Chapter Three

Materiality and Risk Assessment

3.1 Audit Risk
The objective of the auditor is to conduct the audit of financial statements in a manner that
reduces audit risk to an appropriately low level. To form an appropriate basis for expressing an
opinion on the financial statements, the auditor must plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement
due to error or fraud. Reasonable assurance is obtained by reducing audit risk to an appropriately
low level through applying due professional care, including obtaining sufficient appropriate audit
evidence
Definition of Audit Risk
According to the IAASB Glossary of Terms (1), audit risk is defined as follows. The risk that the
auditor expresses an inappropriate audit opinion when the financial statements are materially
misstated. i.e., the financial statements are not presented fairly in conformity with the applicable
financial reporting framework. Audit risk is the risk that an auditor will not detect errors or
fraud while examining the financial statements of a client. It is the risk that auditors issue an
incorrect audit opinion to the audited financial statements. In other words, audit risk is the risk
that the company’s financial statements are not presenting its actual financial position or the
management has an intention to cover the facts although the audit opinion has stated that those
financial statements do not contain any material misstatement. Reducing audit risk to a modest
level is a key part of the audit function, since the users of financial statements are relying
upon the assurances of auditors when they read the financial statements of an organization.
Auditors can increase the number of audit procedures in order to reduce the level of audit
risk.
Component of Audit Risk
Auditor is required to assess the risks of material misstatements in the financial statements as per
requirement from ISA 315 Identifying and Assessing the Risks of Material Misstatement through
understanding the entity and its environment.
The components of audit risk are:
 inherent risk -relating to the nature of the entity;
 control risk - concerning the entity's controls; and
 detection risk - the risk that the auditor does not detect deviations
 A) Inherent risk
This is the risk that an error or omission appears for reasons other than control failures. This is
the risks that both the management and the company could not prevent due to some
uncontrollable factors, and the auditors did not find them in the audit. Inherent risk refers to the
risk that could not be protected or detected by the entity’s internal control. Inherent risk
indicates the probability of any material misstatements in financial reporting caused
by factors other than an internal control failure. It is the risk that the financial statements of
a company contain material misstatements before auditors can consider any related controls. This
is the type of audit risk that can’t be identified by anybody, be it the internal auditor of the company,
or other financial officials. It usually exists due to the nature and environment of a company. For
example, a company that has complex business transactions involving financial instruments is
more susceptible to inherent risk as compared to another company that has relatively simple
transactions. Usually, the more complex and dynamic a company and its transactions are, the
higher the inherent risks involved will be for the audit process.
Inherent risk is a type of audit risk that auditors cannot reduce as it is related to the nature of the
company and, therefore, uncontrollable. The only way auditors can deal with inherent risk is to
plan audit procedures according to their assessment of the risk. That means if the auditor
considers the inherent risk of a company high, they can increase their audit procedures to
minimize the overall audit risk of the company.
Sources of Inherent Risk:
 Complex business transactions involving derivative instruments;
 Transactions requiring a high level of judgment may lead to the risk of not being
identified;
 Industry having frequent technological developments may expose the firms to technology
obsolescence risk.
 A company that has already misreported certain figures in the past may be more likely to
misreport it again.
A higher inherent risk indicates that the transaction class, balance, or an attached disclosure is at
risk of being materially misstated. Lower inherent risk implies that the account is not likely to be
materially misstated. Inherent risk is based on factors that ultimately affect many accounts or are
peculiar to a specific assertion. For example, the inherent risk could potentially be higher for the
valuation assertion related to accounts or GAAP estimates that involve the best judgment.
B) Control Risk
Control Risk is the risk of error or misstatement in financial statements due to the failure of
internal controls. Control risk is the probability that financial statements are materially
misstated, due to failures in the controls used by a business. When there are significant control
failures, a business is more likely to experience undocumented asset losses, which mean that its
financial statements may reveal a profit when there is actually a loss. The managers of a
business are responsible for designing, implementing, and maintaining a system of controls that
is adequate for preventing the loss of assets. It is not easy to maintain a solid system of controls,
since the system must be periodically altered to fit ongoing changes in business processes, as
well as to deal with entirely new business transactions. Also, management may knowingly avoid
implementing certain controls, on the grounds that they are too expensive to maintain or that
they interfere with the smooth flow of transactions that impact customers.
Sources of Control Risk
 Failure of management to instill proper and effective internal control for financial
reporting.
 Failure to ensure proper segregation of duties among people responsible for financial
reporting;
 The non-existence of the culture of proper documentation and filing;
Control risks happen because of the limitations of a company’s internal control system. If the
internal control systems aren’t reviewed periodically, it will likely lose its effectiveness over
time. Management should review the internal control system annually and update the internal
controls.
The following elements increase control risk:
 There’s no segregation of duties.
 Documents are approved without management review.
 Transactions aren’t verified.
 The supplier selection process isn’t transparent.
Companies should decide what type of internal controls to implement for each risk based on the
likelihood that the risk will occur and the amount of financial loss if the risk does occur.
C) Detection Risk
Detection risk is the risk that audit evidence for any given audit assertion will fail to capture
material misstatements. Detection risk occurs when auditors are unable to or fail to detect
misstatements in financial statements due to error or fraud. Detection risk is the risk that the
auditor fails to detect the material misstatement in the financial statements and then issued an
incorrect opinion to the audited financial statements. This is the risk that the procedures
performed by the auditor to reduce audit risk to an acceptably low level will not detect a
misstatement that exists and that could be material, either individually or when aggregated with
other misstatements. That is the audit procedure applied by the audit firm to examine the
financial statements was not sufficient to detect the material misstatement due to frauds or errors.
The detection risk generally occurs due to sampling or non-sampling errors.
The common cause of detection risk is improper audit planning, poor engagement management,
wrong audit methodology, low competency, and lack of understanding of audit clients. Detection
risk is occurred because of the auditor part rather than the client part. As mentioned, detection
risk could be the result of poor audit planning. For example, if audit planning is poor, not all
kinds of risks are defined, and the audit program used to detect those risks is deployed
incorrectly. Then, the result is the material misstates are not detected. Certain guidelines could
help auditors minimize detection risks so that the audit risks are also subsequently minimized. At
the time of planning, auditors should set the right audit strategy, employed the right audit
approach, and have a strong strategic audit plan. These include having a good understanding of
the nature of the business, the complexity of the business operation, the complexity of the
client’s financial statements, and a deep understanding of the client’s internal control over
financial reporting. A clear understanding of audit objectives and audit scope could help auditors
set audit approaches and tailor the right audit program. Having a strong audit team could also
help auditors to minimize detection risks. For example, having enough team members and those
team members have good experiences and knowledge related to the client’s business and
financial statements.
Audit Risk Model
The main job for any auditing team is determining that a company’s financial documents are
accurate. Before beginning the process, they use a tool called an audit risk model to evaluate any
risk that might be part of performing this audit. So, what is an audit risk model? The auditor
risk model is a methodology that auditors use to try and identify the audit strategy that
they need to follow. An audit risk model is a conceptual tool applied by auditors to evaluate
and manage the various risks arising from performing an audit engagement. The tool helps the
auditor decide on the types of evidence and how much is needed for each relevant assertion.
Audit Risk Model is a formula that weighs and manages the risks associated with evaluating
each financial document. By using this model, the auditor can determine the type of evidence
they’ll need for each assertion made, all based on potential risk. It is a tool used by auditors to
understand the relationship between various risks arising from an audit engagement enabling
them to manage the overall audit risk. Audit risk model suggests that overall audit risk of an
engagement is the product of the following three component risks:
 Inherent Risk
 Control Risk
 Detection Risk
This is often represented in equation form as follows:
Audit Risk = Inherent Risk × Control Risk × Detection Risk
These three risks are multiplied together to calculate overall audit risk, or the risk of an auditor
drawing inaccurate conclusions. 
Since inherent risk and control risk make up risk of material misstatement, therefore another way
to state audit risk model is:
Audit Risk = Risk of Material Misstatement × Detection Risk
How to apply the audit risk model
Audit risk models are used during the planning stages of an audit to help the team determine
which procedures make the most sense. Before running the formula, auditors will need to study
the client’s business, including its daily operations and financial reporting procedures. They’ll
also need to look at external factors like government policy and market conditions, as well as
financial performance and management strategies. Auditors will also look at the client’s internal
controls and risk mitigation procedures during this evidence gathering process. With a greater
understanding of the controls and procedures put in place, auditors can then pinpoint the areas
where risks are higher.
Audit risk model example
We can see what the formula above looks like in practice with this audit risk model example.
Imagine that a financial consulting firm has an acceptable audit risk of 5%. An auditing team has
determined that the level of inherent risk is 90%, while the control risk is assessed to be 40%.
Required: Calculate detection risk
0.05 = 0.90 x 0.40 x Detection Risk
To calculate detection risk, we can change the formula around to:
Detection Risk = 0.05 / (0.90 x 0.40)
Detection Risk = 0.14
Or

