Materiality

Materiality concept in accounting and auditing refers to the concept that all the material items
should be reported properly in the financial statements.

Material items are considered as those items whose inclusion or exclusion results in significant
changes in the decision making for the users of business information. An item is material if its
omission or misstatement can influence the economic decisions of the users of the information.

Materiality concept also allows for the provision of ignoring other accounting principles if doing so
doesn’t have an impact on the financial statements of the business concerned. Therefore, the
information present in the financial statements must be complete in terms of all material aspects, so
that it is able to present an accurate picture of the business.

The users of financial statements can be shareholders, auditors and investors, etc.

The concept of materiality is fundamental to the entire audit process and is applied by the auditor:

 In determining the nature, timing and extent of risk assessment procedures;

 In identifying and assessing the risks of material misstatement;
 In determining the nature, timing and extent of audit procedures to gather sufficient
appropriate audit evidence;
 In evaluating the effect of identified misstatements on the audit and of uncorrected
misstatements, if any, on the financial statements
 In forming the opinion in the auditor’s report on the financial statements

Example of Materiality

A customer who has defaulted in payment of shillings 10,000 to a company that has a net assets of
500 trillion shillings is regarded as immaterial for the company. However, if the default amount is
200 trillion shillings, then it will have an impact on the company and is thus material.

Materiality applies not only to amounts in the financial statements, but also to disclosures that are
non-quantitative. For example, non-disclosure or inadequate disclosure of accounting policy for a
material financial statement area may influence the economic decision of the user of financial
statements.

Materiality is a relative rather than an absolute concept. A misstatement of a given magnitude might
be material for a small company, whereas the error of the same amount could be immaterial for a
large one. For example, an unadjusted misstatement of one billion Uganda shillings on account of
non-provisioning for doubtful debtors will result in material misstatement of financial statements of
a company having a turnover of ten billion Uganda shillings and a net profit of one billion Uganda
shillings. However, the same unadjusted misstatement will not be material to the financial
statements of a company having a turnover of a hundred trillion Uganda shillings and a profit of fifty
trillion Uganda shillings.

Materiality concept is closely related to the other accounting principles, such as

1. Relevance: Material information impacts the financial decisions taken by users and is therefore
regarded as relevant to the users of accounting information.
2. Reliability: If a significant piece of information is omitted or misrepresented, it will result in
impairment of users capability to make important decisions based on the financial statements. It will
impact the reliability of the information.

3. Completeness: If the financial statements contain incomplete information, then it will not present
the business information correctly.

The auditor may consider the following illustrative factors in assessing whether an amount is
material:

(i) the potential impact of the misstatement on trends, especially trends in profitability;

(ii) a misstatement that changes a loss into profit or vice versa (for example recording a provision for
doubtful trade receivables may result in marginal profit before tax turning into a loss);
(iii) the potential impact of the misstatement on the entity’s compliance with debt covenants (for
example current ratio), other contractual agreements, and regulatory provisions;
(iv) the existence of statutory or regulatory reporting requirements
(v) a misstatement that has the effect on variable pay or compensation of key management
personnel (for example, by satisfying the requirements for targeted turnover or net profit before
tax);
(vi) the sensitivity of the circumstances surrounding the misstatement (for example, consider
whether the misstatements involve fraud or possible illegal acts);
(vii) the significance of the financial statement item affected by the misstatement;
(viii) the motivation of management with respect to the misstatement, for example:

(a) an intentional misstatement to ‘manage’ earnings;

(b) an indication of a possible pattern of bias by management when developing and
accumulating accounting estimates;

How to assess an item’s materiality.

 Compare the magnitude of the item with the overall view presented by the accounts
 Compare the magnitude of the item with the same item in previous years
 Compare the magnitude of the item with the total of which it forms a part (e.g debtors may
include employee loans but if employee loans become large ie material then the description
debtors may be inadequate)
 Consider the presentation and context of the item. Does it affect the true and fair view?
 Some items are always material eg director’s remuneration.

