Pop Quiz: Which company would likely have a lower materiality level regarding its net income?
Hi!
Based on the explanation: "Company B has smaller net income and smaller swings in net income would have a proportionately greater impact on decision-making (versus Company A.)".
Does this imply that company B has **higher **materiality level instead of lower as stated as the conclusion?
Thanks!
Comments
Hello,
No, it would mean company B has a lower materiality level -> The conclusion is correct.
Let's give a simple example to highlight this assuming we have two companies
Company A with an annual net income of 1,000M
Company B with an annual net income of 10M
During the course of creating the appointed actuary's report, company A and B are unable to balance these numbers with what they have in say some other financial report.
Scenario: Both companies are unable to balance to the sum of 2M
Basically that represents 0.2% of Company A's net income. Would it be concerning? Probably not. However, this same sum represents 20% of the net income for company B. Would it be concerning? Very.
Again to reiterate for arguments sake, let's assume a 20% mismatch would cause concern for management. 20% for company A would be 200M while it would be 2M for company B.
It takes a 200M mismatch for company A to be concerned whereas it only takes a 2M mismatch for company B to be concerned. Therefore, the materiality standard is lower for company B.
Your example makes sense but the source is implying the opposite for lower level (more rigorous for larger entities). How do you explain this?
The source is just saying it is much harder for a company making 1000M in net income to meet a 2M materiality threshold than for a company making 10M to meet that same 2M dollar threshold. I don't see any contradiction here
My question was regarding the level of materiality depending on the size of the company.
In your example based on income the lower the income the more rigorous but according to the text the larger the entity the more rigorous, so if your example is correct the level of materiality based on income and size go in opposite directions, which I have difficulty understanding
@graham
The smaller your income, the smaller your materiality. It's in the same direction. The source is not saying the larger the size, the smaller your materiality.
It is saying for a fixed dollar threshold, the materiality as a % of income would be more rigorous for larger rather than smaller companies
May we look at an example? Given a dollar standard of materiality of $2M and two entities with income of $100M and $10M, the standard of materiality as a percentage of income would be 2% and 20% respectively, so like you said in your example 20% is more concerning so the materiality standard for the smaller entity is lower and thus more rigorous. Therefore a given dollar standard of materiality is more rigorous for a small entity than a large company (opposite of text)
A lower % is more rigorous than a higher percentage. Rigorous from an audit standpoint means the amount of accuracy needed in your Financial statements. Limiting your SUM to within 2% of Net Income is more rigorous than limiting SUM to 20% of Net Income
I understand the logic behind this, but I feel like I am not interpreting it correctly. In the wiki it states:
Pop Quiz: Which company would likely have a lower materiality level regarding its net income?
Company A: incorporated in 1970
Company B: incorporated in 2016
I understand and agree that this impact Company B more. But the question is asking which company has a lower materiality level? Since it is affecting company A less, wouldn't company A have a lower materiality level?
Higher materiality means it takes a greater discrepancy in a number to prompt action. By this definition, company A will have a higher materiality
So its referencing their tolerance level. Its like saying who has a lower tolerance level, so company B has a lower tolerance level.
Yup - materiality is really just tolerance to discrepancies