Detection Risk = 0.05/(0.9080.40)= 0.14

The conclusion of the audit risk model is that there’s a planned detection risk of 14%, meaning
that the auditor needs to manage risks to ensure the risk of detecting material misstatements falls
to below this level.
What are some limitations of the audit risk model?

The audit risk model formula is undoubtedly a useful tool. However, there’s some level of
detection risk involved with every audit due to its inherent limitations. This includes the fact that
financial statements are created with a standard range of acceptable numerical values. They’re
also subject to human error. Auditors don’t always have full access to a company’s financial
statements. There’s always a risk of fraudulent or incomplete information being given, which
means an auditor cannot say with 100% certainty that their opinions will be correct. It’s also
impossible to gather all relevant evidence, as auditors are bound by cost and time restrictions
during the initial stages of an audit.
Materiality
Materiality can have various definitions under different accounting standards, such as the
Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting
Standards (IFRS). Under U.S. GAAP, the definition for materiality is “The omission or
misstatement of an item in a financial report is material if, in light of surrounding circumstances,
the magnitude of the item is such that it is probable that the judgment of a reasonable person
relying upon the report would have been changed or influenced by the inclusion or correction of
the item.”  On the other hand, the definition under IFRS, “information is material if omitting,
misstating, or obscuring it could reasonably be expected to influence decisions that the primary
users make on the basis of those financial statements.” Stated otherwise, materiality refers to the
potential impact of the information on the user’s decision-making relating to the entity’s
financial statements or reports.
In an audit, materiality is a matter of professional judgment that auditors need to
decide for any audit engagement. There is no professional standard that states
how much amount or percentage auditors should use for calculation of
materiality.

However, there is a rule of thumb that auditors can use together with their
professional judgments to decide the level of materiality in audit. Auditors may
use a range of the percentages and benchmarks as a basis for quantitative factors
of materiality as follow:

 0.5% to 1% total revenues or expenses

 1% to 2% total assets
 5% to 10% net profit
For the benchmark to use, it will usually depend on what type of company
auditors face. For example, for a commercial business, auditors may use net profit
as a benchmark; but for a not-for-profit organization that doesn’t have a profit
figure, auditors may need to use other benchmarks such as total assets or total
expenses.
 Characteristics Of Materiality
 Given the fact that materiality is the first and foremost pillar of financial
reporting, it can be seen that it is defined in ISA 320 as a separate standard.

In this particular standard, the overall characteristics of materiality are

described, which include the following:

 Misstatements are considered to be material if they are likely to influence

the decisions of the end-users of the financial statements
 Judgments about materiality are subsequently based on external
surrounding circumstances, which mainly include the size and nature of the
subsequent misstatement
 Lastly, judgments are also based on users’ common needs as a group

The Financial Accounting Standards Board

provides the materiality definition as follows:
The omission or misstatement of an item in a financial report is material if,
in light of surrounding circumstances, the magnitude of the item is such that
it is probable that the judgment of a reasonable person relying upon the
report would have been changed or influenced by the inclusion or
correction of the item.
Interesting. This definition is not a formula such as one percent of total
assets. Even so, we need clearly laid stripes, do we not? We need a
number. So here we have a planning materiality definition, as well as a
materiality definition for the conduct and completion of the engagement. 
So, consider that material misstatements include:
 the omission of a significant disclosure
 an incomplete disclosure
 a known financial statement line misstatement
 an unknown financial statement line misstatement
 an unreasonable estimate

Materiality is the threshold above which missing or incorrect information in financial statements
is considered to have an impact on the decision making of users. Materiality is sometimes
construed in terms of net impact on reported profits, or the percentage or dollar change in a
specific line item in the financial statements. Examples of materiality are as follows:

 A company reports a profit of exactly $10,000, which is the point at which earnings per share
exactly meet analyst expectations. Any reduction in profit below this point would have triggered
a sell off of company shares, and so would be considered material.

 A company reports a current ratio of exactly 2:1, which is the amount needed to meet its loan
covenants. Any current asset or current liability amounts resulting in a ratio of less than 2:1
would be considered material, since the loan could then be called by the lender.

 A company omits the existence of a lawsuit from its financial statement disclosures that
indicates the potential for a large settlement that could bankrupt it.

Based on the preceding examples, it should be clear that sometimes even quite a small change in
financial information can be considered material, as well as a simple omission of information.
Thus, it is essential to consider all impacts of transactions before electing not to report them in
the financial statements or accompanying footnotes.

Determining Materiality

No steadfast rule exists for determining the materiality of transactions

within financial statements. Auditors must rely on certain principles and
professional judgment. The amount and type of misstatement are taken
into consideration when determining materiality.

In the example above, there are two transactions of absolute dollar

amounts. However, in practice, determining materiality is more effective
on a relative basis.
 For example, instead of looking at whether a transaction of $1.00 or
$1,000,000 is considered to be material, the auditor will refer to the
percentage impact that the misstatement may have on the financial
statements.

So, for a company with $5 million in revenue, the $1 million misstatement

can represent a 20% margin impact, which is very material.

However, if the company has $5 billion in revenue, the $1 million

misstatement will only result in a 0.02% margin impact, which, on a
relative basis, is not material to the overall financial performance of the
company.

If the $1 million error was due to fraudulent behavior – perhaps an

executive employee embezzling money from the company – this
misstatement can be considered material since it involves potential
criminal activity.

Therefore, it is crucial to consider not only the absolute and relative

amounts of the misstatements but also the qualitative impacts of the
misstatements.

Materiality is first and foremost a financial reporting, rather than auditing, concept. It isn’t
defined in ISA 320 Materiality in planning and performing an audit but the ISA highlights the
following key characteristics:
 Misstatements are considered to be material if they could influence the decisions of users of the
financial statements

 Judgements about materiality are based on surrounding circumstances, including the size and
nature of the misstatement

 Judgements are based on the users’ common needs as a group.

 How does materiality apply in an audit?

The objective of a financial statement audit is to enable the auditor to express an

opinion as to whether the financial statements are prepared, in all material respects, in
accordance with an applicable financial reporting framework. This is a separate
responsibility and a separate decision from that made by the entity itself when preparing
the financial statements.

In auditing, materiality means not just a quantified amount, but the effect that amount
will have in various contexts.

During the audit planning process the auditor decides what the level of materiality will
be, taking into account the entirety of the financial statements to be audited. Materiality
relates to both the content of the financial statements and the level and type of testing to
be done. The decision is based on judgements about the size, nature and particular
circumstances of misstatements (or omissions) that could influence users of the
financial reports. In addition, the decision is influenced by legislative and regulatory
requirements and public expectations.