The statement on auditing standards requires auditors to consider materiality and its relationship
with audit risk. It points out a number of issues

 Materiality is a matter of professional judgement and it has both quantity(amount) and

quality (nature) dimensions. Auditors should take it into account when considering the
nature, timing and extent of audit procedures.
 Materiality should be taken into account at the planning stage and reconsidered if the
outcome of tests, enquiries or examination differs from expectation
 In evaluating whether the financial statements give a true and fair view, the auditors should
assess the materiality of the aggregate of uncorrected statements. If the directors adjust the
 financial statements for these, all maybe well but if not, the aggregate misstatement may be
material when each individual misstatement is not.
 Calculation of Materiality is not simply following the firm’s guidance or a rule of thumb. For
example consider that an engagement team calculates materiality as 5% of adjusted profit
before tax after excluding exceptional items. While the firm may have materiality guidelines
limiting the engagement team’s choices, the selection of materiality would still require
considerable professional judgment.
 In determining overall materiality:
(a) The auditor makes judgments in light of the circumstances surrounding the entity and
which are affected by the size and nature of the misstatement, or a combination of both;
(b) Judgments about matters that are material to users of the financial statements are
based on a consideration of the common financial information needs of users as a
group, not each user individually (such as a bank, debenture-holder, or shareholder).

Types of Materiality

1. Overall Materiality

When establishing the overall audit strategy, the auditor determines materiality for the financial
statements as a whole. It is a threshold, above which, the financial statements would be materially
misstated. This is called “materiality for the financial statements as a whole” or simply overall
materiality.

2. Performance Materiality

Performance Materiality is set at an amount less than the overall materiality and acts like a “safety
buffer” to lower the risk of aggregate uncorrected and undetected misstatements being material for
the overall financial statements. Performance materiality enables the auditor to respond to specific
risk assessments (without changing the overall materiality), and to reduce to an appropriately low
level the probability that the aggregate of uncorrected and undetected misstatements exceeds
overall materiality.

3. Specific Materiality

Specific materiality is established for classes of transactions, account balances, or disclosures where
misstatements of lesser amounts than overall materiality could reasonably be expected to influence
the economic decisions of users, taken on the basis of the financial statements. (For example;
potential investors may be interested in revenue)

4. Specific Performance Materiality

Specific performance materiality is the same concept as performance materiality, except that it is set
in relation to specific materiality and not overall materiality.

1 Overall Materiality

Overall materiality is based on the auditor’s professional judgment as to the maximum amount of
misstatement(s) that if not corrected in the financial statements will not affect the economic
decisions taken by a financial statement user. If the amount of uncorrected misstatements, either
individually or in the aggregate, is higher than the overall materiality established for the audit, it
implies that the financial statements are materially misstated. The overall materiality amount is one
of the factors by which the ultimate success or failure of the audit will be judged.
For example, consider that overall materiality was set at an amount of ` 25 millions. If, as a result of
performing audit procedures:

(i) No misstatements were identified—an unmodified opinion will be issued;

(ii) A few small (immaterial) misstatements were identified and not corrected: an unmodified
opinion will be issued;
(iii) Uncorrected misstatements exceeding materiality (of ` 25 millions) were found and management
recorded some or all proposed adjustments such that remaining uncorrected misstatements were
less than materiality (of ` 25 millions): an unmodified opinion may be issued subject to auditor’s
assessment of misstatements;
(iv) Uncorrected misstatements exceeding materiality (of ` 25 millions) were found and management
was unwilling to make the necessary adjustments: a qualified or adverse opinion will be required;
(v) Uncorrected errors exceeding materiality (of ` 25 millions) exist in the financial statements but
were not detected by the auditor — then there is an audit risk of issuing an inappropriate
unmodified audit opinion.

Determining Overall Materiality

There are three steps in determining overall materiality:

i. Selecting an appropriate benchmark;

ii. Identifying appropriate financial data for the selected benchmark;
iii. Determining the percentage to be applied to the selected benchmark;

i) Selecting an appropriate benchmark

Overall materiality is based on the common financial information needs of the various users as a
group and therefore, the possible effect of misstatements on specific individual users, whose needs
may vary widely, is not considered.

In selecting the most appropriate benchmark to determine materiality, the auditor should develop
an understanding of the users of the financial statements specific to their client. Some of the
benchmarks commonly used include: revenue, profit before taxes, total assets or expenses. The
auditor makes a judgment on which benchmark to use by understanding what the users of the
financial statements are most likely to be concerned about. 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. An illustrative list of factors that affect the selection of an appropriate
benchmark by the auditor includes:

 Elements of the financial statements (assets, liabilities, equity, income, expenses);

 Whether there are items on which the users tend to focus (for example, the users may tend
to focus on EBITDA);

 Past history with audits (whether numerous adjustments are required?);

 The nature of the entity and the industry (for example retail sector or company engaged in
real estate);

 The entity’s ownership structure and the way it is financed (for example if the entity is
mainly financed by equity investors who are concerned with financial performance, net
profit before taxes may be an appropriate benchmark);
  The relative volatility of the benchmark (for example, does the pre-taxation profit fluctuates
significantly from year to year?).

