Balance Sheet Materiality Calculation and Control Deficiency 2425



  • We have a control deficiency that we are evaluating to determine if it is significant deficiency or material weakness. The accounts affected are a balance sheet account and OCI. Does the ‘5% rule’ also apply when calculating material for non-income statement accounts? If not, then what % would you use?



  • Basically materiality refers to what an investor in your comany’s equity or debt securities would consider material.
    An investment decision, is usually based on past financial reports by making projections for future financial performance (discounted cash flow models, market multiples, etc.) or comparing them to peer companies.
    You could ask a securities analyst that covers your comany whether he or she is willing to shares his valuation model for the security. You could then use the model to see if the value of the security would materially differ if certain of the financial numbers that do as input factors into the model change.
    In a model based on discounted future cash flows, a lot of balance sheet positions may be irrelevant unless they cover non-core assets that could be sold to reduce debt or to return to shareholders. Most of the information to project future cash flows will come from the cash-flow statement or the income statement or the notes. A need to make capital expenditures in the immediate future will also have a strong impact on the value of securities.
    In the case of loss-making companies or companies with negative operating cash-flows, the amount of available financing (cash or debt) will have a material impact on the value of the comany’s equity or debt securities.
    A lot of balance sheet items will have an effect on the cash-flows in the cash-flow statement or on future cash-flows. E.g. if the useful life is wrong, the fixed asset is wrong and the assumption about the timing of future capital expenditures may be wrong, wrong inventories, accounts receivable and accounty payable will only have a short-term impact on the cash-flows of the next year, but probably not on the value of the securities. If an analyst uses EBITDA- or EBIT-market multiples, an error on the asset or liability side may have its counter effect on revenues or expenses and thus EBITDA. However, the multiple to arrive at the enterprise value can easily be more than 5 times EBITDA or a higher multiple for EBIT or even higher for net earnings.
    I hope this helps to do some calculations.


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