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Materiality guidelines for extraordinary items.

Materiality GUIDELINES for Extraordinary Items

Materiality is an important concept to accountants. Materiality levels are set for detecting errors and irregularities. Proposed audit adjustments are recorded only if they are material. Footnote disclosures are written to include material items only. An auditor's report is an attestation that the financial statements are free of any material omissions or misstatements. Accounting methods specified in authoritative pronouncements apply only if their effects are deemed material. Based on the pervasive use of the materiality concept by accountants, one might assume that materiality is well-defined in the accounting literature. This, of course, is not the case.

In 1975, the Financial Accounting Standards Board (FASB) began investigating the possibility of developing general materiality criteria that could be used in various circumstances. The project started with the issuance of a discussion memorandum (DM), "Criteria for Determining Materiality." Based on the profession's response to the DM, however, the FASB concluded that general standards of materiality are not feasible. This opinion is expressed in the FASB's Statement of Concepts No. 2 (1980, para. 131) where the board states that its "present position is that no general standards of materiality could be formulated to take into account all the considerations that enter into experienced human judgment." The board does provide a very general definition of materiality in Concept No. 2 (para. 132). An item is deemed to be material if the correction or inclusion of the item in the financial statements would have a probable impact on a user's judgment.

Even though the FASB does not provide a general set of materiality guidelines, it does recognize that materiality guidelines may be useful for specific items. For example, Statement of Financial Accounting Standards (SFAS) No. 14 provides specific materiality guidelines for determining reportable business segments. Also, Accounting Principles Board (APB) Opinion No. 15 specifies that the reduction of earnings per share caused by potentially dilutive securities is not material if it is less than 3% in the aggregate. In addition, there are numerous specific item materiality guidelines provided by the Securities and Exchange Commission.

In the absence of authoritative materiality guidelines, which is most of the time, accountants often use their own rules of thumb. Even though the decision concerning materiality is situation specific and depends on many factors (including the nature of the item and size of the entity), rules of thumb such as the following are often used: * 10%-15% of average net

income after taxes for the three

to five most recent years; * 5%-10% of the current year's

income from continuing

operations before taxes; * .5%-2% of total revenue or

total assets; and * 1%-2% of owners' equity.

One area where the concept of materiality has direct application is the disclosure of extraordinary items required by APB Opinion No. 30. The APB did not provide specific materiality guidelines for disclosing extraordinary items. As such, this article presents information on materiality levels practitioners are currently using in disclosing extraordinary items. These materiality levels can be used as guidelines by accountants in applying APB Opinion No. 30.

Reporting Extraordinary


APB Opinion No. 30 defines an extraordinary item as one which is both unusual in nature and infrequent in occurrence. An event or transaction is unusual in nature if it is abnormal and clearly unrelated to the typical activities of the business. It is infrequent in occurrence if it is not reasonably expected to recur in the foreseeable future. An extraordinary item is required to be disclosed separately on the face of the income statement on a net of tax basis. However, before this separate disclosure is required, the event or transaction must meet an additional requirement - it must be material. Regarding the materiality of an extraordinary item, the APB stated: "The effect of an extraordinary event or transaction should be classified separately in the income statement . . . if it is material in relation to income before extraordinary items or to the trend of annual earnings before extraordinary items, or is material by other appropriate criteria. Items should be considered individually and not in the aggregate in determining whether the extraordinary event or transaction is material." (APB Opinion No. 30, para. 24)

Thus, the board did provide some materiality guidance by stating that an item should be material in relation to income before extraordinary items. However, they did not mean that this should be the only materiality base considered or even the most important one. The phrase "or is material by other appropriate criteria" indicates that other materiality bases may be just as important.

In addition to leaving the appropriate materiality base largely up to the accountant's judgment, the APB leaves the materiality level entirely up to the accountant, as no mention is made of materiality levels in APB Opinion No. 30. With little guidance for determining the materiality of extraordinary items provided in the authoritative literature, it was felt that an examination of current practice would prove enlightening.

Developing Materiality


To determine the materiality levels currently being used for disclosing extraordinary items, the 1988 year-end financial statements of all firms included in Moody's Industrial Index were examined. Of the approximately 1,800 firms examined, 243 (13.5%) disclosed an extraordinary item on their income statement for the 1988 year end.

Since APB Opinion No. 30 requires firms to separately disclose extraordinary items only if such items are material, the assumption was made that all amounts disclosed had been judged material by the firms' accountants. If the amounts had been deemed immaterial, the extraordinary items would not have been given separate disclosure on the face of the income statement.

To evaluate the materiality levels used by those firms that reported extraordinary items, various materiality measures were examined for each firm. Since the APB did not specify the exact materiality base to be considered, numerous materiality measures were collected to provide readers with information on different materiality "yardsticks." For each of the 243 firms, the following materiality bases were obtained: 1. Current year's income before

extraordinary items; 2. Average income before extraordinary

items for the three most

recent years; 3. Net sales; 4. Net income; 5. Total assets; and 6. Owners' equity.

