Chapter 5

Materiality

TECHNICAL COMPETENCIES

4.3.4 Assesses materiality for the assurance engagement or project

This chapter describes the next step in the planning stage of the audit process, determining materiality.

0 Summary
There is no summary available for this chapter
1 Setting Materiality
Organizations can have many users of their financial statements. These users may include the bank, regulators, other
businesses, shareholders and investors, and other stakeholders, such as employees. The users will review the
organization's financial statements to make decisions about whether they should invest in, purchase, do business with,
assess the compliance of, or lend money to the organization.
The concept of materiality recognizes that transactions, amounts, or certain types of errors, either individually or in the
aggregate, directly influence the relevance and reliability of information for decision-making purposes. The practitioner is
responsible for assessing whether the financial statements are free from material misstatement.
Materiality is an important concept and it is used in the various stages of the audit:
• During the planning stage, materiality is used to determine which balances and transactions the practitioner will
focus procedures on, and also to assist the practitioner in deciding which audit procedures to perform.
• During the execution stage, materiality is used to evaluate errors discovered and determine the extent of any
additional audit procedures required.
• During the reporting stage, materiality is used to evaluate the aggregate of the uncorrected errors that have been
identified throughout the audit. If the errors exceed overall materiality or a specific materiality amount (as
applicable) and the client will not correct them, the practitioner's opinion may be affected.
Determining materiality requires professional judgment, as both quantitative and qualitative factors need to be taken into
consideration.
Several steps are required to determine materiality.
1.1 Step 1: Identify the users of the financial statements
The practitioner is tasked with identifying the significant users of the financial statements. Users will vary based on the
organization's circumstances. For example, a non-profit organization will have a very different group of users than a for-profit
organization, and a publicly listed company will have a different group of users than a privately held company. Depending on
case facts, common users may include (among others):
• lenders
• shareholders
• potential investors
• management (if compensation or performance is based on financial statement line items)
1.1.1 Test your knowledge
 You, CPA, are the audit engagement lead on the 20X2 audit of Buddy's Bootcamp (Buddy's). Buddy's is a large fitness
studio with three locations in Toronto, Ontario. The business is privately owned by Buster Van Kamp. Recently, Buster has
been considering expanding Buddy's across Canada, and the company has taken a five-year term loan from the bank to
help fund the expansion. Buddy's growth rate has attracted the attention of a local investment management firm, LCP
Capital (LCP). LCP is considering investing in Buddy's and plans to base its decision on the 20X2 financial statements.
Identify the users of the financial statements.
Answer
The users of the financial statements are:
• Buster Van Kamp, owner
• Bank, lender
• LCP, potential investor
1.2 Step 2: Identify the users' objectives
The practitioner must gain an understanding of the objectives and sensitivities of all of the significant users of the financial
statements (as identified in Step 1). For example, lenders often monitor financial leverage, liquidity, covenants, asset values,
and debt coverage ratios. Investors will look at financial stewardship, free cash flow generation, and earnings growth. Senior
executives will look at financial statements in terms of their incentive compensation plan.

A good setup when assessing materiality in a case is to list the

users with bullets and then use sub-bullets below to define each
user's objectives.

