As a guest speaker at a recent, global accounting network event I was very interested to hear a robust discussion focused on the subjective area of “materiality”. The unsurprising, and somewhat unsatisfactory, conclusion from the room was that determining materiality depended on a number of different factors, and that there was no “golden rule”. Not the preferred answer for a room full of accountants. What is clear, though, is that to determine materiality one must first of all calculate the numbers before judging what is material or not.
From a financial instrument valuation perspective, my take on materiality is slightly different.
A different take on materiality
The complex nature of financial instruments means that auditors cannot simply rely on the client provided valuations and use these to judge materiality. It is a big assumption that the valuations are, indeed, correct. Valuations need to be cross-checked to ensure the starting point of deciding whether they are material is valid.
There are two important points to remember with this. Firstly, banks are often the source of clients’ valuations and they can, and do, get it wrong. The disclaimer at the bottom of any counterparty provided valuation is testament to this. The message that valuations should not be relied upon comes through loud and clear. There is plenty of scope for human error in the process of calculating financial instrument valuations. We see it regularly, when we are asked to check valuations. Despite the disclaimers it is understandable that companies do actually rely on the valuations for financial reporting purposes, particularly small and mid-size companies as they often don’t have access to the systems to value these instruments themselves.
Check the valuation
So, as an auditor, you need to check the valuation. If not, what might at face value be regarded as immaterial might in fact be quite the opposite. The correct valuation may well be material. Again, we have seen plenty examples of this. Auditors need to look at the underlying transaction. If the notional amounts are large, or maturing a long way out into the future, then you need to check the valuation. The correct valuation is unlikely to be small due to financial market volatility.
Interest rate swaps are a good example of this. They tend to be large notional amounts and maturing in more than twelve months’ time, sometimes out 10 or 15 years. Equally, with foreign exchange contracts you need to look at the maturity date and the notional amounts being bought and sold to be able to make an informed decision on whether the results are likely to be material or not.
A conversation no one wants to have
If there is found to be a material difference in the financial instrument valuation, it is better to find it before the audit is complete, rather than after. No one wants to have that discussion with the CFO or Finance Director about having to restate the accounts.
So next time you get involved in that riveting conversation about materiality don’t forget to look behind the numbers.