The first two measures were included because they were specifically mentioned in APB Opinion No. 30. The last four measures are commonly used materiality bases and were included to provide "other appropriate criteria."

The extraordinary item as a percentage of each of the above six bases was computed for each firm in the sample. For each of the six groups of percentages, a median was determined for the entire sample of firms. The median is simply the middle value in an array of items and, when dollar values are involved, is generally considered more representative of a group than is the mean. This is because the mean can be unduly influenced by a few very large or small values; the median is affected very little by these extreme values. The medians for the six materiality bases are shown in Table 1.

Table : Table 1

Median Materiality Levels for Extraordinary Items
Materiality base Extraordinary item
 as a percentage of base

Current year's income

before extraordinary items 25.61%

Average income before

extraordinary items for the
 three most recent years 26.17%
Net sales .94%
Net income 22.18%
Total assets .89%
Owners' equity 2.74%

These medians provide surrogates for the materiality thresholds used by the group as a whole. Since firms only disclose extraordinary items that are equal to or above their own materiality thresholds, the medians will be somewhat higher than the true materiality thresholds for the group (assuming such thresholds exist). Still, however, the median percentages provide an indication of the materiality levels of extraordinary items being disclosed by the profession as a whole. As such, the medians can be used by accountants as general guidelines or rules of thumb for evaluating the materiality of extraordinary items.

Using the Materiality


The medians displayed in Table 1 are not intended to replace an accountant's judgment. Obviously, many of the firms in the sample disclosed extraordinary items at materiality levels well above or below the thresholds shown. These measures could, however, be quite useful to an accountant who is trying to evaluate the materiality of an extraordinary item.

For example, assume an accountant has determined that a transaction meets the criteria for an extraordinary item but feels that the amount may not be material enough to warrant separate disclosure. The item is 9.5% of the current year's income before extraordinary items and .45% of total assets. Table 1 shows that the median amounts for the sample companies are greater (i.e., 25.61% and .89% for income before extraordinary items and total assets, respectively). Knowing this, the accountant might conclude that the firm's extraordinary item is indeed immaterial and that separate disclosure is not required. Of course, the accountant might also wish to consider all the materiality bases before making the final decision. In this hypothetical case, the accountant actually makes the decision; the information in Table 1 simply provides additional input for and comfort in the particular decision reached.

The risks or consequences of omitting a material item increase as the size of the firm increases. This is because more users rely on the financial statements of a larger firm than on the financial statements of a smaller firm. Thus, materiality levels for larger firms are often set at lower percentages than they are for smaller firms.

The sample of firms in this project included firms of widely-varying sizes; sales for the companies ranged from a low of less than $.5 million to a high of almost $97 billion. To make the information on materiality levels more useful, the sample was divided into two subsamples with an equal number of firms in each group. A company's sales was used as the measure of its size. Firms with sales of less than or equal to $166 million were placed in one group while firms with sales exceeding $166 million were placed in the other group. This cut-off point was chosen because it represented the middle point for the entire group and resulted in 121 firms in each group. The median materiality thresholds for the two groups are shown in Table 2. [Tabular Data Omitted]

Table 2 reveals that materiality thresholds do indeed decrease as the size of the firm increases. For each of the six materiality bases, the median materiality threshold is significantly smaller for the group of large firms. Again, the thresholds in Table 2 are not intended to replace an accountant's judgment, but they do provide useful information that could be used when making materiality decisions concerning the disclosure of extraordinary items.


It is both the FASB's and the profession's belief that general quantitative guidelines applicable for various circumstances are not feasible. There are too many qualitative factors that enter into human judgment for such wide-ranging guidelines to be useful. However, rule of thumb materiality guidelines are often used in practice as one of the many factors that enter into individual materiality decisions.

One important area where accountants must make materiality judgments is in disclosing extraordinary items in accordance with APB Opinion No. 30. Since the authoritative pronouncements do not provide specific materiality guidelines in this area, accountants are "on their own." This article has provided materiality guidelines for disclosing extraordinary items based on amounts currently being disclosed in practice. The guidelines are, of course, not intended to replace an accountant's judgment, but rather to provide more comfort or satisfaction with the particular decision reached.

Charles Jordan, CPA, DBA, is assistant professor of accounting at the University of Southern Missisippi in Hattiesburg. He received his DBA from Louisiana Tech University and has published articles in numerous journals.

Jim Henderson, CPA, PhD, is assistant professor of accounting at the University of Southern Mississippi in Hattiesburg. He received his PhD from Texas A&M University and has presented numerous seminars across the U.S.

Gus Gordon, CPA, DBA, is assistant professor of accounting at Stephen F. Austin State University in Nagogdoches, Texas. He received his DBA from Louisiana Tech University and has several years of experience in public accounting and oil and gas accounting.
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Author:Jordan, Charles; Henderson, Jim; Gordon, Gus
Publication:The National Public Accountant
Date:Dec 1, 1990
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