures and evaluating the significance of known financial statement misstatements all depend, in part, on materiality determinations.
Some profound changes have appeared recently in the authoritative accounting and auditing literature specific to state and local governments. Every GASB standard includes a “materiality box” that states in boldface type: “The provisions of this Statement need not be applied to immaterial items.” GASB no. 34, as all other GASB pronouncements, does not elaborate on the possible implications of that notice; the determination of what is or is not material is appropriately left to the professional judgment of preparers and auditors. It should surprise no one that differences of opinion are common—what’s material is, in many ways, in the eye of the beholder. Further, in any standard like GASB no. 34, which is so comprehensive that it redefines what constitutes basic financial statements, the challenge of assessing materiality is considerable.
G ASB no. 34 includes many specific financial statement display requirements. At the government-wide level of reporting, it requires financial statements for governmental activities to be presented separately from the financial statements of business-type activities. For example, governmental activities such as police protection and public education are aggregated and reported separately from business-type activities such as airports and utilities, which also are separately aggregated and reported. GASB no. 34 requires separate financial statements for the general fund and all other “major” funds in the fund reporting section of the basic statements. The standard makes it clear that neither government-wide statements nor fund financial statements are considered superior or subordinate to the other—they are equally important, and all are required for a “complete” set of statements presented in conformity with GAAP.
Although not explicitly addressed in GASB no. 34, the board’s implied philosophy in writing the standard was quite simple and can be characterized as follows: GAAP requires that separate financial statements be presented for specific reporting units. If those financial statements are presented in accordance with GAAP, the reader can expect the statement for each unit to be fairly stated.
GASB no. 34 requires the separate presentation of financial statements for certain individual government and enterprise funds based on a “major funds” concept. That is, the financial statements of each of the most quantitatively significant (based on dollar magnitude) funds must be presented in a separate column. Therefore, individual funds that are required to be presented as major funds have passed a quantitative test that ordains them as “material.” In addition governments may choose to present other funds separately, based on the concept that some may be considered by management to be significant qualitatively to financial statement users even if they are not significant quantitatively. Therefore, the funds selected by the government entity to be reported separately are, in essence, material for their qualitative characteristics.
The GASB standards require government financial statements to present the financial reporting entity as defined in GASB no. 14, The Financial Reporting Entity. The presence of component unit financial information adds more pieces to the materiality puzzle because component unit financial statements are required to be presented in one or more columns in the government-wide statements of the reporting entity. GASB no. 14 allows the component units to be aggregated in a single column but also includes a requirement to provide additional information about “major” component units. Thus, in formulating a solution to the materiality dilemma, it is necessary to consider also the financial reporting objectives of GASB no. 14 and the component unit display and disclosure requirements contained in it.
GASB’s Comprehensive Implementation Guide—2003 contains questions and answers that address, in part, issues of financial reporting materiality in applying GASB no. 34. That guidance is based on the requirements of GASB standards to report separate financial statements or information for various reporting units (see the exhibit below for a summary of such units). Specifically, the implementation guide asserts that practitioners should view the financial statement columns reporting “governmental activities, business-type activities, and each major fund…to be quantitatively material.” Preparers should also view as quantitatively material any funds that do not meet the GASB no. 34 criteria for major funds but which management elects to identify as major even though the amounts reported may be relatively small compared with other funds required to be reported as major. The remaining fund information—nonmajor funds, internal service funds and fiduciary funds—may or may not be material. The determination of how the data presented for those reporting units should be assessed would consider relevant qualitative factors and the relationship of the remaining fund reporting units to other appropriate information in the financial statements. In addition the implementation guide says that major component units are not equivalent to major funds for purposes of assessing materiality. Rather, because GASB no. 34 provides a variety of ways to acceptably report major component units, the preparer’s consideration of materiality should be based on the manner in which such units are included in the government’s financial statements. The implementation guide acknowledges in several of the answers to questions about applying GASB no. 34 that preparers of financial statements of state and local governments should consider the qualitative aspects of materiality, but it does not provide extensive guidance for doing so.