If, during the audit, the auditor acquires information that would have caused it to
determine a different materiality level, it will revise the materiality level accordingly.
 
What is materiality?
Materiality is first and foremost a financial reporting, rather than auditing, concept. It isn’t
defined in ISA 320 Materiality in planning and performing an audit but the ISA highlights
the following key characteristics:
 Misstatements are considered to be material if they could influence the decisions of users of the
financial statements

 Judgements about materiality are based on surrounding circumstances, including the size and
nature of the misstatement

 Judgements are based on the users’ common needs as a group.

Why is materiality important?

As the basis for the auditor’s opinion, ISAs require auditors to obtain reasonable
assurance about whether the financial statements as a whole are free from material
misstatement. The concept of materiality is therefore fundamental to the audit. It is
applied by auditors at the planning stage, and when performing the audit and evaluating
 the effect of identified misstatements on the audit and of uncorrected misstatements, if
any, on the financial statements.

Who is the guide aimed at and how does it help?

This guidance is aimed at auditors in all jurisdictions where ISAs are applied. It is
intended to be of particular help to smaller audit firms. The guidance takes a look at the
ISA requirements on materiality and uses practical illustrations to highlight good
practice, key challenges and common pitfalls. It has been put together by a working
group of experienced auditors. It is intended to help audit firms better understand, and
appropriately apply, materiality when planning and performing audits and evaluating
misstatements.

Key themes
Determining materiality
While not set in stone, typically there are three key steps to determining overall
materiality (materiality for the financial statements as a whole):

 Choosing a benchmark

 Determining a level of this benchmark

 Justifying the choices.

The guide looks at these steps and the potential challenges that arise. It provides
guidance on when it might be appropriate to set specific levels of materiality for
individual balances, classes of transactions or disclosures, what to do with short/long
periods of account or situations where materiality might need to be reassessed. The
guide also explains what performance materiality is, providing guidance on how it might
be determined.

Applying materiality to the evaluation of identified misstatements

This section of the guide looks at the practical issues around:

 Accumulating misstatements during the audit;

 Categorising misstatements according to their nature;

 Assessing the materiality of misstatements; and

 Considering the impact of misstatements on the audit.

Materiality in group audits
Just as auditors would for a single entity audit, group auditors must use judgement to
determine group materiality and group performance materiality. However, a key
difference is that group auditors also have to determine levels of component materiality
for components that have audits or reviews for the purposes of the group audit. The
guide takes auditors through practical illustrations covering how to determine
component materiality and component performance materiality, a clearly trivial
threshold, component materiality for associates and joint ventures and the effects of
changes in group materiality.

Communications with management and those charged with governance

There will be a number of communications with management and those charged with
governance during the audit in relation to materiality and the misstatements identified
and the guide focuses on what might need to be communicated at the planning stage,
as the audit progresses and in the final stages of the audit.

Documentation
Auditors need to document materiality, the evaluation of misstatements and the rational
for both. This section of the guide examines the documentation requirements and
provides practical illustrations.

What is the Materiality Threshold in Audits?

The materiality threshold in audits refers to the benchmark used to obtain
reasonable assurance that an audit does not detect any material
misstatement that can significantly impact the usability of financial
statements.

t is not feasible to test and verify every transaction and financial record, so
the materiality threshold is important to save resources, yet still
completes the objective of the audit.

Materiality Explained

Materiality can have various definitions under different accounting

standards, such as the Generally Accepted Accounting Principles (GAAP)
and the International Financial Reporting Standards (IFRS). Other more
specific accounting standards may apply in different circumstances.
Under U.S. GAAP, the definition for materiality is “The omission or
misstatement of an item in a financial report is material if, in light of
surrounding circumstances, the magnitude of the item is such that it is
probable that the judgment of a reasonable person relying upon the
report would have been changed or influenced by the inclusion or
correction of the item.” 

On the other hand, the definition under IFRS, “information is material if

omitting, misstating, or obscuring it could reasonably be expected to
influence decisions that the primary users make on the basis of those
financial statements.”

Stated otherwise, materiality refers to the potential impact of the

information on the user’s decision-making relating to the entity’s financial
statements or reports.

Users of financial statements include:

 Shareholders
 Creditors
 Suppliers
 Customers
 Management
 Regulating entities
Example of Materiality Threshold in Audits

There are two transactions – one is an expenditure of $1.00, and the other
transaction is $1,000,000.

Clearly, if the $1.00 transaction was misstated, it will not make much of an
impact for users of financial statements, even if the company was small.
However, an error on a transaction of $1,000,000 will almost certainly
make a material impact on the user’s decisions regarding financial
statements.
Qualitative and Quantitative Factors of
Materiality in Audit
Quantitative Materiality

In an audit, materiality is a matter of professional judgment that auditors need to

decide for any audit engagement. There is no professional standard that states
how much amount or percentage auditors should use for calculation of
materiality.

However, there is a rule of thumb that auditors can use together with their
professional judgments to decide the level of materiality in audit. Auditors may
use a range of the percentages and benchmarks as a basis for quantitative factors
of materiality as follow:

 0.5% to 1% total revenues or expenses

 1% to 2% total assets
 5% to 10% net profit
For the benchmark to use, it will usually depend on what type of company
auditors face. For example, for a commercial business, auditors may use net profit
as a benchmark; but for a not-for-profit organization that doesn’t have a profit
figure, auditors may need to use other benchmarks such as total assets or total
expenses.

Qualitative Materiality

The rule of thumb above is considered quantitative factors. However, auditors

need to consider both quantitative and qualitative factors when assessing
materiality in audit.

In the table below are the three qualitative factors that auditors usually need to
consider when determining the materiality in audit.

Qualitative factors of materiality in audit

 Although materiality usually concerns with a big dollar amount
Nature of
auditor is dealing with, some small transactions or issues may be
transaction
material too if they involve illegal activities such as fraud, thief or
or issue
bribery.

Some audit circumstances may require auditors to exercise more care

when deciding materiality in audit engagements.

Audit Examples of such circumstances include:

circumstance
 those involving a lot of uncertainties of future events,
 those involved with public interest such as listed companies,
 those companies that give incentive to management that
meets earning target, etc.

Auditors need to consider the probability that the aggregate of

uncorrected and undetected misstatements could exceed overall
Possible
materiality for the financial statement.
cumulative
effects For example, if an overall misstatement is $100,000, the five individual
misstatements of $25,000 will exceed the overall misstatement.

Determining Materiality

No steadfast rule exists for determining the materiality of transactions

within financial statements. Auditors must rely on certain principles and
professional judgment. The amount and type of misstatement are taken
into consideration when determining materiality.

In the example above, there are two transactions of absolute dollar

amounts. However, in practice, determining materiality is more effective
on a relative basis.
For example, instead of looking at whether a transaction of $1.00 or
$1,000,000 is considered to be material, the auditor will refer to the
percentage impact that the misstatement may have on the financial
statements.

So, for a company with $5 million in revenue, the $1 million misstatement

can represent a 20% margin impact, which is very material.

However, if the company has $5 billion in revenue, the $1 million

misstatement will only result in a 0.02% margin impact, which, on a
relative basis, is not material to the overall financial performance of the
company.

If the $1 million error was due to fraudulent behavior – perhaps an

executive employee embezzling money from the company – this
misstatement can be considered material since it involves potential
criminal activity.

Therefore, it is crucial to consider not only the absolute and relative

amounts of the misstatements but also the qualitative impacts of the
misstatements.

