August 2007 NEWSLETTER: Financial Literacy for Not-for-Profits
"Financial Literacy for Not-for-Profits"
This newsletter is a free service to the North American not-for-profit community from William Harper Associates. Its focus is on helping organizations that do good, do better ... by helping Not-for-Profit Boards and managers improve their understanding of financial management and reporting concepts, and implementing practical, effective financial controls and processes.
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August 2007: Financial Literacy for Not-for-Profits
This month's Financial Literacy Newsletter discusses the concept of materiality.
The concept of materiality is one of the underlying principles of accounting. It is often referred to, but rarely defined. So, just what does it mean?
Materiality has slightly different meanings in different contexts.
Bookkeeping
At a basic bookkeeping or transactional level, materiality refers to activities - transactions - that have a financial or monetary impact and that therefore merit recording. Since this is so fundamental a principle, it is rarely referred to, except in basic bookkeeping classes.
Accounting and Reporting
Materiality is a more complex subject, however, in the context of financial accounting and reporting. Essentially ...
information is considered material if its inclusion or disclosure in a financial report would change, impact or influence the decision of a user of that report.
Note that this is a user-focused test. Materiality is in the eye of the user, so to speak. As a result, what is material to one user may not be to another. A Board member may have different needs and interests from a donor, who may have different needs again from the Canada Revenue Agency. Materiality has to be considered, not in the context of one of these users, but in the context of all of them. If a piece of information would influence any one of them, it may be a material item.
So, the users of the financial statements matter here, not the preparer. And, yet, it is the preparer who must decide what information to include or exclude, and how to present it. Obviously, the preparer has to understand who the users are, and what is important to them.
There are various ways in which a piece of information can be material (or not). For example, if a transaction is simply not recorded, its omission may be material. Or, if a transaction is recorded, but in the incorrect place, its placement may be material. Finally, if information isn't strictly the result of a transaction (i.e. it isn't material in a bookkeeping sense), it wouldn't be recorded in the organization's accounts. But, perhaps it should be shown in a note to the financial statements.
Here's an example. Let's consider a large payment made by an organization for consulting services:
- If this transaction is not recorded, the organization's cash will be overstated, and its expenses will be understated. Users will be misled as to the financial position and results of operations of the organization.
- Now, let's assume this transaction was recorded, but the amount was shown as salaries instead of consulting expense. This misplacement, or misclassification, could cause a reader of the financial statements to make incorrect judgements about how the organization was being run, what its employees were being paid, and what it was spending on outside consultants.
- Finally, let's assume the transaction was correctly recorded as a consulting expense. However, let's also assume that the sizeable fee paid was well in excess of market rates, and this fee was paid to the Board chair's husband. Some additional disclosure (at a minimum!) is clearly called for, even though the transaction was correctly recorded in the accounts. This information is clearly material!
This latter issue - that of a related party or non-arms-length payment - illustrates one of the difficulties of preparing materially correct statements. It is not just a matter of good bookkeeping, of getting the numbers recorded in the right accounts (though that is a basic first step). It is also a matter of understanding and evaluating the many qualitative aspects of the organization's financial activities, and seeing that these are fairly presented in the statements.
In this sense, accounting is too important to be left (entirely) to the accountants!
Audit
Materiality is also a term often used in the context of the audit. Since the auditor needs to form an opinion on whether the statements are fair, he or she needs to consider what is material to those statements. In fact, much of the auditor's work relates to materiality.
Often, the auditor will determine and work with a numerical figure for materiality. This figure will form the basis for determining the nature and extent of testing that he or she needs to do as part of the audit. This figure will help establish how much detailed work needs to be done in checking the bookkeeping and the other basic recording and classification activities of accounting.
Materiality, as we've seen above, however, is not so simple as a single number, and the auditor will temper the use of this single materiality figure in his or her work with professional knowledge and experience. The auditor will likely pay close attention to areas that are of particular interest to known or expected financial statement users, such as the related party disclosures called for under the third bullet above.
William Harper is a Chartered Accountant, and has broad experience in accounting, auditing and financial reporting. Contact us for help.