Consistency between Overall and Account-level Materiality Measures: An Inter-Industry Comparison and an Analysis of the Correlation with the Financial Ratios System

This study analyses the consistency between overall and account-level materiality measures. The study starts emphasizing the need for further research on planning materiality, considering that prior studies have shown large differences in materiality methods. A review of literature on materiality [Messier et al. (2005)] suggests continuing inter-industry investigations on planning materiality [Wheeler and Pany (1989)]. We have also noticed the absence of research in the area of connection between overall and account-level materiality amounts, considering the insufficiency of authoritative guidance about the allocation of preliminary materiality judgments to segments (balance sheet and income statement accounts). This paper, initially, presents an inter-industry comparison with the same approach used in the Wheeler-Pany study. The sample of annual reports refers to 2010 large and medium-size companies for the years 1996 through 2005. Data were obtained from a study annually published by Mediobanca (the leading Italian merchant bank) which focuses on manufacturing and services industries (thus excluding financial services companies). Financial statements data represent 30 different industries and are disaggregated in 3 clusters based on the trend analysis of net income over the ten-year period (constantly break-even or positive results; constantly negative results; non-constants results over the period). The firms in the sample represent, in the Italian economic scenario, the 44% of the whole revenues, the 55% of exportations and the 49% of the investments in fixed assets; 108 companies are listed at the Milano stock exchange. It is important to point out that the database described above is temporally homogeneous thanks to the fixed number of companies analyzed in each of the ten years. The results confirm some of the conclusions obtained by Wheeler-Pany but the magnitude and stability of different materiality measures over the period and across the 30 industries show partially different ratios. This may confirm a need to consider industry-specific materiality definitions. Subsequently the study verifies the size differences of the materiality measures with a simulation model related to the financial statement of a “perfect company” presenting a set of financial ratios unanimously considered excellent by the financial analysis literature. We calculated, for the “perfect company”, the same materiality measures considered in the inter-industry comparison; this simulation proves that, also in the case of a “perfect company” having excellent profitability, solvency, and liquidity ratios, the well-known materiality rules produce very different and anomalous results. We then modified the materiality percentages for the “constant percentage methods” in order to identify a set of measures internally consistent, i.e. producing the same amount of overall materiality. Subsequently we applied these new percentages to our inter-industry analysis in order to verify changes in magnitude, stability and measure ratios compared with the percentages typically used by auditors in the professional practice. Finally we adopted a bottom-up approach to define materiality measures, first by applying account-level materiality to the different administrative cycles (we used the general rule of “5 to 10%” modifying the account-level percentage according to the different degree of standardization of administrative cycle and the degree of technical indeterminateness of the diverse financial accounts) and then by aggregating the account-level materiality amount in order to calculate their overall effects on the main materiality base amounts (assets, equity, sales etc.). Our simulation proves that a bottom-up approach produces materiality measures considerably large in comparison with the overall amounts typically obtained by practitioners. We also made some sensitivity analysis of the impact that changes in financial ratios have on overall materiality illustrating which ratios can amplify the differences among the typical materiality rules