1.2.1 Test your knowledge

1.2.1 Test your knowledge
Planning for the audit of Buddy's described in 1.1.1 is ongoing. You've identified the following users of the financial
statements:
• Buster Van Kamp, owner
• Bank, lender
• LCP, potential investor
Next, based on the information provided, identify the users' objectives.
Answer
• Buster Van Kamp, owner:
o Buster will be primarily concerned with assessing the performance of the business and earning a return on his
investment.
• Bank, lender:
o The bank will be concerned about whether Buddy's can repay the amount borrowed. If the loan includes
covenants, the bank's objective will also be to determine whether or not those covenants are being met.
• LCP, potential investor:
o LCP will be concerned with Buddy's ability to be profitable now and in the future. LCP's objective will be to use
the financial statements to determine whether an investment in Buddy's can be expected to earn a positive return.
1.3 Step 3: Determine the base for materiality
The practitioner will use their understanding of the users' objectives to determine which materiality base is most appropriate.
For example, if the client is a for-profit entity, its users are most likely concerned with profitability; therefore, net income
before tax would likely be most appropriate. However if a for-profit entity is in a loss position or their earnings are volatile,
then revenue may be the more appropriate measure. On the other hand, if the client is an active not-for-profit organization,
users may be most concerned with responsible spending, making total expenses the most appropriate basis. If the
organization is a foundation concerned with donor contributions, assets may be a more appropriate basis for materiality.
CAS 320 Materiality in Planning and Performing an Audit does not provide specific guidance on which basis should be
chosen for various different organizations; the practitioner must use professional judgment.
The most common bases, otherwise known as benchmarks of materiality, are:
• normalized income before tax (this is the most common case for for-profit entities)
• total assets
• total revenues
• total expenses
• total equity
1.3.1 Test your knowledge
Planning for the audit of Buddy's described in 1.1.1 is ongoing. In 1.2.1, you have identified the objectives of the users of the
financial statements. You have received the following additional information:
• Buddy's has generated positive net income since it was founded, with the exception of the company's first year of
operations.
• The loan from the bank includes a covenant requiring Buddy's to maintain a current ratio of 1.5:1.
• In addition, the land, building, and equipment used in operations have been taken as collateral on the bank loan.
Based on this additional information and information provided earlier, conclude on the appropriate base for materiality.
 Answer
• Buster Van Kamp, owner:
o Given Buster's objective is to assess the company's performance and earn a return on his investment, he is
likely to be focused on total revenues and net income when reviewing the financial statements.
• Bank, lender:
o The bank is likely to be focused on net income as an indicator of Buddy's ability to meet its obligations as they
come due. Given that the loan covenant requires Buddy's to maintain a current ratio of 1.5:1 and the loan is
secured by property, plant, and equipment, the bank will also be interested in Buddy's total assets.
• LCP, potential investor:
o LCP is concerned with Buddy's ability to be profitable now and in the future. LCP is likely to use net income in
assessing current and future profitability.
Conclusion: Based on the above analysis, net income before tax is the most appropriate benchmark for materiality. This
amount should be normalized for any unusual revenue or expenditures earned or incurred during the period.
1.4 Step 4: Identify the percentage threshold for materiality
The practitioner must consider the users' objectives again when determining the percentage to apply to the selected base for
the calculation of materiality.
CAS 320 does not specify exact percentages, but it does indicate that professional judgment should be applied. The
Professional Engagement Guide (PEG) suggests the following guidelines for the calculation of materiality:
For-profit entities:
• 3% to 7% of normalized income before tax
• 1% to 3% of revenues or expenses
• 1% to 3% of total assets
• 3% to 5% of equity
Not-for-profit entities:
• 1% to 3% of revenues or expenses
• 1% to 3% of total assets
A high degree of professional judgment is required to choose a percentage within the relevant range.
Generally, the sensitivity of the users' decisions to misstatement will drive the practitioner's selection of a percentage. For
example, if a user is very sensitive to misstatement, the practitioner will choose a percentage near the lower end of the
range. When a lower materiality threshold is established, the practitioner will be required to increase the quality and quantity
of evidence gathered.

When determining the base and threshold for materiality, make sure
to consider the users and their objectives, not risk of material
misstatement. Conclude in one or two sentences on the base and
threshold for materiality that you have selected, linking back to the
users' objectives that you have identified.

1.4.1 Test your knowledge

Planning for the audit of Buddy's described in 1.1.1 is ongoing.

Based on the users' objectives identified in 1.2.1, use professional judgment to identify the percentage threshold for materiality.

Answer

In addition to Buster, there are two new sets of users to consider in determining a percentage threshold for materiality: the bank
and LCP, the potential investor. Given that the bank is a new lender and that LCP will base its investment decision on the 20X2
financial statements, we can expect these new users to have a high degree of sensitivity to potential misstatements. A typical
range for calculating materiality based on net income before tax is 3% to 7%. Given the sensitivity of the new users, I recommend
selecting a percentage in the lower end of this range, such as 4%.