The AICPA assembled a task force to revise the state and local government audit and accounting guide, issuing it in September 2002 as Audits of State and Local Governments (GASB 34 Edition). (See “ Each Audit Is Unique .”)
As described in SAS no. 47, “the auditor’s consideration of materiality is a matter of professional judgment and is influenced by his or her perceptions of the needs of a reasonable person who will rely on the financial statements.” Thus, materiality for audit purposes is directly related to an entity’s required financial statements. In audits of commercial entities, determining materiality is somewhat simplified by the fact that every entity presents generally the same basic financial statements: balance sheet, income statement and statement of retained earnings and statement of cash flows. In contrast to business enterprises, the required financial statements (reporting units) of government entities may vary from one entity to the next and, in some cases, for the same entity from period to period. The audit guide on state and local governments establishes the concept of opinion units to identify individual units for which the auditor must make materiality determinations when planning, performing, evaluating the results of and reporting in a government audit.
Normally, the opinion units consist of governmental activities, business-type activities, the aggregate discretely presented component units, each major government and enterprise fund and the aggregate remaining fund information (that is, nonmajor funds, internal service funds and fiduciary funds). Because the auditor provides an opinion on each of these units, he or she must make separate materiality determinations for each one. In other words, the auditor must plan and perform the audit to provide reasonable assurance there are no material misstatements of any of the opinion units. This relationship among the basic financial statements, reporting units and opinion units is presented in the exhibit .
O ther considerations may complicate the determination of materiality levels. As an example, paragraph 4.20 of the state and local government audit and accounting guide discusses item 7.6 of the GASB’s Comprehensive Implementation Guide—2003, which advises preparers to consider disaggregating the remaining fund information for purposes of materiality evaluations. However, the audit guide states that even if a preparer disaggregates this information for evaluation purposes, the auditor should not establish more than one opinion unit for the aggregate opinion unit. Thus, the auditor is still responsible for providing only reasonable assurance of detecting material misstatements in the aggregate remaining fund information and not the individual disaggregated presentations within that opinion unit. Similarly, the auditor is not required to establish more than one opinion unit for the aggregate discretely presented component units, regardless of how the component units are presented in the entity’s financial statements. However, the audit guide points out that the opinion units for the aggregate remaining fund information and the aggregate discretely presented component units may include diverse information. For that reason the auditor should consider how qualitative and quantitative factors relating to those aggregate opinion units may affect the nature, timing and extent of audit procedures.
In most audits the auditors treat the aggregate discretely presented component units and the aggregate remaining fund information as separate opinion units. However, in some audits, the aggregate discretely presented component units may not be qualitatively or quantitatively material to the financial statements of the primary government. For example, a township (the primary government) has a single component unit—a small community mental health board—that provides services to residents, the operations of which are immaterial to the township.
|In other situations the aggregate remaining fund information may not be qualitatively or quantitatively material to the primary government. For example, the remaining fund information for a county (the primary government) might consist of only a small internal service fund used to account for telephone services to various county departments and a small nonmajor real estate assessment fund used to account for the monies from tax settlements, both of which are immaterial to the county. In either of these situations, the audit guide says, the auditor may elect to combine the two aggregate opinion units (the aggregate remaining fund information and the aggregate discretely presented component units) into a single opinion unit for purposes of planning, performing and reporting on the entity’s financial statements. The combined opinion unit would be referred to in the auditor’s report as the “aggregate discretely presented component unit and remaining fund information.” For audit purposes this information may not be aggregated with other opinion units even if the combined opinion unit is not material to the primary government.
