I use the following analogy to explain the auditor’s preliminary judgment of materiality.
“Imagine this desk in the front of the room is a pile of sand. And imagine I tell you there are one or more bowling balls buried in the sand. Your assignment is to tell me how many bowling balls there are. What tools would you use and how long would it take you to find all the bowling balls?” Students answer that using a rake they could find all the bowling balls within a couple of minutes.
“Now imagine this pile of sand contains one or more dimes and your job is to tell me how many dimes there are.” Students realize they would have to sift through the entire pile of sand teaspoon by teaspoon and the task would take many hours. The size of the item being sought affects the tools chosen and the time necessary to complete the search.
In the same way, the auditor’s preliminary judgment of materiality affects both the nature of the tests performed and the time that must be budgeted. During planning, auditors decide if they are looking for “bowling balls” (misstatements of $1 million or more) or “dimes” (misstatements of $5,000 or more).
“Revisiting Materiality,” Willie Gist & Trimbak Shastri, CPA Journal (November 2003): 60-63. Describes how auditors apply the concept of materiality during planning, when determining sample sizes, and when evaluating misstatements.
“Current Materiality Guidance for Auditors,” Thomas McKee & Aasmund Eilifsen, CPA Journal (July 2000): 54-57. Describes common quantitative approaches for determining an overall preliminary judgment of materiality and for determining tolerable misstatements for individual account balances.
“Measuring Stockholder Materiality,” S-Y Cho, R.L. Hagerman, S. Nabar & E.R. Patterson, Accounting Horizons (Supplement 2003): 63-76. Based on stock price fluctuations surrounding earnings announcements, differences in earnings as small as 0.2 percent of pretax income can influence stock market reactions.
“The Effect of Misstatements on Decisions of Financial Statement Users: An Experimental Investigation of Auditor Materiality Thresholds,” Brad Tuttle, Maribeth Coller & R. David Plumlee, Auditing: A Journal of Practice & Theory (March 2002): 11-27. Based on behavior of undergraduate students participating in an experimental market, financial statement misstatements equal to or less than 10% of net income do not appear to affect prices investors are willing to pay for securities.