1.5 Step 5: Determine overall materiality

Once the practitioner has selected an appropriate base for materiality, they must determine, based on their understanding of
the client, if there are any unusual or non-recurring items that may need to be normalized or adjusted for. Examples of
normalizing items that may have an impact on net income as a materiality base include:
• unusual or non-recurring revenue or expenses
• special management bonuses
• unusual gains or losses on the disposition of property, plant, and equipment
Once the normalized base is determined, the threshold is applied.
The quantified number is generally rounded down to the nearest hundred or thousand, based on users' needs.
1.5.1 Test your knowledge
 Planning for the audit of Buddy's described in 1.1.1 is ongoing. In 1.3.1 and 1.4.1, you have determined that 4% of net
income before tax would be an appropriate percentage and benchmark for calculating overall materiality. The following
additional information is provided:
• Buddy's net income before tax for 20X2 is $1,800,500.
• Buster normally takes a salary each year of $110,000. He has done the same in 20X2.
• Included in 20X2 expenses is a one-time ad campaign costing $250,000. Buddy's ran the campaign as part of a
partnership with a visiting sporting event. No similar campaigns are planned for the future.
Based on the information provided, determine overall materiality for the 20X2 audit.
Answer
Before overall materiality can be calculated, net income before tax should be normalized. Buster has withdrawn his normal
salary from the company during 20X2. As this is consistent with the amount withdrawn in all previous periods, net income
does not need to be normalized for this figure. However, net income has been calculated including expenses for a one-time
ad campaign that is not expected to be repeated. This amount will need to be added back to net income before tax to arrive
at a normalized figure, as follows:

Net income before tax $1,800,500

Add: Ad campaign expense 250,000

Normalized net income before tax $2,050,500

Overall materiality can then be calculated as follows:

$2,050,500 × 4% = $82,020, rounded to $82,000.
1.6 Step 6: Determine performance materiality
Performance materiality (PM) is auditor focused. This means that when setting PM, the practitioner considers the amount of
audit work required to ensure that the identified and potential unidentified misstatements will not exceed overall materiality.
A possible suggested base for PM per PEG is 60% to 75% of overall materiality, but actual percentages used vary
throughout audit firms and should be based on professional judgment.
PM creates a cushion or safety buffer that ensures any unidentified misstatements or the aggregate of individually identified
immaterial misstatements do not exceed materiality. When the risk of a material misstatement is higher, a PM threshold at
the lower end of the range is generally selected, increasing the practitioner's sensitivity to potential misstatements.

While risk should not impact overall materiality, it should be

considered in setting PM.

1.6.1 Test your knowledge

Planning for the audit of Buddy's described in 1.1.1 is ongoing. For various reasons, risk of material misstatement for this
engagement has been set as HIGH.
See the related E-book chapter for more detail on assessing risk of material misstatement.
Based on the information provided, determine PM for the 20X2 audit.
Answer
Given that the risk of material misstatement for this engagement has been set as high, PM should be calculated using the
lower end of the typical range from 60% to 75% of overall materiality. Based on professional judgment, 60% will be used. PM
is calculated as follows:
$82,000 × 60% = $49,200, rounded to $49,000.
1.7 Step 7: Determine specific materiality
Specific materiality (SM) is set if there are balances or classes of transactions where an amount less than overall materiality
would influence or change the decision of a known user.
SM is used for designing audit procedures that address specific risks and balances in sensitive audit areas. For example, if a
bank loan has a maximum limit based on a percentage of inventory and accounts receivable, the practitioner may set SM for
these two accounts, given the bank's reliance on these accounts.
Establishing SM is based on professional judgment. The practitioner can use a percentage of the accounts that the user is
concerned about, as long as the amount is less than overall materiality. Alternatively, the practitioner may simply use a
reasonable percentage of overall materiality in the calculation of SM.

