What it means
Many financial questions have no precise answer, such as how much a company should pay its owner-manager or whether a bad debt provision is large enough. The reasonableness standard gives a common-sense yardstick for these judgement calls.
The test is not about perfection or hindsight. It asks whether, on the information available at the time, a prudent person acting in good faith could have reached the same conclusion.
A decision can turn out badly and still be reasonable, and a lucky outcome can still be unreasonable if the process was careless. Tax rules apply the idea to expenses and pay.
A tax authority may deny a deduction for compensation that is far above what comparable businesses pay for similar work, treating the excess as a disguised profit distribution. Businesses defend their position by keeping evidence such as pay surveys, job descriptions and written board approvals.
In auditing, a reasonableness test is an analytical check that compares a recorded figure with an expectation built from other data. If the gap is larger than a set tolerance, the auditor investigates further.
This is a quick way of catching mistakes or manipulation without testing every transaction. Because the standard is flexible, it can differ between industries, countries and cases.
Documentation is the best protection, since a clear paper trail turns an opinion into a supportable position. When in doubt, write down who decided, what information they had and why the amount made sense.
The standard also appears in contracts and in the law of directors' duties. A director is generally expected to act with the care and skill that a reasonable person in that role would show.
Courts tend to respect decisions made after proper information gathering, even when they later go wrong.
In practice
Real-world examples.
Example
A family-owned engineering firm pays its owner a salary of $600,000, while similar managing directors in comparable firms earn about $250,000. The tax authority questions the amount. The firm shows that the owner works 70 hours a week and brought in most of the clients, and the dispute ends in a compromise.
Example
A retailer sets its provision for returns at 3% of sales, based on the last three years of data. Returns this year are 2.8% of sales, so the auditor concludes that the estimate is reasonable. If returns had been 8%, the auditor would have challenged the provision.
Example
A non-profit board approves a $90,000 fee for a consultant after obtaining three quotes ranging from $80,000 to $110,000. Minutes record why the chosen consultant was selected. The documentation supports the claim that the fee was reasonable.
Formula
Calculation
Variance % = (Recorded amount - Expected amount) / Expected amount x 100
Suppose an auditor expects payroll cost to equal 40 employees x $65,000 average salary = $2,600,000. The company has recorded payroll of $2,750,000. The difference is 2,750,000 - 2,600,000 = $150,000, which is 150,000 / 2,600,000 = 5.77%. The auditor's tolerance is 5%, or $130,000, so the gap is too large to accept without explanation and further testing is needed.Case study
Seen in the real world.
Stonebridge Interiors is an illustrative, fictional design company owned by two founders. During a review, a tax adviser notices that each founder received total pay of $480,000, including a bonus, in a year when profit after that pay was $1,100,000.
The adviser compares the pay with published surveys for similar roles, which suggest total pay of around $300,000 each. She warns that the excess of $180,000 per founder, or $360,000 in all, could be challenged as unreasonable compensation.
The founders agree to document their duties, obtain a pay survey and have the board approve the amounts in writing for the future. In this illustrative case, they also reclassify part of the bonus as a dividend, which makes the position clearer. The adviser notes that the tax treatment of dividends differs from pay, so the change needs careful checking with the local rules.
Watch out
Common mistakes.
- Assuming the standard is a fixed number, when it is a judgement that depends on facts and evidence.
- Judging a decision only by its outcome rather than by what was known at the time.
- Failing to document the reasoning, which leaves a perfectly sensible decision hard to defend.
Questions
People also ask.
Who decides what is reasonable?
It depends on the setting, with tax authorities, courts, auditors and boards each applying the test in their own area.
Is a reasonableness test the same as a materiality threshold?
No, materiality asks whether an error is large enough to influence users of the accounts, while reasonableness asks whether a figure is plausible.
How can a business prepare for the test?
Keep evidence such as comparable data, quotes, board minutes and written explanations at the time the decision is made.
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