As audit season begins for calendar-year entities, it’s important to review issues that may arise during fieldwork. One common issue is materiality. This concept is used to determine what’s important enough to be included in — and what can be omitted from — a financial statement. Here’s how materiality is determined and used during an external financial statement audit.
What is materiality?
Under U.S. auditing standards and Generally Accepted Accounting Principles (GAAP), “The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable [emphasis added] that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” This aligns with the definition of materiality used by the U.S. judicial system.
How do auditors determine the materiality threshold?
Auditors rely on their professional judgment to determine what’s material for each company, based on such factors as: Size, Industry, Internal controls, and Financial performance. During fieldwork, auditors may ask about line items on the financial statements that have changed materially from the prior year. A materiality rule of thumb for small businesses might be to inquire about items that change by more than, say, 10% or $10,000. For example, if shipping or direct labor costs increased by 30% in 2023, it may raise a red flag, especially if it didn’t correlate with an increase in revenue. Businesses should be ready to explain why costs went up and provide supporting documents (such as invoices or payroll records) for auditors to review.
Establishing what’s material is less clear when CPAs attest to subject matters that can’t be measured — such as sustainability programs, employee education initiatives or fair labor practices. As nonfinancial matters are taking on increasing importance, it’s critical to understand what information will most significantly impact stakeholders’ decision-making process. In this context, the term “stakeholders” could refer to more than just investors. It also could refer to customers, employees and suppliers.
For more information contact Dan Harris, our experienced Audit Partner, to discuss the appropriate materiality threshold for your upcoming audit. Liquidity overload: Why having too much cash may be bad for business In today’s uncertain marketplace, many businesses are stashing operating cash in their bank accounts, even though they might not have imminent plans to deploy their reserves. However, excessive “rainy day” funds could be an inefficient use of capital. Here’s a systematic approach to help estimate reasonable cash reserves and maximize your company’s return on long-term financial positions.
What’s the harm in stockpiling cash?
An extra cushion helps your business weather downturns or fund unexpected repairs and maintenance. But cash has a carrying cost — the difference between the return companies earn on their cash and the price they pay to obtain cash. For instance, checking accounts often earn no (or very little) interest, and many savings accounts generate returns below 2%. If a company has cash reserves while simultaneously carrying debt on its balance sheet, such as equipment loans, mortgages and credit lines, it will pay higher interest rates on loans than it’s earning from the bank accounts. This spread represents the carrying cost of cash.
What’s the optimal amount of cash to keep in reserve?
Unfortunately, there’s no magic current ratio (current assets divided by current liabilities) or percentage of assets that’s right for every business. A lender’s liquidity covenants are just an educated guess about what’s reasonable. However, you can analyze how your company’s liquidity metrics have changed over time and how they compare to industry benchmarks. Substantial increases in liquidity — or ratios well above industry norms — may signal an inefficient deployment of capital. Prospective financial reports for the next 12 to 18 months can be developed to evaluate whether your company’s cash reserves are too high. For example, a monthly forecasted balance sheet might estimate expected seasonal ebbs and flows in the cash cycle. Or a projection of the worst-case scenario, based on certain what-if assumptions, might be used to establish a company’s optimal cash balance. Forecasts and projections should take into account a business’s future cash flows, including capital expenditures, debt maturities and working capital requirements. Formal financial forecasts and projections provide a method for building up healthy cash reserves. This is much better than relying on gut instinct. You also should compare actual performance to your forecasts and projections — and adjust them, if necessary.
What’s the highest and best use of excess cash?
After prospective financial reports and industry benchmarks have been used to determine a company’s optimal cash balance, management needs to find ways to reinvest its cash surplus. For example, you might consider repurposing the surplus to: Invest in marketable securities, such as mutual funds or diversified stock-and-bond portfolios, Repay debt to lower the carrying cost of cash reserves, Repurchase stock, especially when minority shareholders routinely challenge management’s decisions, or Acquire a struggling competitor or its assets. With proper due diligence, these strategies could allow your business to reap a higher return over the long run than leaving funds in a checking or savings account.
We can help Connect with Dan Harris, our experienced Audit Partner, for more information.
Reynolds + Rowella is a regional accounting and consulting firm known for a team approach to financial problem solving. As Certified Public Accountants, our partners foster a personal touch with our clients. As members of DFK International/USA, an association of accountants and advisors, our professional network is international, yet many of our clients have known us for years through the local communities we serve. Our mission is to operate as a financial services firm of outstanding quality. Our efforts are directed at serving our clients in the most efficient and responsive manner possible, delivering services that exceed the expectations of those we serve. The firm has offices at 90 Grove St., Ridgefield, Conn., and 51 Locust Ave., New Canaan, Conn. For more information, please contact Elizabeth Bresnan at 203.438.0161 or email.