Methods of Calculating Materiality

The International Accounting Standards Board (IASB) has refrained from

giving quantitative guidance and standards regarding the calculation of
materiality. Since there is no benchmark or formula, it is very subjective at
the discretion of the auditor.

However, some academic bodies have developed calculation methods.

Norwegian Research Council Materiality Calculation Methods

The Norwegian Research Council funded a study on the calculation of

materiality that includes single rule methods in addition to variable size
rule methods.
Single Rule Methods:

 5% of pre-tax income
 0.5% of total assets
 1% of shareholders’ equity
 1% of total revenue

Variable Size Rule Methods:

 2% to 5% of gross profit (if less than $20,000)

 1% to 2% of gross profit (if gross profit is more than $20,000 but less
than $1,000,000)
 0.5% to 1% of gross profit (if gross profit is more than $1,000,000 but
less than $100,000,000
 0.5% of gross profit (if gross profit is more than $100,000,000)

There are also blended methods that combine some of the methods and
use appropriate weighting for each element.

Discussion Paper 6: Audit Risk and Materiality (July 1984)

This published paper gives methods for ranges of calculating materiality.

Depending on the audit risk, auditors will select different values inside
these ranges.

 0.5% to 1% of total revenue

 1% to 2% of total assets
 1% to 2% of gross profit
 2% to 5% of shareholders’ equity
 5% to 10% of net income

They can be combined into blended methods as well.

What is Materiality?
 Materiality is the threshold above which missing or incorrect information in financial statements
is considered to have an impact on the decision making of users. Materiality is sometimes
construed in terms of net impact on reported profits, or the percentage or dollar change in a
specific line item in the financial statements. Examples of materiality are as follows:

 A company reports a profit of exactly $10,000, which is the point at which earnings per share
exactly meet analyst expectations. Any reduction in profit below this point would have triggered
a sell off of company shares, and so would be considered material.

 A company reports a current ratio of exactly 2:1, which is the amount needed to meet its loan
covenants. Any current asset or current liability amounts resulting in a ratio of less than 2:1
would be considered material, since the loan could then be called by the lender.

 A company omits the existence of a lawsuit from its financial statement disclosures that
indicates the potential for a large settlement that could bankrupt it.

Based on the preceding examples, it should be clear that sometimes even quite a small change in
financial information can be considered material, as well as a simple omission of information.
Thus, it is essential to consider all impacts of transactions before electing not to report them in
the financial statements or accompanying footnotes.

Audit Materiality
Materiality is to reasonable assurance what white stripes are to a
basketball court. And understanding materiality is a key to making sure no
one blows the whistle on you. Moreover, understanding trivial
misstatements can reduce your audit time.
So what is materiality in auditing?
Financial statements are seldom perfect. Some misstatements are present,
and that’s okay as long as they aren’t too large. But how big can they be
without affecting financial statement users’ decisions? Audit materiality
provides the answer. It is a boundary, like white stripes on a basketball
court.
That boundary, however, is not precise. The white stripes are different for
each audit. Why? Because materiality is judgmental. The boundary is
based on what is important to financial statement users. And different users
focus on different information.
In one audit, the benchmark is total revenues. In another, it’s total assets.
And what is a benchmark? It’s what’s most important to the financial
statement users. Once the benchmark is chosen, auditors apply a percent
to it to compute materiality. For example, one percent of total assets.
Additionally, qualitative factors, such as risks of the client, play into
materiality, but auditors need a clearly defined boundary. That’s why
materiality is number, not a feeling. Auditors use materiality in planning
their audits; they assess the risk of material misstatement at the assertion
level. It’s also used in the conduct and evaluation of evidential matter at the
conclusion of the engagement, particularly in reviewing passed audit
journal entries. Passed journal entries should not exceed materiality.
Once SSARS 25 is effective, CPAs should document materiality in review
engagements.
So how is materiality defined?

What is Materiality in
Auditing?
The Financial Accounting Standards Board
provides the materiality definition as follows:
The omission or misstatement of an item in a financial report is material if,
in light of surrounding circumstances, the magnitude of the item is such that
it is probable that the judgment of a reasonable person relying upon the
report would have been changed or influenced by the inclusion or
correction of the item.
Interesting. This definition is not a formula such as one percent of total
assets. Even so, we need clearly laid stripes, do we not? We need a
 number. So here we have a planning materiality definition, as well as a
materiality definition for the conduct and completion of the engagement. 
So, consider that material misstatements include:
 the omission of a significant disclosure
 an incomplete disclosure
 a known financial statement line misstatement
 an unknown financial statement line misstatement
 an unreasonable estimate
Also keep in mind that financial statement readers—management, owners,
lenders, vendors—make decisions. The FASB lumps these together as a
reasonable person whose judgment…would have changed if the
misstatement were not present. So, what does this reasonable person look
for? What omission or misstatement affects her judgment? And
what magnitude of misstatement alters her decisions? The answers tell us
what materiality is.
Additionally, an entity’s risks are important. One business might have a
high level of debt, for example. The lender is concerned about debt
covenant compliance. Another business has an inventory obsolescence
issue. The owners might focus here. Risk impacts materiality for each user.
In light of a myriad of factors, the auditor’s job is to provide reasonable
assurance that the financial statements are materially correct. So how do
we do this? We begin by computing materiality.

Computing Audit Materiality

In order to compute audit materiality, we must first decide which benchmark
is best. Examples include total revenues, total assets, and net income. We
select a benchmark that is relevant to financial statement users and stable
over time. Often total assets or total revenues are good choices. So what’s
a poor example? Net income. Why? Because some businesses “salary out”
their profits. Zero net income gives you little to work with. (Net income can,
however, be appropriate for some entities.)
Once the benchmark is selected, we need to apply a percent to compute
materiality. The percent is not defined in professional standards, so
again, it’s judgmental. Most CPAs use percentages in materiality forms
provided by third-party publishers; others create their own. Either
way, auditors must provide reasonable assurance that the financial
statements are fairly stated. So, materiality and the related percentages
need to be sufficiently low. There are no magical percentages, but an
excessively high materiality can lead to an improper audit opinion.
Moreover, materiality is proportional. For instance, a $100,000 error in a
billion dollar company may not affect users’ decisions. But a $100,000 error
in a million dollar company might.

Uncorrected and Undetected

Misstatements
Even with a good materiality number, uncorrected and undetected
misstatements can create problems.
The total of undetected errors may exceed materiality. What if, for example,
materiality is $100,000, there are no uncorrected audit adjustments, but
undetected misstatements of $80,000, $20,000, and $25,000 exist in
receivables, inventory, and investments, respectively?  Well, an aggregate
material misstatement is present.
Similarly, what if materiality is $100,000, the client refuses to post an
$80,000 audit adjustment, and there are $45,000 in undetected
misstatements? In such a situation, the auditor might think the financial
statements are fairly stated, but they are not.
Because uncorrected and undetected errors are sometimes material, we
need a cushion, a number less than materiality. Something to protect
us. And what is that cushion? Performance materiality.

Audit Performance Materiality

Performance materiality is another key to ensuring your audits don’t
result in improper audit opinions. This number is usually less than
overall audit materiality and applies to transaction classes, account
balances, and disclosures. 
AU-C 320.A14 describes performance materiality in the following manner:
Performance materiality is set to reduce to an appropriately low level the
probability that the aggregate of uncorrected and undetected
misstatements in the financial statements exceeds materiality for the
financial statements as a whole. Similarly, performance materiality relating
to a materiality level determined for a particular class of transactions,
account balance, or disclosure is set to reduce to an appropriately low level
the probability that the aggregate of uncorrected and undetected
misstatements in that particular class of transactions, account balance, or
disclosure exceeds the materiality level for that particular class of
transactions, account balance, or disclosure.
As you can see, performance materiality calls for materiality thresholds at
the transaction class, account balance, and disclosure level. Usually
performance materiality is calculated at 50% to 75% of materiality. Why the
range? Different risk levels for different clients. If you believe the risk of
undetected misstatements is high, then use a lower percent (e.g., 55% of
materiality). Likewise, if your client is not inclined to record detected errors,
lower the percent. Remember your goal: the combined undetected error
and uncorrected misstatements must be less than materiality—both for the
statements as a whole and for classes of transactions, account balances,
and disclosures. We don’t want misstatements, in whatever form, to
wrongly influence the decisions of financial statement users.
As we perform an audit, we need to summarize uncorrected
misstatements.