When stating whether certain accounts require SM, be sure to base

your determination on the users and their objectives, not on risk.
 After discussing the users' objectives, conclude in one or two
sentences on the account(s) that have an impact on the users and
what your threshold for SM will be, linking back to those objectives.

1.7.1 Test your knowledge

Planning for the audit of Buddy's described in 1.1.1 is ongoing.
As noted in 1.3.1, the land, building, and equipment used in Buddy's operations have been taken as collateral on the bank
loan. In addition, as part of the loan agreement the loan balance outstanding at any one time cannot exceed 75% of total
property, plant, and equipment.
At the end of 20X2, total property, plant, and equipment was $7,430,000. The amount of the term loan outstanding was
$5,000,000.
Based on the information provided, determine SM for the 20X2 audit.
Answer
Based on the terms of the bank loan, the bank will be particularly sensitive to misstatements in the property, plant, and
equipment balance. Given this, SM can be set for testing property, plant, and equipment. I recommend using 50% of overall
materiality to calculate SM as follows:
$82,000 × 50% = $41,000. Note that SM is less than overall materiality of $82,000.
1.8 Step 8: Determine specific performance materiality
Specific performance materiality (SPM) is established by the practitioner based on what is required to reduce the risk of
material misstatement (RMM) to an appropriately low level. To address RMM, SPM at the class of transaction or account
balance level is set at a lower level than both overall materiality and SM. When setting SPM, the practitioner considers the
amount of audit work required to ensure that the identified and potential unidentified misstatements will not exceed SM. SPM
is required only when SM has been set for an account or group of accounts.
1.8.1 Test your knowledge
Planning for the audit of Buddy's described in 1.1.1 is ongoing. RMM related to the existence of property, plant, and
equipment has been set as HIGH.
See the related E-book chapter for more detail on assessing RMM.
Based on the information provided, determine SPM for the 20X2 audit.
Answer
Given that the RMM for property, plant, and equipment has been set as high, SPM should be calculated using the lower end
of the typical range from 60% to 75% of SM. Based on professional judgment, 60% will be used. SPM is calculated as
follows:
$41,000 × 60% = $24,600, rounded to $24,000.
2 Materiality and Risk of Material Misstatement
Although materiality and RMM are both considered in determining the nature, timing, and extent of the audit work performed,
it is important to understand that materiality is not based on risk. In other words, the practitioner should not use risk when
determining overall or specific materiality. Risk is based on factors that relate to the company, while materiality is driven by
the needs of the users of the company's financial statements.
When RMM is high, the practitioner should not lower materiality to address this risk. Rather, the practitioner should increase
the quality and quantity of audit evidence obtained to reduce the RMM to an acceptably low level. Conversely, if RMM is low,
the practitioner should not increase materiality.
3 Practice Problem
Handy Hardware Inc. (HHI) is a retailer of tools and home improvement products. HHI is a family owned and operated
business, and the founder's grandson Marcus is HHI's newly appointed chief executive officer (CEO) and chair of the board.
HHI has a December 31 year end.
Despite operating in a highly competitive market, HHI has expanded its operations rapidly over the last five years, opening
up three retail stores in the past year alone. HHI is an "iconic" brand with a strong reputation for the quality and durability of
its products.
In 20X3, HHI implemented a new automated accounting system, AcctPro. While AcctPro resulted in significant efficiencies in
inventory management, the new system was installed quickly and without a formal plan. HHI's staff received little training on
the new system, and in many instances, they have reverted to manual tracking of accounts in Excel.
In order to finance its expansion, HHI has recently assumed a long-term loan with National Bank. It also has an operating
line of credit with the bank. The company has been paying the interest on the operating line but does not have sufficient
cash flow to pay down the principal borrowed. Any excess cash flow is being used to make the monthly payments on the
long-term bank loan.
Extracts from HHI's financial statements are as follows (in '000s):