The users of the financial statements include: investors, creditors, suppliers, employees, customers,
state institutions, public in general. However, in every case, the users, who are interested in financial
statements and its information, are different.

Some users of the financial statements and their needs are illustrated below:

User Interest of the user

Shareholders/investors Profitability (return on investment, dividend paying capacity)

Potential investors in start-up Revenue

Assets (for example patents)

Lenders such as banks Total Assets (security against debts)

Profitability (capacity to serve interest)

Tax authorities Profitability (income tax collections)

Revenue (GST Collections)

Commonly used benchmarks

(a) Profit before tax

Users of the financial statements of profit-orientated entities (for example listed entities) are
generally concerned with reported earnings both at the pre-taxation and post-taxation levels. When
profit before tax is used as a benchmark, it is appropriate to exclude abnormal items such as unusual
profits and losses, and exceptional items. In situations where there significant fluctuations in profit
before tax from one year to another, auditor may find it useful to consider materiality in relation to
‘normalized’ pre-taxation profit. ‘Normalized’ pre-taxation profit might be arrived at by taking an
average of pre-taxation profit over a period of several years. Consider following illustrations:
Illustration 1

Particulars FY 2019-20(trillion shillings) FY 2018-19 (trillion FY 2017-18 (trillion

shillings) shillings)

Turnover 2,700 2,097 1,823

Profit 325 286 187

before
Tax (PBT)

PBT% 12.03% 13.64% 10.25%

In this example, both the revenue and profit before tax are increasing from year to year and the
profit before tax as percentage of sales is fluctuating. The company estimates the turnover for FY
2020-21 to be 2,800 trillion based on 11 months actual sales and orders in hand.

The auditor considers that it is more appropriate to use ‘normalised’ profit before tax to determine
materiality. The auditor considers average profit before tax of past three years, that is 266 trillion to
calculate materiality.

Illustration 2

Particulars FY 2019-20 FY 2018-19 FY 2017-18

(trillion shs) (trillion shs) (trillion shs)

Turnover  1,17,262.48  1,17,895.79  1,04,221.92

Profit before 83.58 57.06 3.16

Tax  (PBT)

Exceptional items

Retrenchment Cost 1,545.45 1,794.78 2,012.15

Normalised PBT 1,629.03 1,851.84 2,015.31

Normalised PBT% 1.39% 1.57% 1.93%

In this example, the profit before tax is fluctuating on year basis both in absolute terms and as
percentage of sales. The auditor notes that the company is rationalising its operations and has been
retrenching workers in the past three years. However, there is no further retrenchment in FY 2020-
21.

Accordingly, the auditor considers it appropriate it to first compute normalised profit by excluding
retrenchment costs and then use the average of three years’ normalised profit before tax to
calculate materiality Therefore the auditor considers 1,832.06 trillion shs as the benchmark for
calculating materiality.

(b) Turnover
Though most users of financial statements are generally concerned with profitability, this is not the
only consideration, particularly in companies where profit before tax is volatile. For some industries,
for example retail, revenue is a significant factor in management reporting and important to
investors. In such cases, revenue may be considered to be an appropriate benchmark for
determining materiality.

(c) Total Assets/Net Assets

Total assets (as well as net assets) might be an appropriate benchmark for determining materiality
for an entity with significantly higher values in the balance sheet compared to its income statement
(such as an investment property entity or an investment company having significant income from
assets held).

(d) Other benchmarks

Other benchmarks may be considered appropriate for calculating materiality depending on the facts
of the entity. Some other commonly used benchmarks include:

 Gross Profit

 Total Expenses

 Shareholders’ equity

ii) Identifying appropriate financial data

Identifying the financial data is not as straightforward as it appears. It may be necessary to consider
materiality before the financial statements to be audited are prepared, for example when planning is
done prior to the year-end. In other cases, planning takes place after the draft financial statements
to be audited have been provided, but it may be apparent that those statements require significant
modification. In such situations materiality is based on a reasonable expectation of the amounts in
the eventual financial statements. This may be obtained by extrapolating amounts either from
interim management reports or from interim financial statements (for example nine months
financial results) or the financial statements of one or more prior annual periods, as long as these
are adjusted for major changes in the entity’s circumstances, such as a significant merger.