Uncorrected Misstatements
AU-C 450.11 says the following about uncorrected misstatements:
 The auditor should determine whether uncorrected misstatements are
material, individually or in the aggregate. In making this determination, the
auditor should consider:

 the size and nature of the misstatements, both in relation to particular

classes of transactions, account balances, or disclosures and the financial
statements as a whole, and the particular circumstances of their
occurrence and
 the effect of uncorrected misstatements related to prior periods on the
relevant classes of transactions, account balances, or disclosures and the
financial statements as a whole.
We need to accumulate uncorrected misstatements in a manner that allows
us to judge them at these levels: classes of transactions, account balances,
or disclosures and the financial statements as a whole. And this is more
than just computing performance materiality and comparing it to passed
adjustments. We should always ask, “Will these uncorrected misstatements
adversely affect a user’s judgment?” Misstatements caused by fraud, for
example, are more significant than those caused by error.
So what are the documentation requirements for uncorrected
misstatements?
AU-C 450.12 requires the auditor to document:
 The amount designated by the auditor below which misstatements need
not be accumulated (clearly trivial)
 All misstatements accumulated and whether they have been corrected
 A conclusion as to whether uncorrected misstatements, individually or in
the aggregate, cause the financial statements to be materially misstated,
and the basis for the conclusion
Some identified misstatements are so small that they will not be
accumulated. We call these trivial misstatements.
Audit Trivial Misstatements
AU-C 420.A2 says the following about trivial misstatements:
The auditor may designate an amount below which misstatements would
be clearly trivial and would not need to be accumulated because the auditor
expects that the accumulation of such amounts clearly would not have a
material effect on the financial statements.
Why create a trivial misstatement amount? Efficiency. All misstatements
below the trivial threshold (e.g., $5,000) are not accumulated. The auditor
simply notes the trivial difference on the work paper, and she is done. No
journal entry is proposed, and no other documentation is necessary. If you
expect dozens of passed adjustments, then the trivial threshold should be
smaller. You don’t want the cumulative trivial misstatements to become
material.

Audit Materiality Summary

Now you know about materiality in auditing.
Want to become a better auditor? Then use materiality, performance
materiality, and trivial misstatements in the right manner. And you’ll be well
on your way.
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Materiality is relevant in all audits. A matter can be judged material if knowledge of it would
be likely to influence the decisions of the intended users. Determining materiality is a
matter of professional judgment and depends on the auditor’s interpretation of the users’
needs. This judgment may relate to an individual item or to a group of items taken
together.
Materiality is often considered in terms of value, but it also has other quantitative, as well
as qualitative, aspects. The inherent characteristics of an item or group of items may render
 a matter material by its very nature. A matter may also be material because of the context
in which it occurs.”—International Standards of Supreme Audit Institutions (ISSAI) 100.
The concept of materiality is well-developed for financial auditing, including a substantial
amount of research literature. However, materiality, as defined in ISSAI 100, has not been
given equal attention when it comes to compliance and performance auditing.
This article stems from a thesis submitted to the Norwegian School of Economics and
concentrates on the subject of materiality when SAIs, having discretion to choose which
audits to present, initialize and report compliance and performance audits. The thesis is
based on theoretical discussions of ISSAI 100, its definition of materiality, and an empirical
study of materiality considerations (as executed by SAI Norway).
THE ISSUES
What should be the overall perspectives on the concept of materiality in public sector
auditing given the role of SAIs in a democratic government system?
A cross-disciplinary perspective is necessary to assess the concept of materiality in public
sector auditing, and the approach in this article draws upon relevant theories from auditing,
economy, law and political science, as well as discussions from:
 Economic welfare theory;
 Research on accountability (within law);
 Theory of democracy as outlined in political science and philosophy; and
 The notion of principal and agent, which explains the relationship between user and
auditor.
 The user (principal) is the point of departure.
One specific feature of materiality (as defined in ISSAI 100) is that what is material is a
“matter,” which can be information that is both negative and positive depending on user
decisions. This aspect differs fundamentally from materiality as expressed in financial
auditing, where only “a misstatement” may be considered material by the audit user.
What are specific user needs that form the basis for materiality in public sector
auditing?
Specific user needs associated with public sector auditing are related to primary legislative
functions of granting public funds, passing laws and exercising control.
Justifying SAIs as institutions is, largely, related to the legislative control function; however,
user needs may also be connected to public administration learning and development.
Considering user needs, how are value, nature and context (ISSAI 100) best
defined?
In granting public funds, legislative bodies prioritize public resources, and the economic
perspective associated with the welfare theory provides the basis to consider the value
aspect. Materiality considerations (where accountability and asymmetrical information are
at stake) directly link to, and justify, the public control mechanism.
These issues, therefore, should be considered material by their very nature. Context
materiality has direct ties to SAI constitutionality—specific legislative statements, as well as
the general learning and development of public administration.
Examples of considering materiality by value:  (1) Audits initiated and reported due to
excessive budgetary spending where government projects considerably exceeded granted
parliamentary limits. (2) Matters related to administrative changes covering substantive
public spending amounts were reported whether errors were detected (or not) due to
materiality factors where economic amounts at stake were considered material by value.
An example of materiality by nature: an audit on how the Ministry of Justice
implemented measures to improve public security and ensure preparedness toward
thwarting potential future terror attacks. Major deficiencies were reported in an area given
specific parliament priority following attacks on government buildings and the Youth Labor
party’s political summer camp in July 2011. SAI Norway quelled its level criticism, and
parliament precipitated this case’s hearing to emphasize its priority.
“On this matter, a common political consensus that the terror attacks was an attack on
democracy was a driver in materiality considerations,” noted one SAI Norway leader.
The most common reason for audits performed and reported across divisions in the SAI of
Norway was the ambition of the audit to contribute to change, learning and development in
the public sector. This kind of materiality consideration falls clearly into the aspect of
“context”.
Other aspects of materiality (in the sense of context): The argument that an issue
was audited and reported because it was a central issue of a specific policy area, as for
instance a major administrative reform. Hence, it was material in the context of this policy
area as such. In the case of reform in the Norwegian health system, this materiality
consideration was supported explicitly by parliament.
How can materiality guide a SAI in choosing which compliance and performance
audits to carry out and eventually report to parliament?
The different aspects of materiality in public sector auditing can be visualized using a
materiality map” (see Figure 1: Materiality Map on page 18) depicting the multi-
dimensional, cross-disciplinary considerations that require considerable auditor experience.
Materiality considerations imply a SAI must (1) consider the user needs that should be
fulfilled by a specific audit and (2) sometimes choose between conflicting needs. The
materiality map can illustrate the different paths associated with materiality considerations.
For additional information about this study or to request a more detailed version of this
article, contact

udit Materiality

Article byAshish Kumar Srivastav

Reviewed byDheeraj Vaidya, CFA, FRM

Audit Materiality Definition

 Audit Materiality is an important part of an audit wherein the
company’s misstatements will be considered material in the case. Likely,
such misstatement will reasonably influence the users’ economic
decision of the company’s financial statement. While considering
materiality, both the quantitative and qualitative aspects are considered.
In the case of the qualitative aspects, the approach is generally quite
difficult to measure compared with the quantitative approach.