Revenue $7,890

Net income before tax $4,600

Total assets $11,700

Accounts receivable $700

Inventory $3,875

Accounts payable $1,025

Additional information:
• A $150,000 bonus was paid to HHI's management team in 20X6 for reaching the set revenue target ($7 million in
sales). Shareholders have disclosed that they want to be sure that the bonus calculations were accurate, given the
company's cash flow position.
• During 20X6, HHI sold a warehouse. The gain on the sale of the warehouse totalled $480,000.
HHI has been audited for many years by Hunter Manfield, CPAs. Since 20X3, Hunter Manfield has detected a number of
accounting errors resulting from the new accounting system, though HHI has been agreeable to correct most of the errors
identified.
It is now January 15, 20X7. You, CPA, work as a manager for Hunter Manfield. You have been tasked with completing the
planning for HHI's December 31, 20X6, audit engagement.
Required
During the planning stage of the audit, a practitioner must set materiality. Calculate overall materiality, PM, SM, and SPM for
the 20X6 audit.
Answer
Steps 1 and 2: Identify the users of HHI's financial statements and identify their objectives
HHI's users include the bank and the company's shareholders.
The bank has recently loaned HHI money and is primarily concerned with:
• Ability to meet the loan principal and interest payments as they come due (profitability and cash flow)
HHI's shareholders are primarily concerned with:
• HHI's financial health, and whether will it continue as a going concern (profitability)
• Whether management's bonus was calculated correctly (revenues and bonus calculation)
Step 3: Determine the base for materiality
Because HHI is a for-profit, privately held company, and both of HHI's financial statement users are concerned with
profitability, normalized net income before tax will be the basis used for calculating materiality.
Step 4: Identify the threshold for materiality
PEG recommends a range of 3% to 7% of normalized net income before tax.
HHI's primary financial statement user, the bank, has recently loaned HHI money. The bank is particularly sensitive to
material misstatement, as it will use HHI's financial statements to monitor the company's financial health and its compliance
with the debt covenant imposed.
Given the bank's increased sensitivity to material misstatement, 3% of normalized net income has been chosen for the
calculation of overall materiality.
Step 5: Determine overall materiality
There are two items that must be considered in the calculation of materiality, as they are considered to be unusual or non-
recurring: the $150,000 bonus paid to HHI's management team in 20X6 and the $480,000 gain on the sale of HHI's
warehouse.
Normalizing calculation:

Net income before tax: $4,600,000

Deduct: Gain on sale of warehouse $(480,000)

Add: Management bonus $150,000

 Normalized net income before tax: $4,270,000

3% of normalized net income before tax: $4,270,000 × 3% = $128,100

Overall materiality $128,000 *

Based on the calculation above and the reliance of the users on net income, overall materiality shall be set at $128,000.
Step 6: Determine PM
A percentage of 60% of overall materiality will be chosen for the calculation of PM. A percentage in the lower range is
chosen given the fact that there have been errors in the past resulting from the accounting system that would affect all
balances, increasing the potential for uncorrected or undetected misstatements in HHI's financial statements.
PM = $76,000 ($128,000 × 60% = $76,800 rounded down)
Step 7: Determine SM
The shareholders, a primary user of HHI's financial statements, are particularly sensitive to material misstatement in HHI's
revenue balance, as it is the basis of the bonus calculation, which they have expressed concerns with.
Given that they want to ensure that the bonus was accurately calculated, and the calculation is based on a revenue target,
SM should be set for the revenue account.
A percentage of 50% of the overall materiality balance will be used in the calculation of SM (remember that SM is
determined using professional judgment and must not exceed overall materiality).
SM equals $64,000 ($128,000 × 50% = $64,000) and will be applied to revenue transactions and accounts receivable
balances.
Step 8: Determine SPM
Again, a percentage in the lower range is chosen given the fact that there have been errors in the past resulting from the
accounting system that would affect all balances, including revenue, increasing the potential for uncorrected or undetected
misstatements in HHI's financial statements.
SPM equals $38,000 ($64,000 × 60% = $38,000 rounded down).
4 Supplemental Resources
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5 Practice Multiple Choice Questions (MCQ) Quizzes
Log into the Knotia course in D2L, in the Content section, navigate to the volume of the eBook to find the MCQ quizzes for this
chapter.

Document ID: Chapter 5 – Materiality

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