Chapter 10 – Audit Materiality

Objective: To describe the concept of materiality and its relationship with audit risk and planning.

1.1 Concept

1.1.1 Accounting
Definition

Materiality – information is material if its omission or misstatement could influence the decisions
primary users taken on the basis of the financial statements. … Materiality depends on the nature and/o
size of the items to which the information relates. It is entity specific. The IASB does not (cannot) speci
a uniform quantitative threshold.

1.1.2 Auditing
The relevant standard is ISA 320 Materiality in Planning and Performing an Audit.
 Definition

Performance materiality – the amounts set by the auditor at less than materiality for the financi
statements as a whole to reduce to an appropriately low level the probability that the aggregate
uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.

Key Point

 The auditor must apply the concept of materiality appropriately in planning and performing th
audit.
 Materiality is an expression of the relative significance or importance of a particular matter in th
context of the financial statements as a whole.

1.2 Basic Principles

The auditor must exercise professional judgment to determine what is material (and what is
immaterial) based on:
 understanding of the entity and its environment;
 the entity’s financial results (transactions and balances) and disclosures; and
 the requirements of the users of the financial statements.
A rigid materiality model would not be practical because of the many differences between entities
and the users of their financial statements.
Materiality may be quantitative (based on values) or qualitative (based on the nature of the
matter). Qualitative misstatements include failure to disclose information as required by laws,
regulations or GAAP (e.g. IFRS disclosure requirements – but remember that IFRS Standards
apply only to material items).
Although an individual amount or procedure may not be material, consideration must be given to
the cumulative impact, for example:
 A deviation in a procedure may not be material, but repeated deviations (e.g. each
month) would indicate the potential for material misstatement.
 Individual immaterial pricing errors in purchases may result in a material cumulative
total, especially when extrapolated through work-in-progress and finished goods.
 Failure to apply an accounting policy (e.g. depreciation of buildings) may not be material
to profit and loss in a given year. Still, cumulatively it may become so (e.g. in
accumulated depreciation on the statement of financial position).

1.3 Levels of Materiality

Materiality at the financial statement level must be set, as must performance materiality.
Determining materiality for particular transactions, balances and disclosures is a matter of
professional judgment, not routine. Performance materiality will usually be less than other
materiality levels.
 Key Point

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

1.4 Performance Materiality

Key Point

Performance materiality is used when performing audit tests (e.g. receivables confirmation, purchas
transaction testing, inspection of non-current assets).

Planning the audit to consider only individually material misstatements overlooks the cumulative
impact of aggregated undetected immaterial misstatements exceeding the overall financial
statement materiality level.
The determination of performance materiality is not a simple mechanical calculation but draws on:
 the nature of the entity;
 the auditor's experience (e.g. numerous immaterial misstatements found during audit
testing);
 the use of professional judgment; and
 the expectation of misstatements in the current period.
The aggregate of unadjusted immaterial misstatements must be compared with performance
materiality to ensure that the aggregate is not material.
 Example 1 Applying Performance Materiality

GT & Co is conducting the audit of Werner Co. After planning considerations, it has set an overa
materiality level of 4% of profit before tax.
Werner Co has a high volume of credit customers and GT & Co has some concerns about the valuation
trade receivables, as the effectiveness of Werner’s collection activities have deteriorated. Because of thi
GT & Co has set the performance materiality level for audit procedures performed on receivables to b
3% of total receivables.
Applying this lower threshold during testing reduces the risk that the aggregate of misstatements exceed
overall materiality.

1.5 Qualitative Materiality

Benchmarks for assessing materiality qualitatively include, for example, disclosure requirements
detailed by IFRS Standards and statutory disclosure requirements. These may be subdivided into:
 objective disclosures that can be easily determined and verified (e.g. disclosures
concerning changes in accounting policies or prior period errors); and
 subjective disclosures (e.g. wholly narrative disclosures).
To judge whether or not disclosures concerning subjective (and estimated) matters are materially
misstated, the auditor needs a thorough understanding of the entity's business and sound
professional judgment. Such disclosure matters must be discussed with TCWG (e.g. the audit
committee).

Example 2 Qualitative Materiality

Boros & Co is conducting the audit of Juggler Co, a listed company with extensive holdings of non-curre
assets.
Juggler Co is reluctant to disclose how it applies its accounting policies for depreciation and revaluation
its financial statements, especially in light of some significant changes in the utilisation and market valu
of some of its non-current assets.
Considering Juggler Co’s operating environment and business model, Boros & Co deems th
nondisclosure of Juggler’s accounting policies to be material and has requested Juggler & Co to disclos
them. Failure to do so might result in a modification of the audit opinion.