Table of contents

 Audit Materiality Definition

o Types of Audit Materiality
 #1 – Overall Materiality
 #2 – Overall Performance Materiality
 #3 – Specific Materiality
o Example of Audit Materiality
o Why is Audit Materiality Important?
o Limitations
o Key Points
o Conclusion
o Recommended Articles
Types of Audit Materiality

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an attribution link

#1 – Overall Materiality
The level which represents the significant level in the company’s
financial statements, which can influence the decision making of the
users of the company’s financial statement as a whole, as judged by
the auditor appointed by the company, is known as the “overall
materiality.”

#2 – Overall Performance Materiality

“Overall Performance materiality” is the materiality level judged by the
company’s auditor. It can be the amount that is less than the overall
materiality level. This materiality level is reduced from the “overall
materiality level” to consider the risk of several smaller errors or
 omissions that the auditor could not find. But they are material if
aggregated in totality, thereby reducing the probability that the
aggregate amount of small misstatements exceeds the overall
materiality level.

#3 – Specific Materiality
Specific materiality refers to the materiality level set to identify
potential misstatements. These may exist in different areas in the
company, for certain classes of transactions, and for the account
balances that may affect the economic decisions of the users of the
company’s financial statement of the company.
If you want to learn more about Auditing, you may consider taking
courses offered by Coursera –

1. Auditing I: Conceptual Foundations of Auditing

2. Auditing II: The Practice of Auditing

Example of Audit Materiality

Let’s consider an example of Company XYZ Ltd, which took a loan
from the bank for $ 100,000. Bank gave the loan but on the condition
that the company’s current ratio should not fall below the level of
1.0. The company agreed to this and signed an agreement with the
bank in this aspect. While conducting the audit, the auditor of the
company came to know about this agreement.
At present, the company’s current ratio is only slightly more than the
level of 1.0. Now for the company’s auditor, a minute misstatement of
$ 3,000 can be material. It could lead to a violation of the agreement
between the company and the bank. With the $ 3,000 misstatement
also, the company’s current ratio would fall below the level of 1.0. So
this would be considered part of the audit materiality as it could lead
 to the violation of the agreement. It can reasonably influence the
economic decision-making of the users of the company’s financial
statement.

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Why is Audit Materiality

Important?
 Audit materiality is an important concept that considers both the
quantitative and qualitative aspects. Both aspects impact the
 economic decision-making of the users of the company’s financial
statement. Qualitative aspects such as adequate disclosures
concerning the contingent liabilities, related party transactions,
changes in the accounting policy, etc., of the company also
significantly influence the economic decision-making of the users of
the company’s financial statement.
 It is the basis on which the auditor’s opinion about the company
forms, as the auditor requires to obtain a reasonable level of assurance
about whether the company’s financial statements are free from
material misstatements or not.

Limitations
 The auditor may not be able to set the materiality at the proper level,
which may hamper the purpose of the same.
 The misstatement that affects the company’s compliance with the
regulatory requirements might not get detected by the company’s
auditor.
 In the case of the qualitative aspects, the approach is generally quite
difficult to measure compared with the quantitative approach.

Key Points
 Both the quantitative and qualitative aspects are considered in the
case of audit materiality. The quantitative considerations include
setting up preliminary judgment for the materiality; Considering the
performance materiality; Estimating the misstatement in a cycle,
accounting and Estimating the total aggregate amount of
misstatements, etc. The qualitative considerations include providing
adequate disclosures concerning the company’s contingent liabilities,
providing the proper disclosures concerning the transactions with the
 related parties of the company, disclosure regarding the change in
any accounting policy in the company, etc.
 While dealing with material misstatements, an auditor must consider
all the types of misstatements, including Identified Misstatements,
Likely Misstatements, Likely Aggregate Misstatements, Further
Possible Misstatements, and Maximum Possible Misstatements.
 Three types of audit materiality include overall materiality, overall
performance materiality, and specific materiality. The auditor uses
these as per the different situations prevailing in the company.

Conclusion
Audit materiality provides the opportunity to the user of the financial
statement, auditor, and the company. The materiality level is set at the
level that could reasonably influence the users’ economic decision-
making of the company’s financial statement

hat Is Audit Materiality? Definition, Characteristics, Types And More

Audit, Audit Opinion

Definition
Materiality can be regarded as a concept in auditing and accounting, which
relates to the importance and significance of an amount, transaction or
respective discrepancy that might occur in the financial statements.

It stands to be one of the most important objectives of the audit

arrangements since it is the auditors’ responsibility to base his opinion on the
judgment regarding if financial statements are prepared, in material aspects,
and include all the relevant disclosures that should be included.

Characteristics Of Materiality
 Given the fact that materiality is the first and foremost pillar of financial
reporting, it can be seen that it is defined in ISA 320 as a separate standard.

In this particular standard, the overall characteristics of materiality are

described, which include the following:

 Misstatements are considered to be material if they are likely to influence

the decisions of the end-users of the financial statements
 Judgments about materiality are subsequently based on external
surrounding circumstances, which mainly include the size and nature of the
subsequent misstatement
 Lastly, judgments are also based on users’ common needs as a group
Types Of Materiality
Audit Materiality can be broadly seen as Qualitative as well as Quantitative.

As far as qualitative materiality is concerned, it can be seen that it is

something that is fundamentally important, because it reflects on
discrepancies that exist within the financial statements, and can have an
alternating impact on the decision-making process.

For example, a company might choose to amortize an asset for 25 years,

whereas the useful life is only stated to be 10 years, in the disclosures
presented.

Related article  General Contents of Audit Report - What Are the Main Element Of the
Report?

Additionally, any discrepancy about contingent liabilities, or related party

transactions can also make an impact on the overall state of affairs.
On the other hand, as far as quantitative materiality is concerned, it is basically
numerical misstatements, or discrepancies, that would have a significant
impact on the end decision-making tool.

For example, it can be seen that a line item of irrecoverable amounts (bad
debts) was not disclosed in the financial statements, whereas this item, would
otherwise have had a significant impact on the overall financial statements.

Why Is Audit Materiality Important?

Audit Materiality is a very important concept that bases on both, quantitative
as well as qualitative aspects.

This really helps in the end-users of the financial statements to be able to use
it as a tool for economic decision-making tools, as they would have sufficient
knowledge pertaining to contingent liabilities, related party transactions, and
any other subsequent change in accounting policy that they should be aware
of.

Therefore, all these factors play a very important role in determining the
overall extent to which users can base their judgments on.

Audit Materiality forms the very basis on which the auditor is able to formulate
an opinion regarding the overall level of assurance that can be provided to the
end-user.

This is because, they have to report whether financial statements are free from
material misstatements or not, and therefore, this is the main crux around
which their work revolves.

Conclusion
Therefore, it can be seen that Audit Materiality is a very important concept,
that proves to be the basis of the scope of audit work and the ultimate audit
opinion that is presented for the shareholders
 1. Introduction
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

SA 320 “ Materiality in Planning and Performing an Audit” explains materiality:

Misstatements, including omissions, are considered to be material if they, individually or
in the aggregate, could reasonably be expected to influence the economic decisions of
users taken on the basis of the financial statements.

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 Rupees one lakh on account of non-

provisioning for doubtful debtors will result in material misstatement of financial
statements of a company having a turnover of Rupees Ten lakhs and a net profit of
Rupees One lakh. However, the same unadjusted misstatement will be not be material to
the financial statements of a company having a turnover of Rupees thousand crores and a
profit of Rupees fifty crores.

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 (for example interest payable to parties
covered under MSMED Act, 2006 and disclosures thereof);
(v) a misstatement that has the effect an 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;

2. Factors affecting Materiality

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.

