Zero Tolerance for Materiality
Back when I was America’s favorite least qualified CFO I spent a lot of time thinking about materiality thresholds. This is the accounting concept that you can’t audit everything, so if you end up within 5% of reality, it’s fine.
On the one hand, that idea is a huge time saver. If something is not going to move the numbers by a meaningful amount, why do the work of nailing it down? But on the other, it’s hugely unsettling. How can you put something out to the world knowing full well that it’s wrong? Moreover, doesn’t materiality depend on quality and not just quantity?
I watch our credit card statement like a hawk. I’m paranoid about fraudulent charges and the mess that such things create. This paranoia was compounded when I learned that fraudsters and thieves are most likely to make small charges to your credit card before making big ones to see if you notice. And if you let those slide because the hassle of calling your credit card company outweighs the expense amount, you’re likely signing up for a big problem.
So that’s an example of a case where a zero tolerance policy makes sense.
There’s tension between these two ideas, materiality versus zero tolerance. When does one apply and not the other?
We encounter this tension often when diligencing investments because companies are rarely exactly as they are presented in CIMs. What amount of slippage is tolerable versus what prompts renegotiation versus what would cause us to walk away? The line is fine and it always depends.
But what we do know is that problems never get better on their own. So if you let something slide because it’s immaterial, know that it’s likely to become material eventually.
– By Tim Hanson
