Audit Materiality: Session 10

Session 10
Audit Materiality
FOCUS
This session covers the following content from the ACCA Study Guide.
B. Planning and Risk Assessment

3. Assessing audit risks
c) Define and explain the concepts of materiality and performance
materiality.
d) Explain and calculate materiality levels from financial information.
Session 10 Guidance
Revise the IFRS definition of materiality and learn the term "performance materiality" (s.1.1).
Understand the concept of materiality in relation to the types of error, their cumulative effect and
different levels (s.1.2–s.1.4).
Understand the considerations which affect the assessment of materiality, paying particular attention
to quantitative (s.2.2) and qualitative (s.2.3) aspects.
(continued on next page)

F8 Audit and Assurance Becker Professional Education | ACCA Study System
Ali Niaz - ali.niaz777@gmail.com

VISUAL OVERVIEW
Objective: To describe the concept of materiality and its relationship with audit risk
and planning.
MATERIALITY
• Concept
• Basic Principles
• Levels of Materiality
• Performance Materiality
• Qualitative Materiality
• Impact
CONSIDERATIONS
• Professional Judgement
• Amount
• Nature
AUDIT PROCEDURES
• Planning
• Effect on Audit Work
• Relationship With Risk
• Changing Materiality
• Documentation
Session 10 Guidance
Understand how materiality affects audit planning (s.3.1) and audit work (s.3.2). Attempt
Examples 1 and 2.
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Session 10 • Audit Materiality F8 Audit and Assurance (INT)
1 Materiality
1.1 Concept
Materiality (from IASB and IFRS)—information is material if its

omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements. ... Materiality
depends on the size of the item or error judged in the particular
circumstances of its omission or misstatement. It provides a
threshold or cut-off point rather than being a primary qualitative
characteristic which information must have if it is to be useful.
Performance materiality (from ISA 320)—the amounts set by
the auditor at less than materiality for the financial statements as a
whole to reduce to an appropriately low level the probability that the
aggregate of uncorrected and undetected misstatements exceeds
materiality for the financial statements as a whole.
■ The objective of the auditor is to apply the concept of materiality

appropriately in planning and performing the audit.
■ Materiality is an expression of the relative significance or
importance of a particular matter in the context of the financial
statements as a whole.
● "The objective of an audit is to enable the auditor to express
an opinion whether the financial statements are prepared, in
all material respects, in accordance with an applicable financial
reporting framework." (Session 1)
● "The objective of the auditor is to identify and assess the risks
of material misstatement, whether due to fraud or error, at
the financial statement level and assertion levels, through
understanding the entity and its environment, including the
entity's internal control, thereby providing a basis for designing
and implementing responses to the assessed risks of material
misstatements." (Session 8)
1.2 Basic Principles

 The auditor must use his professional judgement to determine
exactly what is, and what is not, material based on:
 his understanding of the entity and its environment;
 its financial results (transactions and balances) and
*Qualitative
disclosures; and
misstatements include
 the requirements of the users of the financial statements. failure to disclose
 A rigid materiality model would not be practical because of information as required
the many differences between entities and the users of their by laws, regulations
financial statements. or GAAP (e.g. IFRS
disclosures—but
 Materiality may be quantitative (based on values) or remember that IFRSs
qualitative (based on the nature of the matter).* apply only to material
items).
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F8 Audit and Assurance (INT) Session 10 • Audit Materiality
 Although an individual amount or procedure may not be

material, consideration must be given to the cumulative
impact, for example:
 An error in a procedure may not be material, but repeating
(e.g. each month) would indicate a potential material
misstatement.
 Individual immaterial pricing errors in raw materials may
result in a cumulative total that will be material especially
when extrapolated through work-in-progress and finished
goods.
 Failure to apply an accounting policy (e.g. depreciation
of buildings) may not be material to profit and loss in
any one year, but cumulatively it may become so (e.g. in
accumulated depreciation on the statement of financial
position).
1.3 Levels of Materiality*
Materiality level for the financial statements as a whole

*Materiality at the
financial statement
level must be set, as
must performance
Particular classes of materiality.
transactions, account Determining
materiality for
balances or disclosures,
particular transactions,
if considered appropriate
balances and
disclosures is a
matter of professional
judgement, not a
matter of routine.
Performance
Performance materiality Performance materiality for
materiality will usually
for above, if any assessing risks and planning
be less than other
further audit procedures materiality levels.
■ Having determined a materiality level based on the financial

statements as a whole, the auditor must consider if there are any
particular classes of transactions, balances and disclosures for
which misstatements less than the overall materiality level could
reasonably be expected to influence the economic decisions
of users.
Examples include:
● The effect of laws or regulations (e.g. remuneration, related party
transactions, fraud).
● Key disclosures relating to the industry (e.g. research and
development in a pharmaceutical company).
● Events that would cause particular focus on a specific aspect of a
company's activities (e.g. acquisitions and disposals).