For instance, how did the engagement team decide that 5% was appropriate, and that net income was an
appropriate base?

In determining overall materiality:


 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;
 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).

3. 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.

4. 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.
4.1 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;

4.2 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

FY 2019-20 FY 2018-19
Particulars

(` Crs) (` Crs)

Turnover 2,700 2,097 1,823

Profit before Tax (PBT) 325 286 187

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
crores 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 crores to calculate materiality.

Illustration 2

FY 2019-20 FY 2018-19
Particulars

(` Lakhs) (` Lakhs)

Turnover  1,17,262.48  1,17,895.79  1,0

Profit before Tax (PBT) 83.58 57.06 3.1

 Exceptional items

Retrenchment Cost 1,545.45 1,794.78 2,0

Normalised PBT 1,629.03 1,851.84 2,0

Normalised PBT% 1.39% 1.57% 1.9

In this example, the profit before tax is fluctuating on year 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 lakhs 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

4.3 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.

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Materiality in Audit
Definition
In an audit, materiality is the concept or expression that refers to the matter that
is important in the financial statements. In this case, a matter is material if it can
affect the economic decision making of the users of financial statements.
Likewise, the misstatements on financial statements are considered material if
they can influence the economic decisions of users taken on the basis of the
financial statements.
In the audit, materiality is viewed as the threshold that auditors determine in
order to focus their attention on the matters that have a significant impact on
financial statements as a whole.

Hence, any matter or misstatement that is not material is usually not detected or

ignored by auditors. This is due to auditors cannot perform the audit tests on all
the transactions and balances in the client’s accounts.
One purpose of financial statement audit performed by the independent auditors
is to examine whether the financial statements contain any material
misstatement. Likewise, the auditors only give a clean opinion on financial
statements if they contain no material misstatement. In other words, they give a
true and fair view in all material respects.

Types of Materiality in Audit

In the audit work, auditors must calculate materiality for financial statements as a
whole, which is known as overall materiality, and performance materiality in order
to use as guidance in performing the audit.

Types of Materiality in Audit

Overall materiality is the materiality that auditors estimate and determine

whole financial statements in the planning stage of the audit by using the
professional judgment. Auditors then use this materiality in developing th
overall audit strategy in order to perform the audit work in an effective an
Overall efficient manner.
Materiality
If there is any unexpected event that arises during the audit work, materia
need to be changed so that it reflects the risks that auditors face. So, aud
need to review overall materiality throughout the whole audit process an
they think it is necessary.
 Performance materiality is the materiality that auditors estimate and dete
the lowest level so that they can be sure that small errors or omissions ad
do not exceed the overall materiality. While overall materiality is set for fi
statements as a whole, performance materiality is set for particular classe
Performance transactions, account balances, or disclosures.
materiality
Auditors will need to use performance materiality throughout their audit
the engagement in order to perform audit procedures on various transac
balances of the client. For this reason, performance materiality is sometim
“working materiality”.

Qualitative and Quantitative Factors of

Materiality in Audit
Quantitative Materiality

In an audit, materiality is a matter of professional judgment that auditors need to

decide for any audit engagement. There is no professional standard that states
how much amount or percentage auditors should use for calculation of
materiality.

However, there is a rule of thumb that auditors can use together with their
professional judgments to decide the level of materiality in audit. Auditors may
use a range of the percentages and benchmarks as a basis for quantitative factors
of materiality as follow:

 0.5% to 1% total revenues or expenses

 1% to 2% total assets
 5% to 10% net profit
For the benchmark to use, it will usually depend on what type of company
auditors face. For example, for a commercial business, auditors may use net profit
as a benchmark; but for a not-for-profit organization that doesn’t have a profit
figure, auditors may need to use other benchmarks such as total assets or total
expenses.
Qualitative Materiality

The rule of thumb above is considered quantitative factors. However, auditors

need to consider both quantitative and qualitative factors when assessing
materiality in audit.

In the table below are the three qualitative factors that auditors usually need to
consider when determining the materiality in audit.

Qualitative factors of materiality in audit

Although materiality usually concerns with a big dollar amount

Nature of
auditor is dealing with, some small transactions or issues may be
transaction
material too if they involve illegal activities such as fraud, thief or
or issue
bribery.

Some audit circumstances may require auditors to exercise more care

when deciding materiality in audit engagements.

Audit Examples of such circumstances include:

circumstance
 those involving a lot of uncertainties of future events,
 those involved with public interest such as listed companies,
 those companies that give incentive to management that
meets earning target, etc.

Auditors need to consider the probability that the aggregate of

uncorrected and undetected misstatements could exceed overall
Possible
materiality for the financial statement.
cumulative
effects For example, if an overall misstatement is $100,000, the five individual
misstatements of $25,000 will exceed the overall misstatement.

hat is Audit Materiality?

The term “audit materiality” refers to the mechanism of selecting a benchmark that can

be used to reasonably assure if the audit doesn’t notice any misstatement in accounting

then it won’t significantly misguide the users of the financial statements. The US GAAP

doesn’thave any concrete definition for audit materiality, while IFRS states that any

transaction can be considered as material if its omission or misstatement from the

financial statements can potentially influence the decision of the various stakeholders.

Explanation
The audit materiality is considered to be the first and foremost pillar in financial

reporting. It can be defined on the basis of the following characteristics:

 Misstatements and omissions are considered to be material if they can potentially

influence the decisions of the users of the financial statements.

 At times decisions on materiality are judgments made on the basis of the surrounding

circumstances coupled with the size and nature of the misstatement.

 In some cases, audit materiality decisions are judgments made on the basis of the

common needs of the user group.

How to Determine Audit Materiality

As already mentioned above, there is no steadfast framework available for the

determination of audit materiality of any transaction within the financial statements.

However, auditors often rely either on their professional judgment or certain guidelines
(discussed later in the article under “Audit Materiality guidelines”). Consequently, it is

important the auditor has a thorough knowledge of how to apply the concept of

materiality as it is all relative and is significantly impacted by the size and surrounding

circumstances. The determination of materiality takes into account the amount and type

of misstatement.

Examples of Audit Materiality

Following are the examples are given below:

Example #1
Let us take the simple example of two companies with revenue of $1billion and $5

million. The auditors in both the companies unearthed a misstatement of $2 million.

Comment on the materiality of the misstatement in both the cases. In the case of the

company with revenue of $1 billion, the misstatement of $2 million only results in a 0.2%

margin impact, which is not that material compared to the company’s overall financial

performance. On the other hand, the misstatement of $2 million for the company with

$5 million revenue represents a 40% margin impact, which is very significant beyond any

doubt. As such, this can be considered as material.

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Example #2
Let us take the example of an auditor who has set a materiality threshold of 1% for

revenue. While auditing the financial reports of ASD Inc. for the year 2019 the auditor

discovered an understatement of revenue by $1 million that occurred due to some

operational error However, later the auditor realized that it was deliberately done to

evade taxes. Determine the materiality of the misstatement if the revenue of ASD Inc. is

$200 million.

As per the materiality threshold of the auditor, the misstatement of $1 million is not a

material error as it is less than 1% of the company’s revenue, i.e. $2 million (= 1% * $200

million). However, the company had understated its revenue by $1 million to evade tax,
which is a fraudulent activity. Therefore, the auditor may deem the misstatement to be

material because it involves a potential criminal activity.

Importance of Audit Materiality

The concept of audit materiality is very important, which is based on both qualitative as

well as quantitative aspects. The auditor is responsible for correctly determining the

materiality of misstated financial information. In case the auditor discovers any material

misstatement in the financial reporting of a company, it his or her responsibility to bring

it to the client’s notice for rectification. In this way, the auditors help the end-users of

the financial statements who take their economic decisions on the basis of the

disclosures in the financial reporting, such as related party transactions, contingent

liabilities, any material change in accounting policies, etc.