1.6 Relevance to the Audit

Materiality is relevant to all stages of the audit:

 planning an audit (through its relationship with audit risk);
 determining audit procedures (their nature, timing and extent);
 carrying out the audit (identified errors may affect materiality levels);
 evaluating errors identified during the audit process; and
 evaluating misstatements in the financial statements.

2.1 Professional Judgment

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

Key Point

Understanding what is and is not material enables the auditor to consider the nature, timing and extent
audit procedures (e.g. sampling, substantive analytical procedures, stratification) to reduce audit risk to a
acceptably low level.

2.2 Amount (Quantitative Materiality)

In designing the audit plan, the auditor initially sets an appropriate materiality level to detect
quantitatively material misstatements at the financial statement level.
By understanding users' economic decisions, lower materiality levels may also be set based on
the classes of transactions, account balances or disclosures that such users would consider
material.

Financial Statement Level Assertion Level

Compare an item to a category (e.g. an invento

Compare an item to the financial statements as a
whole. For example, compare to:
 revenue;
 profit before taxation;
 total assets;
 capital and reserves.
Consider the elements of the financial statements
(e.g. a different materiality level for the statement of
profit or loss and the statement of financial position).
error of $50,000 compared to a total invento
value of $650,000).
It may be established as a set figure or as
percentage of a total.
The error of $50,000 may be considered materi
to inventory but may not be material to th
statement of financial position, if inventory as
whole is not a material item.

As a "yardstick", materiality must be relevant to the user rather than the preparer of financial
statements and consider critical points. For example:
 Turning a reported profit into a loss (might be material to employees);
 Turning net current assets into net current liabilities (may be material to investors).
The auditor must also consider that some balances are capable of "precise determination" and
dictated by law and regulations, while others are not and are determined by opinion and judgment
rather than fact.

Precise Determination Use of Opinion/Judgment

For example, directors' emoluments and For example, bad debt allowance, contingent liabilities an
share capital. asset useful lives.
Any error (however small) may be The depreciation expense based on five years may b
considered material and adjusted, material to profit and loss, but if based on six years it may n
 be: five or six years is a matter of opinion and judgment. Bo
could be equally acceptable.
especially as the precise amount must
be disclosed by law. Some reasonable degree of latitude is acceptable.

2.3 Nature (Qualitative Materiality)

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

3.1 In Planning

Key Point

In planning the audit, the auditor makes judgments about the size of misstatements considered materia
These judgments provide a basis for:
 determining the nature, timing and extent of risk assessment procedures;
 identifying and assessing the risks of material misstatement; and
 determining the nature, timing and extent of further audit procedures.
Determining materiality involves the exercise of professional judgment. A percentage is often
applied to a chosen benchmark as a starting point in determining the materiality level for the
financial statements as a whole. The ISA does not specify any particular guidelines or values; to
do so might imply that professional judgment need not be used.
Factors that may affect the identification of an appropriate benchmark include the following:
 the elements of the financial statements (e.g. revenue, expenses, assets, liabilities);
 elements that are of particular importance to users (e.g. to evaluate financial
performance, users may tend to focus on profit, revenue or net assets);
 the nature of the entity, where the entity is 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 (e.g. if substantially debt-
financed rather than equity-financed, users may put more emphasis on assets, and
claims on them, than on earnings); and
 the relative volatility of the benchmark.
Past practice has, over time, established general percentage guidelines for the calculation of an
initial materiality level at the planning stage. For example:

5–10% net profit before taxation

1–2% net assets

 ½ –1% total assets

½ –1
% revenue
In general, less than the lower end of a range is immaterial and greater than the upper end is
material; the "grey area" in between is a matter for professional judgment. In this approach, profit,
net assets, total assets and revenue are considered the main quantitative elements in the financial
statements. The auditor then uses professional judgment to determine:
 which element is the prime driver for materiality, or, more usually, which combination;
and
 where, within the range, to set materiality.
Example 3 Benchmark

High-turnover, low-margin operations would probably use revenue as the benchmark as this would be th
key to their success.
Industrial entities would typically use assets and revenue as benchmarks, with profits as an indicat
within the range suggested by assets and revenue.
Asset-based entities (e.g. property management and development) would use assets as the benchmark.

