Materiality guidelines for modifying audit reports.

A change in accounting principle, as defined in Accounting Principles Board Opinion no. 20, Accounting Changes, is a change from one generally accepted accounting principle to another. The cumulative effect usually is disclosed on the face of the income statement in the year of the change. Such a change impairs the consistency of a company's financial statements and requires special consideration by the auditor.

Statement on Auditing Standards no. 58, Reports on Audited Financial Statements, says issuance of a standard audit report implies "the comparability of a firm's financial statements between periods has not been materially affected by changes in accounting principles. A standard report may be issued when there is no change in principle or when a change has occurred but its effect on the financial statements is deemed immaterial. However, a material change in principle requires auditors to modify the standard report by referring to the change in an explanatory paragraph.

SAS no. 58 provides no guidance on what constitutes a material effect. Opinion no. 20 furnishes some guidance by simply saying the materiality of an accounting change is determined by its effect on various income variables. Thus, an auditor's decision on the materiality of a change in principle rests almost exclusively on professional judgment. This article provides guidelines to help auditors determine whether the effect of a change in accounting principle is material enough to warrant audit report modification.

DEVELOPING MATERIALITY GUIDELINES

To determine the materiality levels auditors use in modifying audit reports because of a lack of consistency, we examined the financial statements of all companies listed in Moody's industrial index for five years (1988 to 1992). This index contains the primary financial statements of approximately 2,000 companies. During this period, 840 companies--ranging in size from $250,000 to $193 billion in total assets (median size: $579 million)--disclosed the cumulative effect of changes in principle on their income statements.

We also examined the audit reports for these 840 companies, Since SAS no. 58 requires that a report be modified for any material change in principle, we assumed a standard (unmodified) report indicated the auditor's conscious assessment that the effects were immaterial. Any reports modified for a lack of consistency suggested the auditors deemed the effects of the changes to be material,

The 840 companies fell into two groups--those with standard reports and those with modified reports. A standard report is one with no reference to the change in accounting principle. A modified report contains an explanatory paragraph referencing the principle change. Only 72 companies (8.6%) had standard reports. (There is a possibility some auditors modified their reports without making materiality judgments.

To determine the materiality levels auditors use, we obtained three widely used materiality bases for each of the 840 companies:

* Total assets.

* Owners' equity.

* Current year's income from continuing operations after taxes.

For each company we computed the cumulative effect of the change in principle, expressed as a percentage of these bases. For each base, we established a median percentage for both the standard and modified report groups. The median (the middle value in a distribution above and below which lie an equal number of values) generally is considered more representative of a group than the average because the average can be unduly influenced by a few extreme values. The medians for the two report groups appear in exhibit 1, above.

These medians provide benchmarks of the materiality levels used by the two groups of auditors. Exhibit 1 shows the relationships between the groups to be as expected: For each base, the median percentage is significantly higher for the companies with modified reports.

Several factors suggest an auditor's likelihood of issuing a modified report increases as company size increases. For example, since more users (such as investors and analysts) rely on a large company's audit report, an auditor's hability risk for failing to issue a modified report when warranted with company size. The larger number of investors increases both the probability and dollar size of any potential legal action. To reduce the risk, auditors may be more likely to modify the reports of large companies.

The dollar magnitude of accounting changes for larger companies also can affect auditors' decisions. The absolute dollar size of any item, regardless of its impact on a materiality base, may compel an auditor to modify the report. An auditor also might modify a large company's report simply to provide investors with more information.

The data bear this out; exhibit 1 shows the median total asset size of the modified report group ($671 million) was more than double the total asset size of the standard report group ($284 million). Exhibit 2, page 92, contains the breakdowns by company size of modified versus standard reports. It further demonstrates the increasing probability that accounting firms will modify their reports as company size increases. For very large companies, those with total assets exceeding $5 billion, the decision to issue a modified report appears almost automatic.

APPLYING MATERIALITY GUIDELINES

Representing the collective judgment of hundreds of auditors, the medians in exhibit 1 provide yardsticks other auditors can apply to materiality decisions. For example, assume an auditor has three clients (companies A, B and C as shown in exhibit 3, page 92) that changed accounting principles during the year. The auditor concurs with each change; thus, the primary question is whether the changes are material enough to warrant report modification.

The auditor's preliminary judgment about company A is that the effect of the change probably is material enough to warrant report modification. Comparing company A's percentages to the medians in exhibit 1 provides additional justification for modification. For each materiality base, company A's cumulative effect exceeds the median level for the modified report group. Company A's size points toward modification as total assets ($710 million) are in the range of companies with modified reports (a median asset size of $671 million).

The quantitative effect of company B's change is much less significant and the auditor believes report modification may not be warranted. The medians in exhibit 1 support this view as company B's cumulative effect falls well below the medians for the standard report group. In addition, company B's size ($85 million) is far less than the median size ($284 million) for the standard report group. Thus, as other auditors have done, issuing a standard report for company B appears justified.

Company Cs decision is more perplexing. The guidelines in exhibit 1 reveal that company C's percentages are greater than the medians of the standard report group but less than those of the modified report group. Company C's total asset size also falls between the median for the standard and modified report groups. Thus, the guidelines do not readily suggest a clear decision.

For additional information, the auditor examines the asset levels and auditors' propensities to modify the reports shown in exhibit 2. Company C's total assets ($580 million) fall in the $500 million to $1 billion range, in which approximately 92% of firms modified their reports. When combined, these facts provide justification to modify this report.

ULTIMATE DECISION

The guidelines shown here are not intended to dictate how materiality decisions should be made. They simply provide additional information auditors may draw on to reach their own conclusions. The ultimate decisions continue to rest with individual auditors.

RELATED ARTICLE: EXECUTIVE SUMMARY

[] A CHANGE IN ACCOUNTING PRINCIPLE is a change from one generally accepted accounting principle to another. The cumulative effect usually is disclosed in the income statement in the year of the change.

[] STATEMENT ON AUDITING STANDARDS NO. 58, Reports on Audited Financial Statements, says issuing a standard audit report implies the comparability of financial statements between periods has not been materially affected by changes in accounting principles.

[] A STANDARD REPORT MAY BE ISSUED when there is no change in principle or when a change's effect on the financial statements is deemed immaterial. A material change in principle requires auditors to modify the standard report by referring to the change in an explanatory paragraph.

[] AUDITORS CAN BENEFIT FROM HAVING GUIDELINES to help them determine whether the effect of a change is material enough to warrant audit report modification. For example, several factors suggest an auditor's likelihood of issuing a modified report increases as company size increases.

[] GUIDELINES ARE NOT INTENDED TO DICTATE how materiality decisions should be made. The ultimate decisions continue to rest with individual auditors.

CHARLES E. JORDAN, CPA, DBA, is associate professor of accounting at the University of Southern Mississippi, Hattiesburg. STANLEY J. CLARK, CPA, PhD, is assistant professor of accounting at the University of Southern Mississippi. GWEN R. PATE, PhD, is assistant professor of accounting at the