Relevance of Audit Materiality

An auditor needs to decide on the level of materiality based on the entirety of the

financial statements, which includes the content of the financial statements as well as

the kind of testing. The ultimate decision of the auditor is based on his or her judgment

about the misstatement’ssize, nature, surrounding circumstances, and impact on the

users of the financial statements.

Audit Materiality Guidelines
Although there is no defined framework, there is some guidance provided on the basis

of certain studies as mentioned below.

1. Norwegian Research Council

This study includes a single rule and variable size rule methods. These methods provide

guidance for the determination of the materiality threshold on the basis of some or all

criteria using appropriate weightage.

Single Rule Method

 1% of total revenue

 5% of pre-tax income

 1% of equity

 5% of total assets

Variable Size Rule

 For gross profit < $20,000, 2%-5% of gross profit

 For $20,000 <gross profit < $1,000,000,1%-2% of gross profit

 For $1,000,000 < gross profit < $100,000,000, 0.5%-1% of gross profit

 For $100,000,000 < gross profit, 0.5% of gross profit

2. Methods from Discussion Paper 6
This paper on audit risk and materiality was issued in July 1984. Under these methods,

there is a defined range for the determination of materiality.

 5%-1% of revenue

 1%-2% of gross profit

 5%-10% of net profit

 2%-5% of equity

 1%-2% of total assets

Conclusion
So, it can be seen that the concept of audit materiality is very important as it forms the

basis of the scope of the audit work. Eventually, the ultimate opinion of the auditor in

the financial statements prove to be the economic decision-making tool for the

shareholders and other end-users of the financial stat verall Materiality (For Financial Report

as a whole) : the highest amount of information that if omitted, misstated or not disclosed, then that

information has the potential to affect the economic decision of users of the financial report or the

discharge of accountability by management or charged with governance. The determination of

overall materiality should be made with the following questions in mind: Who are the major users of

the financial report? What information is important to their economic decision making and

discharging of their responsibilities? In addition to quantitative amounts, what qualitative factors

might impact upon the users financial reporting requirements as they relate to materiality? Overall

Performance Materiality : The amount set by us as auditor at less than the Overall Materiality, to

reduce to an appropriately low level, the probability that the aggregate of undetected misstatements
exceeds Overall Materiality. Overall Performance Materiality must be set at a % of the Overall

Materiality so as to allow us a margin or buffer for the possible undetected misstatements that may

occur during the engagement. We use a sliding scale of % based upon an estimate of the

engagement risk associated with the client. Specific Materiality (For Particular classes of

transactions, account balances or disclosures): The misstatements or events that are used by the

auditor to identify misstatements at lesser than the Overall Materiality. Specific Materiality could

relate to sensitive areas such as particular note disclosures (that is, management remuneration or

industry-specific data), compliance with legislation or certain terms in a contract, or transactions

upon which bonuses are based. It could also relate to the nature of a potential misstatement such as

an illegal act, non-compliance with loan covenants and statutory/regulatory reporting requirements.

Disclosure of the following transactions, balances or events would normally be subject to a Specific

Materiality level lower than Overall Materiality: Related party transactions and balances Disclosure of

items such as those related to financial instrument risk Significant management estimates or

valuations including sensitivity analysis Director’s remuneration Director’s expense accounts

Auditor’s remuneration, particularly non-audit services Significant accounting policies or changes in

accounting policies Sensitive income and expense accounts such as management fees and

commissions. Determining materiality for the financial statements as a whole and performance

materiality  Determining materiality involves the exercise of professional judgment. A percentage is

often applied to a chosen benchmark as a starting point in determining materiality for the financial

statements as a whole. Examples of benchmarks that may be appropriate, depending on the

circumstances of the entity, include: Profit before tax total revenue gross profit total expenses total

equity or net asset value etc. Factors that may affect the identification of an appropriate benchmark

include the following: The elements of the financial statements Whether there are items on which the

attention of the users of the particular entity’s financial statements tends to be focused The nature of

the entity, where the entity is at in its life cycle, and the industry and economic environment in which

the entity operates The entity’s ownership structure and the way it is financed The relative volatility

of the benchmark Scenario Benchmark Profit before tax is nominal Profit before tax and
remuneration Entities doing public utility programs/projects Total Cost or Expenses Less Revenues

Current Year Profits are Low Average of the Past three years Profit oriented entity with break-even

results Revenue Private Equity Firm primary focus on EBITDA EBIDTA Production Costs recharged

to Group Production Costs Mutual Funds Net Assets

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Audit Materiality explained – Misstatements, including omissions, are considered to be material if

they, individually or in aggregate, could reasonably be expected to influence the economic decision
of users taken on the basis of financial statements. Various legal provisions and professional
pronouncements contains reference to the concept of materiality. Clause 5,6,8 and 9 of part I of the
Second Schedule to the Chartered Accountants Act, 1949, refer to material fact, material
misstatement, material exceptions and to material departure from the generally accepted procedure
of audit. Schedule III of the Companies Act, 2013 is designed to ensure that the Financial
Statements disclose all material Information so as to give a true and fair view of the state of affairs
and working results of a company. Similarly disclosure of all material accounting policies at one
place and disclosure of all changes in polices is also due to materiality concept. It is not possible to
lay down precisely, either in terms of specific items or in terms of amounts, what could be
considered material. Percentage comparison may be useful in determining the materiality of an item.
Part II of Schedule III of the companies any item of income or expenditure which constitute 1% of
revenue from operations or 100000 Rs has to be disclosed separately. The relative significance of
an item has to be viewed from many angles while judging its materiality – One indicator of materiality
will be its impact on the overall figures of profit or loss, another indicator would be impact on total of
the category of the expenditure or income to which it pertains and there can be materiality adjudged
by comparison with previous year figures. Various stages of application of Materiality concept : At
Inception of Audit : In determination the nature, timing and extant of audit procedures During Audit :
In evaluating the effect of misstatements on the measurement and classification of accounts; and

Read more at: https://taxguru.in/chartered-accountant/basics-audit-materiality.html

Copyright © Taxguru.in
Audit Materiality explained – Misstatements, including omissions, are considered to be material if
they, individually or in aggregate, could reasonably be expected to influence the economic decision
of users taken on the basis of financial statements. Various legal provisions and professional
pronouncements contains reference to the concept of materiality. Clause 5,6,8 and 9 of part I of the
Second Schedule to the Chartered Accountants Act, 1949, refer to material fact, material
misstatement, material exceptions and to material departure from the generally accepted procedure
of audit. Schedule III of the Companies Act, 2013 is designed to ensure that the Financial
Statements disclose all material Information so as to give a true and fair view of the state of affairs
and working results of a company. Similarly disclosure of all material accounting policies at one
place and disclosure of all changes in polices is also due to materiality concept. It is not possible to
lay down precisely, either in terms of specific items or in terms of amounts, what could be
considered material. Percentage comparison may be useful in determining the materiality of an item.
Part II of Schedule III of the companies any item of income or expenditure which constitute 1% of
revenue from operations or 100000 Rs has to be disclosed separately. The relative significance of
an item has to be viewed from many angles while judging its materiality – One indicator of materiality
will be its impact on the overall figures of profit or loss, another indicator would be impact on total of
the category of the expenditure or income to which it pertains and there can be materiality adjudged
by comparison with previous year figures. Various stages of application of Materiality concept : At
Inception of Audit : In determination the nature, timing and extant of audit procedures During Audit :
In evaluating the effect of misstatements on the measurement and classification of accounts; and

Read more at: https://taxguru.in/chartered-accountant/basics-audit-materiality.html

Copyright © Taxguru.in