Now, let me give you another thing besides the directionality which is important. Another thing to consider about when can a small misstatement be material. Suppose I say that in our audit firm, we gonna plan the audit in such a way as to get reasonable assurance that there are no material misstatements, where a material misstatements in the quantitative sense is anything bigger than 5% of net income. But then someone on your audit team comes and they say, I found a misstatement, boss, and that's going to be the engagement partner on this engagement. And [COUGH] how big is it? Well, it's only 2% of net income. Well, did we plan the audit to have reasonable assurance that we would find misstatements that are that small? And the answer's no. We generally did not do that, because 5% was our planning of materiality, and it's only 2%, but here's the rub. Suppose that this person who's bringing this to your attention says, and as I was looking at the reason for this misstatement, it is very clear that this was not some honest mistake. And a lot of honest mistakes happen, because generally accepted accounting principles are very complex. You make mistakes all the time if you're management, despite being pretty competent. I mean, the revenue standards just are changing today, leasing standards just are changing today, and maybe by the time you're watching this video, some other standards, maybe environmental liabilities disclosures have just changed. So there's always these changes. So what's happening here is a situation when you have an intentional misstatement. And if it's an intentional misstatement, hopefully you'll see intuitively why that's more likely to be material. Because of that intentionality, you might ask well why is that misstatement there? Is it there because management wanted to exaggerate net income? And why would they want to do that? Well maybe their own personal compensation, equity based compensation, in the contract for how their equity compensation works, is more favorable if they meet some hurdles such as and they needed misstatement of 2% of net income. What if it's just fraud? What if they engage in fraud, intentional, with a malicious purpose, misstatement. So that they could maybe represent a higher net income for a bank that would make their financial statement ratios look more favorable that would enable them to get a loan. This is obviously material. So now we have a couple of attributes, don't we? Holding the quantum, the quantity of a potential misstatement constant. You now see directionality is one and the reason for the deviation is another. These are two factors that can cause seemingly small misstatements to be material. And let me give you one more before moving on. One thing you may be very well versed in is, companies give this earnings calls and they really love to build a report earnings per share that are higher than, certainly not lower than, the consensus analyst earnings forecast. So, if you pick up the New York Times, or the Wall Street Journal, or Chicago Tribune, or London newspaper, and you look at the Financial Times for example. And you look at what has happened to Citibank's earnings and you find out that Citibank earned x dollars per share and that happens to be $0.05 on the dollar higher than what was expected. So they're reporting what's called a positive earning surprise. Sometimes the amount of misstatement that is required to go just above analysts expectations, as supposed to being just below, is a very small misstatement. And you really don't need to fabricate much income, you can just very, very, very easily manipulate the numbers this way. And this of course is not a very satisfying, because we would love to live in a world where you say, I must collect the numbers fall where they fall and then representation faithfully report those numbers. That's not, unfortunately, the world you find yourself living in. As an auditor, you need to be professionally skeptical and realize that management maybe manipulating earnings in precisely this fashion. Even a small misstatement could be a material statement. And by the way, here is a very useful skill for you to have as an auditor if you find yourself talking to management and negotiating with them about whether a misstatement you have found is a material one. What is it that you do? Well you step into the shoes of an investor and you think it's material. Management says it's not material. What's your rejoinder? What's your trump card? Well, I think the best thing to say is, I do agree with you that it's probably not material, as such, you have no problem booking it, right? If management [laugh] doesn't want to book it in their books, that tells you it's actually probably material, right? Their aversion to booking it is itself pretty strong evidence that this is material. So again, don't just roll over when management says it's in material. If it's not material, it's not a big deal, then book it.