1.4 Performance Materiality

 Planning the audit to consider only individually material
misstatements overlooks the cumulative impact of aggregated
undetected immaterial misstatements exceeding the overall
financial statement materiality level.
 The determination of performance materiality is not a simple
mechanical calculation, but draws on:*
 the nature of the entity;
 the auditor's past experience (e.g. numerous immaterial
*Basically, the
errors found during the course of audit testing);
performance
 the use of professional judgement; and materiality level is the
 the expectation of misstatements in the current period. materiality that is used
 In addition, when considering the aggregate of immaterial when performing audit
tests (e.g. receivables
misstatements found during the audit process (but not
confirmation, purchase
adjusted as immaterial), consideration should be given to
transaction testing,
the performance materiality to ensure that the aggregate of inspection of non-
each class of transaction, balance or disclosure unadjusted current assets).
misstatements is not material.
It may be the overall
financial statement
1.5 Qualitative Materiality materiality, the
 Materiality can be measured both quantitatively and individual materiality
qualitatively. The difficulty of determining qualitative for specific classes of
transactions, balances
materiality benchmarks cannot be overlooked.
and disclosures that
 Benchmarks include, for example, disclosure requirements are key to the users,
detailed by IFRS and listing disclosure rules. These may be or a separate lower
subdivided into objective disclosures (those that can be easily level calculated to
determined and verified (e.g. disclosures concerning changes take into account
in accounting policies or through prior year errors) and the possibility of
subjective disclosures (risk narrative disclosures (IAS 1) and undetected material
segmental narrative disclosures—see Illustration 2). misstatements.
 To judge whether or not disclosures concerning subjective

(and estimated) matters are materially misstated, the auditor
needs a thorough understanding of the entity's business and
sound professional judgement (mixed with a large dose of
professional scepticism).* *Discussing such
disclosure matters with
1.6 Impact those charged with
governance (e.g. the
 Materiality will impact when: audit committee) is
 planning an audit (through its relationship with audit risk); essential.
 determining audit procedures (their nature, timing and
extent);
 carrying out the audit (identified errors may affect
materiality levels);
 evaluating errors identified during the audit process; and
 evaluating misstatements in the financial statements.

2 Considerations
2.1 Professional Judgement

 Understanding the entity and its environment establishes
a framework within which the auditor is able to apply
professional judgement to determine what is material in the
context of the entity, its environment and control procedures.
 Professional judgement is also used to determine the classes
of transactions, balances and disclosures that are material.
What is a material class of transaction (or balance) for one
entity may be immaterial for another (e.g. rental income may
not be material to revenue in a retail company but would be
material to a property management company).
Understanding what is, and is not, material enables the auditor

to consider the nature, timing and extent of audit procedures to
apply (e.g. sampling, substantive analytical procedures,
stratification) and what to apply them to, to reduce audit risk
to an acceptably low level.
2.2 Amount (Quantitative Materiality)

 In designing the audit plan, the auditor initially sets an
appropriate materiality level so as to detect quantitatively
material misstatements at the financial statement level.
 Through understanding the economic decisions of users, lower
materiality levels may also be set based on the classes of
transactions, account balances or disclosures that such users
would consider to be material.
Financial Statement Level Assertion Level
Look at the item in relation to financial Comparing an item to a category as

statements as a whole. For example, a whole (e.g. an inventory error of
compare to: $50,000 compared to total inventory
• revenue; value of $650,000).
• profit before taxation;
• total assets; May be established as a set figure or as
• capital and reserves. a percentage of a total.
Consider in relation to the elements of The error of $50,000 may be considered

the financial statements (e.g. a different material to inventory, but may not be
materiality level for the statement of material to the statement of financial
comprehensive income and the statement position, if inventory as a whole is not
of financial position). a material item.
 As a "yardstick", materiality must be relevant to the user

rather than the preparer of financial statements and should
take into account critical points. For example:
 profit  loss (may be material to employees);
 net current assets  net current liabilities
(may be material to investors).