Audit and Accounting Guide, Audits of State and Local Governments (GASB 34 Edition) (012663)
Audit Risk Alert, State and Local Governmental Developments—2003 (022433)
Practice Aid, Auditing Governmental Financial Statements: Programs and Other Practice Aids (006602; available December 2003)
Practice Aid, Applying OCBOA in State and Local Government Financial Statements (006614)
Checklists and Illustrative Financial Statements for State and Local Governments (009033; available November 2003)
Practice Aid, Understanding and Implementing GASB’s New Financial Reporting Model (022516)
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A s discussed in SAS no. 47, although auditors should be alert for misstatements that are qualitatively material, it ordinarily is not practical to design procedures to detect misstatements that are qualitatively but not quantitatively material. However, in both planning the audit and evaluating the results of audit procedures, the auditor should consider qualitative factors, such as the possibility of fraud, illegal acts, conflicts of interest and politically sensitive matters, that might cause quantitatively immaterial items to be material.
In addition, responding to the terms or needs of the engagement, the auditor may set materiality at a lower level than the opinion units required for the audit of the basic financial statements. A greater level of detail is usually dictated by legal or contractual provisions, that is, state law, bond covenants or grant or contribution agreements. In such cases the more detailed audit scope supplements, rather than replaces, the scope of the audit on a government’s basic financial statements. That is, the auditor should continue to plan, perform, evaluate the results of and report on the audit of the basic financial statements based on the opinion units described above. In addition the auditor should design the audit to provide reasonable assurance of detecting misstatements at the specified materiality level.
The consideration of materiality affects the work of financial statement preparers and auditors. In state and local governments, because of recent profound changes in accounting standards and auditing guidance, professional obligations related to materiality considerations have changed significantly and become more complex. Therefore, practitioners should tie the aforementioned financial accounting and reporting literature to the authoritative auditing literature, including the recently published Audits of State and Local Governments (GASB 34 Edition), in order to appropriately prepare and audit such financial statements.
|Each Audit Is Unique |
While the AICPA audit and accounting guide, Audits of State and Local Governments (GASB 34 Edition), makes it clear that rendering multiple opinions is required, it is equally clear auditors must develop these opinions within the context of one audit. Developing and reporting multiple opinions within one audit creates a number of unique issues an auditor must consider in planning, performing, evaluating the results of and reporting in a government audit.
First is the issue of the scope of the audit. A differing number of opinion units can significantly change the audit’s scope. Since management determines the number of major funds (each of which is considered an opinion unit), the auditor may not know the number of opinion units when the terms of the engagement are being set. Late transactions or adjustments also may require a new fund to be presented as major, creating an opinion unit the auditor had not considered in planning the audit. The terms of the engagement should be structured either to accommodate such changes (that is, include a specified fee amount per major fund) or provide for changes to the terms of the engagement. Otherwise, the auditor may end up with a professional requirement to provide another opinion without being compensated for the additional work.
Another issue is internal control. The auditor must have an understanding of the internal controls over each opinion unit. If the auditor decides to test internal controls, he or she may test across the opinion units (assuming the same controls are in place) since the objective is to determine whether the internal controls are effective at preventing or detecting misstatements. While the testing may be performed across opinion units, the auditor must ultimately form a conclusion about the effectiveness of the controls and then ensure that adequate substantive procedures are performed for each opinion unit.
The auditor also will have to make sure the following audit procedures effectively address each separate opinion unit:
Documenting initial materiality decisions.
Understanding and testing internal controls unique to a specific opinion unit.
Accumulating identified uncorrected misstatements.
Evaluating the adequacy of note disclosures.
Testing the budgetary comparison (when included within the financial statements).
Perhaps the biggest concern for the auditor in dealing with opinion units is not to lose sight of the qualitative aspects of materiality in evaluating his or her audit results. A number of unique issues within a government’s financial statements present qualitative considerations that a numeric approach simply can’t adequately address.
—Andrew J. Blossom
Andrew J. Blossom is national industry director for state and local government at KPMG LLP and chairman of the AICPA task force that developed the audit and accounting guide Audits of State and Local Governments (GASB 34 Edition). His e-mail is firstname.lastname@example.org .