The 5% Rule and Materiality

BY STEVEN D. JOHNSON

The discussion of the effects of the Sarbanes-Oxley Act on the evaluation of materiality is a timely one. “ The New Importance of Materiality ” ( JofA , May05) is a well-thought-out approach to how CPAs and managers might work toward identifying and evaluating misstatements internally. But I believe further emphasis is warranted to highlight the fact that the advice is for internal purposes and initial assessment only. Much of the focus of the text relates to a “5% rule” to use internally to make assessments on the likelihood of misstatements being material. While such guidelines can be useful, they are not GAAP or GAAS. However, a reader might incorrectly interpret them to be so because of the way they were presented. For example, there are numerous references to a 5% rule—how auditors determine which opinion to render and which internal control weaknesses are material weaknesses based upon the “rule” and references to materiality being defined by the “rule.”

It is my concern the reader may draw the following inappropriate conclusions:

A 5% rule exists and is authoritative.
GAAP materiality is defined by a 5% rule.
Auditors make decisions based upon a 5% rule.
Misstatements of less than 5% have no effect on financial statement fairness.

The 5% rule is widely used in practice. So long as the practitioner is aware that it is merely a starting point and not in any way a “rule” to be relied upon for final assessment, it is a useful tool. This type of internal assessment, as a starting point, surely supports the spirit and intention of the Sarbanes-Oxley Act, and the article can offer excellent guidance in performing initial internal assessments. But one must be aware to exercise caution to avoid relying upon that advice as GAAP, GAAS or the “rules.”

Steven D. Johnson, CPA
Redondo Beach, Calif.

A Search for the Truth
The JofA 's Centennial Countdown has inspired some thoughts with a flavor for the past, present and future that I would like to share.

Each fiscal year management fulfills the role of raconteur by telling its story regarding the company’s financial position and results of operations. Financial statements prepared by management serve as the medium of communication. Users of financial statements, principally investors and creditors, rely on the content in these company health reports.

The purpose of the audit function is to lend credibility to the financial statements prepared by management in conformity with GAAP. An auditor has the responsibility of forming a professional opinion regarding management’s assertions in the financial statements. Therefore, the auditor must be a credible witness and an impartial judge.

While independence represents a major pillar of auditing, consistent erosion of independence prevails today. Auditing independence provides a vital organ to the financial markets. A loss of public trust in the auditing profession severely jeopardizes the ability of corporations to raise massive amounts of money through equity and debt issues. Auditors face the challenge of regaining this trust by carrying out their duty to honestly certify financial statements.

From a historical perspective, Ellen Libby Eastman in “Speaking of ‘Figgers’” ( The Certified Public Accountant, May 1929, page 139) eloquently wrote of the important relationship between accountants and truth: “There has never lived the perfect certified public accountant, possessing all of the much-to-be-desired qualities: trustworthiness, fearlessness, energy, steadfastness, a studious and inquiring turn of mind, ability to seek the truth and to judge fairly and without prejudice or personality. Forgive us our shortcomings; we are but human.”

Eastman further discussed the concept of truth in accounting: “The next in order after a passionate love of figures and things mathematical, comes the ability to seek and to find the truth. One must know how to translate it with the fewest possible processes and by the simplest procedure into those figures which all…can read, if not understand. And that is all there is to it—to find the truth and translate it efficiently into figures.”

Thus, if you cheat, you will lie. Seek and tell the truth.

Andrew D. Sharp, CPA
Professor of Accounting,
Spring Hill College
Mobile, Ala.

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