 The auditor must also take into account that some balances
are capable of "precise determination" and dictated by law
and regulations, while others are not and are determined by
opinion and judgement rather than fact.
Precise Determination Use of Opinion/Judgement
For example, directors' emoluments and For example, bad debt allowance, contingent
share capital. liabilities and asset useful lives.
Any error (however small) may be The depreciation charge based on five years
considered material and adjusted, may be material to profit and loss, but if
especially as the precise amount is based on six years it may not be: five or six
required to be disclosed by law. years is a matter of opinion and judgement.
Both could be equally acceptable.
Some reasonable degree of latitude is

acceptable.
2.3 Nature (Qualitative Materiality)

 The nature of a misstatement (i.e. qualitative factors) must
be considered when determining whether the misstatement is
material.
 Mistatements are more likely to be considered material
when they:
 Affect trends in profitability or mask a change in trend, or
change a loss into profit (or vice versa);
 Affect compliance with loan covenants, contracts or
regulatory provisions;
 Increase management compensation or indicate a pattern of
management bias;
 Involve fraud;
 Affect significant financial statement elements.
 Some transactions are material by nature, such as directors
transactions.
*The increased complexity of disclosure requirements (e.g. under

IFRS) and recent developments in corporate governance have
resulted in increased difficulty for auditors in determining whether
a particular disclosure is materially misstated (e.g. where directors
have to give a business review including risks). A significant element
of this would be determined by the directors' interpretation of past
and future events and risks, making the disclosure subjective (and
thus making it more difficult to determine materiality).

3 Audit Procedures
3.1 Planning
■ In planning the audit, the auditor makes judgements about the

size of misstatements that will be considered material. These
judgements provide a basis for:
● determining the nature, timing and extent of risk assessment
procedures;
● identifying and assessing the risks of material misstatement; and
● determining the nature, timing and extent of further audit
procedures.
 Determining materiality involves the exercise of professional

judgement. A percentage is often applied to a chosen
benchmark as a starting point in determining materiality for
the financial statements as a whole.
 Factors that may affect the identification of an appropriate
benchmark include the following:*
 the elements of the financial statements (e.g. revenue,
expenses, assets, liabilities);
 elements that are of particular importance to users (e.g. for *Professional
judgement will also be
the purpose of evaluating financial performance, users may
applied in determining
tend to focus on profit, revenue or net assets);
a percentage or range
 the nature of the entity, where the entity is in its life cycle, to be applied to a
and the industry and economic environment in which the chosen benchmark.
entity operates;
 the entity's ownership structure and the way it is financed
(for example, if an entity is financed solely by debt rather
than equity, users may put more emphasis on assets, and
claims on them, than on the entity's earnings); and
 the relative volatility of the benchmark.
 Past practice has, over time, established general percentage
guidelines for the calculation of an initial materiality level at
the planning stage. For example:*
5–10% net profit before taxation
1–2% net assets *Note that the ISA
½–1% total assets does not specify any
½–1 % revenue particular guidelines or
values. To do so would
 In this approach, profit, net assets, total assets and revenue quickly mean that
are considered the prime quantitative elements in the financial professional judgement
statements. The auditor then uses professional judgement to would not be used.
determine:
 which element is the prime driver for materiality, or, more
usually, which combination; and
 where, within the range, to set materiality.

Illustration 1 Benchmark
High-turnover, low-margin operations would probably use revenue as

the benchmark as this would be the key to their success.
Industrial entities would typically use assets and revenue as
benchmarks, with profits as an indicator within the range suggested
by assets and revenue.
Entities that are asset-based (e.g. in property management and
development) would use assets as the benchmark.
Example 1 Planning Materiality
Turnover $5,000,000
Total assets $6,250,000
Profit before tax $417,000
Required:
(a) Commenting on the suitability of setting a materiality level for
planning purposes at:
(i) $20,000
(ii) $40,000
(iii) $100,000
(b) Justify a materiality level which you consider to be more suitable
(if any).
Solution
(a) Suitability of levels
(i) $20,000
(ii) $40,000
(iii) $100,000.
(b) Recommendation