Activity 1 Planning Materiality

The draft financial statements of an audit client show the following:

Revenue $5,000,000

Net assets $6,250,000

Profit before tax $417,000

Required:

a. Comment on the suitability of setting a materiality level for planning purposes at:
i. $20,000
ii. $40,000
iii. $100,000
b. Justify a materiality level that may be more suitable (if any).
*Please use the notes feature in the toolbar to help formulate your answer.
a. Suitability of Levels
i. $20,000: This is likely too low as it falls below the lower limits for revenue, total assets and profit
before tax.
ii. $40,000: This is more suitable because it is within the percentage ranges for revenue
and profit before tax. However, it may still be regarded as too low for the statement of
financial position.
iii. $100,000: Although suitable for the audit of the statement of financial position, this is
likely to be considered too high for classes of transactions. Therefore, audit
procedures may not detect material misstatements in the statement of profit or loss.
b. Recommendation
 This is a matter of judgment; however, as profit before tax is a function of the make-up
of balances and transactions (and at this stage in the audit only draft), it is more likely
that materiality will be determined based on revenue or total assets. As these ranges
have no overlap, no one range will satisfy both. Therefore, an amount could be set to
satisfy just one judged on users' needs (e.g. if users are more interested in revenues
than assets/liabilities, $50,000 may be appropriate). Alternatively, an amount could be
set between ranges as a compromise: $60,000.
WORKING
% $000

Revenue ½ –1 25–50

Net assets 1–2 62.5–125

Profit before tax 5–10 20.8–41.7

3.2 Effect on Audit Work

All matters that are identified as being material must be subject to detailed audit work (e.g. tested
in detail). The auditor must then use his judgment in dealing with the remaining items (e.g.
sampling or analytical procedures).

Example 4 Materiality Level

Having set a materiality level for the financial statements as a whole, the auditor may (through judgme
and expectations from experience of there being various errors in the transactions and balances) s
different performance materiality levels for transactions, assets and liabilities (e.g. 50%, 75% and 50%)
the financial statement materiality level when considering substantive testing.
Therefore, all balances greater than the performance materiality level will be tested with the remainin
items in the sample being selected using, for example, random selection.
The performance materiality level would be used if sample sizes were calculated using a materiality level

Activity 2 Trade Receivables

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

Value range Total
Number of
$000 balances $000

10-15 2 22.3

5-10 6 41.5

1-5 40 87.0

0-1 89 59.6

137 210.4
Prepayments amount to $16,450.
No material misstatements were found in the previous year's audit.

Required:

Suggest how a financial statement materiality level of $25,000 may affect audit procedures
on trade receivables and prepayments.
*Please use the notes feature in the toolbar to help formulate your answer.
Trade Receivables
 Although there is no individual trade receivable balance greater than $25,000, the eight largest
balances total $63,800 and have the greatest potential for containing cumulative material
misstatement (of an overstatement). These individual balances are likely to be tested in detail
(see Chapter 24) to account for performance materiality.
 The average balance in the range $1,000–$5,000 is $2,100 and the average balance less than
$1,000 is $670. If the profile of these balances is similar to the previous year's audit, analytical
procedures may be used (see Chapter 16).
Prepayments
 If $16,450 is in line with the prior period, it is unlikely to be materiality incorrectly stated and audit
tests may be limited to an analytical comparison with the prior year.

3.3 Relationship with Audit Risk

The relationship between materiality and the level of audit risk is described as inverse: as the
materiality level decreases, audit risk increases (and vice versa).
The auditor compensates for this increase in audit risk by reducing detection risk: modifying the
nature, timing and extent of planned substantive procedures (i.e. increasing the level of audit
work).

Example 5 Materiality Level and Audit Risk

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

Key Point

A lower materiality level should be set if the risk of material misstatement is assessed as high.
Setting the materiality level lower reduces detection risk because:
 more audit work will be performed;
 sample sizes will be larger.

3.4 Changing Materiality as the Audit Progresses

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

Example 6 Changing Materiality Level

During an audit, material overstatements in the quantity and valuation of inventory are noted. An increas
in audit risk may be identified, requiring re-working the financial statement materiality calculations.
The materiality level will need to be lowered, and further testing carried out (e.g. larger sample sizes o
additional items now greater than the materiality level will need to be tested).
The auditor will need to use professional judgment to determine if a higher level of testing is required o
other balances and the effect on performance materiality.

3.5 Documentation

As discussed in Chapter 6, the auditor must document all matters to support the audit opinion,
especially those involving the use of professional judgment.
Activity 3 Documentation

List the key matters that should be documented concerning materiality.

*Please use the notes feature in the toolbar to help formulate your answer.
Concerning materiality, the auditor will be expected to document:
 The materiality level for the financial statements as a whole and the underlying factors
considered in its determination.
 Any materiality levels, if applicable, for particular classes of transactions, balances and
disclosures that are important to users of the financial statements (with underlying factors).
 Performance materiality with underlying factors.
 Any revision of any materiality level and why each revision was necessary.
 Reasons for any adjustments made that relate to material misstatements.
 All uncorrected misstatements and the aggregate of such errors for each class of transaction,
balance and disclosure, with reasons why each error (and aggregate total) is not considered
material.

Syllabus Coverage

This chapter covers the following Learning Outcomes.

B. Planning and Risk Assessment

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