Materiality in planning and performing an audit

 

Materiality

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

Financial statements are reliable if there are no material misstatements in them. Accordingly, when conducting an audit, it becomes necessary to determine the level of materiality.

In planning the audit, the auditor makes judgments about misstatements that will be considered material. These judgments provide a basis for:

(a) Determining the risk assessment procedures.

 (b) Identifying and assessing the risks of material misstatement; and

(c) Determining the nature, timing and extent of audit procedures and in forming the opinion in the auditor’s report.

When establishing the overall audit strategy, the auditor shall determine materiality for the financial statements as a whole.

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 company, include categories of reported income such as profit before tax, total revenue, gross profit and total expenses, total equity or net asset value. Determining a percentage to be applied to a chosen benchmark is a matter of professional judgment and depends on the nature of company. For example, the auditor may consider five percent of profit before tax to be appropriate for a commercial company in a manufacturing industry, while one percent of total revenue or total expenses to be appropriate for a not-for-profit company.

The following benchmarks and percentages may be appropriate in the calculation of materiality for the financial statements as a whole:

Value	%
Profit before tax	5
Gross profit	0.5-1
Revenue	0.5-1
Total assets	1-2
Net assets	2-5
Profit after tax	5-10

Materiality Level or Levels for Particular Classes of Transactions, Account Balances or Disclosures

 In the specific circumstances of the company, there is one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. In this situation the auditor shall also determine the materiality level or levels to be applied to those particular classes of transactions, account balances or disclosures. The auditor’s determination of materiality is a matter of professional judgment.

Factors that may indicate the existence of one or more particular classes of transactions, account balances or disclosures for which the materiality level could be determined are following:

·        If  law, regulation or the applicable financial reporting framework affect users’ expectations regarding the measurement or disclosure of certain items (for example, related party transactions, and the remuneration of management and those charged with governance).

·        The key disclosures in relation to the industry in which the company operates (for example, research and development costs for a pharmaceutical company).

·        Attention is sometimes focused on a particular aspect of the company's business that is separately disclosed in the financial statements (for example, a newly acquired business).

Performance materiality

Performance materiality means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole.  It 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. This means a lower threshold is applied during testing. The risk of misstatements which could add up to a material misstatement is therefore reduced.

For example, the auditor may set the performance materiality at the level of 75% from materiality level.

 Performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances or disclosures.

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.

To ensure that financial statements are free from material misstatements auditors accumulate misstatements identified during the audit that are not clearly trivial. Misstatements that are clearly trivial will be of a wholly different (smaller) order of magnitude, or of a wholly different nature than those that would be determined to be material, and will be misstatements that are clearly inconsequential, whether taken individually or in aggregate and whether judged by any criteria of size, nature or circumstances. Clearly trivial threshold may be set at the level of 5% of materiality for the financial statements as a whole.

The auditor must revise materiality for the financial statements as a whole (and, if applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures) in following situations:

·        There appears new information, or a change in the auditor’s understanding of the company and its operations as a result of performing further audit procedures (for example, a decision to dispose of a major part of the company’s business).

·        The actual financial results are likely to be substantially different from the anticipated period-end financial results that were used initially to determine materiality for the financial statements as a whole.

As for documentation, auditors include in the audit documentation the following amounts and the factors considered in their determination:

(a) Materiality for the financial statements as a whole

(b) If applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures.

 (c) Performance materiality and

 (d) Any revision of materiality as the audit progressed.