3.2 Effect on Audit Work

 All matters that are identified as being material must be
subject to detailed audit work (e.g. tested in detail). The
auditor must then use his judgement in dealing with the
remaining items (e.g. sampling or analytical procedures).
Illustration 2 Materiality Level
Having set a materiality level for the financial statements as a

whole, the auditor may (through judgement and expectations from
past experience of there being various errors in the transactions
and balances) set separate performance materiality levels for
transactions, assets and liabilities (e.g. 50%, 75% and 50%) of the
financial statement materiality level when considering substantive
testing.
Thus all balances greater than the performance materiality level will
be tested with the remaining items in the sample being selected
using, for example, random selection.
If sample sizes are calculated using a materiality level, the
performance materiality level would be used.
Example 2 Trade Receivables
Trade receivables total approximately $210,000, made up as follows:
Value Range Number of Total

$000 Balances $000
10-15 2 22.3
5-10 6 41.5
1-5 40 87.0
0-1 89 59.6
137 210.4
Prepayments amount to $16,450.

No material misstatements were found in the previous year's audit.
Required:
Suggest how a financial statement materiality level of $25,000 may affect audit
procedures on trade receivables and prepayments.
Solution

3.3 Relationship With Audit Risk

 The relationship between materiality and the level of audit
risk is described as inverse: as the materiality level decreases,
audit risk increases (and vice versa).
 The auditor compensates for this increase in audit risk by
either:
 reducing control risk (if possible) and carrying out extended
or additional tests of the effectiveness of controls; or
 reducing detection risk by modifying the nature, timing and
extent of planned substantive procedures (i.e. increasing
the level of audit work).
Illustration 3 Materiality Level

and Audit Risk
If, for a given population, the materiality level is lowered, more items
will be greater than the materiality level.
In this case, more items can be considered as potential material
errors, which, if left untested, increases audit risk.
So, by testing all items greater than performance materiality (in this
example there will be more of them, hence more work) the level of
audit risk can be reduced back to an acceptable level.
3.4 Changing Materiality as

the Audit Progresses
 Setting the materiality level for the financial statements at
the planning stage of the audit only takes into account the
understanding, transactions, balances and disclosures known
at that stage. As the audit progresses, information obtained
and evidence gathered, if known at the planning stage, may
have resulted in a different determination of materiality (and
audit approach).
 As material matters are determined, the auditor must consider
their effect on the performance materiality (quantitative
factors) and the nature, timing and extent of further audit
procedures (quantitative and qualitative factors).
Illustration 4 Changing Materiality

Level
During the course of an audit, material overstatements in the
quantity and valuation of inventory are noted. On reworking the
original financial statement materiality calculations, the materiality
level has decreased.
Audit risk will increase and further testing may need to be carried out
(e.g. larger sample sizes or additional items now greater than the
materiality level will need to be tested).
The auditor will need to use professional judgement to determine if
a higher level of testing is required on other balances and the effect
this will have on performance materiality.

3.5 Documentation
 As discussed in Session 6, the auditor must document all
matters to support the audit opinion, especially those involving
the use of professional judgement.
Example 3 Documentation
List the key matters that should be documented in relation to materiality.
Solution

Summary
 Materiality is the expression of the relative significance or importance of a particular matter
in relation to the financial statements as a whole.
 Materiality may be set for particular transactions, balances and disclosures for which
misstatements less than the overall materiality level may influence the decisions of users.
 The auditor also sets performance materiality (at less than materiality for the financial
statements as whole) to use in performing audit tests.
 Factors which affect the assessment of materiality include the economic decisions of users,
professional judgement, quantitative amounts and qualitative aspects.
 Overall materiality is a matter of professional judgement based initially on a percentage
applied to a chosen benchmark.
 All material matters must be subject to substantive audit procedures.
 There is an "inverse" relationship between audit risk and materiality. The amount which is
considered to be material must be decreased as the risk of misstatement increases.
Session 10 Quiz
Estimated time: 10 minutes
1. Define materiality. (1)
2. Explain the concept of performance materiality. (1.4)
3. Explain the difference between quantitative and qualitative materiality. (2)

Session 10
EXAMPLE SOLUTIONS
Solution 1—Planning Materiality
(a) Suitability of Levels

(i) $20,000: This is likely too low as it falls below the lower limits for
turnover, total assets and profit before tax.
(ii) $40,000: This is more suitable in that it is within the percentage
ranges for turnover and profit before tax. However, it may still
be regarded as too low in relation to the statement of financial
position.
(iii) $100,000: Although suitable for the audit of the statement of
financial position, this is likely to be considered too high for
classes of transactions. Material errors in the statement of
comprehensive income may therefore not be detected by audit
procedures.
(b) Recommendation
This is clearly a matter of judgement; however, as profit before tax is a
function of the make-up of balances and transactions (and at this stage
in the audit only draft), it is more likely that preliminary materiality will
be determined in relation to turnover and/or total assets. As there is
no overlap of these ranges, no one range will satisfy both. Therefore,
an amount could be set to satisfy just one judged on the needs of
users. (For example, if users are more interested in revenues than
assets/liabilities, $50,000 may be appropriate.) Alternatively, an
amount could be set between ranges as a compromise: say, $60,000.
Working
% $000
Turnover ½–1 25–50
Total assets 1–2 62.5–125
Profit before tax 5–10 20.8–41.7

Solution 2—Trade Receivables
Trade Receivables
 Although there is no one trade account receivable balance greater
than $25,000, the eight largest balances total $63,800 and have
the greatest potential for containing cumulative material error (of
overstatement). These individual balances are likely to be tested
in detail (see Session 24) to take into account the concept of
performance materiality.
 The average balance in the range $1,000–$5,000 is $2,100 and the
average balance less than $1,000 is $670. If the profile of these
balances is similar to the previous year's audit, analytical procedures
may be used (see Session 16).
Prepayments
 If $16,450 is in line with the prior period, it is unlikely to be
materiality incorrectly stated and audit tests may be limited to an
analytical comparison with the prior year.
Solution 3—Documentation
 In relation to materiality, the auditor will be expected to document:
● The materiality level for the financial statements as a whole and
the underlying factors considered in its determination.
● Any materiality levels, if applicable, for particular classes of
transactions, balances and disclosures that are key for the users of
the financial statements (with underlying factors).
● Performance materiality with underlying factors.
● Any revision of any materiality level and the reasons why each
revision was necessary.
● Reasons for any adjustments made that relate to material
misstatements.
● All unadjusted errors and the aggregate of such errors for each
class of transaction, balance and disclosure, with reasons why
each error (and aggregate total) is not considered to be material.

NOTES

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Session 10

B. Planning and Risk Assessment

(continued on next page)

Ali Niaz - ali.niaz777@gmail.com

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 10-1

Ali Niaz - ali.niaz777@gmail.com

Materiality (from IASB and IFRS)—information is material if its

■ The objective of the auditor is to apply the concept of materiality

1.2 Basic Principles

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 Although an individual amount or procedure may not be

1.3 Levels of Materiality*

Materiality level for the financial statements as a whole

■ Having determined a materiality level based on the financial

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1.4 Performance Materiality

 To judge whether or not disclosures concerning subjective

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2.1 Professional Judgement

Understanding what is, and is not, material enables the auditor

2.2 Amount (Quantitative Materiality)

Financial Statement Level Assertion Level

Look at the item in relation to financial Comparing an item to a category as

Consider in relation to the elements of The error of $50,000 may be considered

 As a "yardstick", materiality must be relevant to the user

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Precise Determination Use of Opinion/Judgement

Some reasonable degree of latitude is

2.3 Nature (Qualitative Materiality)

*The increased complexity of disclosure requirements (e.g. under

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■ In planning the audit, the auditor makes judgements about the

 Determining materiality involves the exercise of professional

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 10-7

Ali Niaz - ali.niaz777@gmail.com

High-turnover, low-margin operations would probably use revenue as

Example 1 Planning Materiality

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3.2 Effect on Audit Work

Illustration 2 Materiality Level

Having set a materiality level for the financial statements as a

Example 2 Trade Receivables

Trade receivables total approximately $210,000, made up as follows:

Value Range Number of Total

Prepayments amount to $16,450.

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 10-9

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3.3 Relationship With Audit Risk

Illustration 3 Materiality Level

3.4 Changing Materiality as

Illustration 4 Changing Materiality

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List the key matters that should be documented in relation to materiality.

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1. Define materiality. (1)