Want to perform your audits correctly but with less time? Then understand audit materiality, performance materiality, and trivial misstatements. Below you’ll see how to use audit materiality in the planning, conduct, and conclusion of your engagements. You’ll also see how to use performance materiality and trivial misstatements.
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 thatโs okay as long as they arenโt too large. But how big can they be without affecting financial statement usersโ 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.ย 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, itโs total assets. And what is a benchmark? Itโs whatโs 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. Thatโs 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. Itโs 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?
The Financial Accounting Standards Board providesย the materialityย 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.ย
So, consider that material misstatements include:
Also keep in mind that financial statement readersโmanagement, owners, lenders, vendorsโmake decisions. The FASB lumps these together as a reasonable person whose judgmentโฆwould 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 entityโs 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 auditorโs job is to provide reasonable assurance that the financial statements are materially correct. So how do we do this? We begin by computing 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 whatโs a poor example? Net income. Why? Because some businesses โsalary outโ 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,ย we need to apply a percentย to compute materiality. The percent is not defined in professional standards, so again,ย itโs judgmental. Most CPAs use percentages in materiality forms provided by third-party publishers; others create their own. Either way,ย auditors must provide reasonable assurance that the financial statements are fairly stated.ย 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 usersโ decisions. But a $100,000 error in a million dollar company might.
Even with a good materiality number, uncorrected and undetected misstatements can create problems.
The total of undetected errors may exceed materiality.ย 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?ย 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.ย And what is that cushion? 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.ย
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 materialityโboth for the statements as a whole and for classes of transactions, account balances, and disclosures. We donโt 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.
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, โWill these uncorrected misstatements adversely affect a userโs judgment?โ 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:
Some identified misstatements are so small that they will not be accumulated. We call these 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 donโt want the cumulative trivial misstatements to become material.
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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Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty-five years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention, The Why and How of Auditing, Audit Risk Assessment Made Easy, and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles consults with other CPA firms, assisting them with auditing and accounting issues.
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Aditya, if you are auditing quarterly statements, you can compute materiality just as you do at year-end. But you’ll use quarterly income statement numbers rather than twelve-month numbers for the income statement amounts. The benchmark (number used to apply the percent to) is based on what the users of the financial statements focus on. If they focus on total assets, then I’d use that. If they focus on revenues, I’d use that number. If expenses, I’d use total expenses. So it depends on what the users of the quarterly financial statements find most important. I usually do not use two different materiality amounts (for the BS and income statement); I use just one (whichever is most important). Hope that helps.
Hi Charles it was a great article. Can you please also let me know generally, how we determine materiality in the case of Quarterly reviews? Can we take separate materiality for BS and Income Statement?
Thank you, Fabio. Glad you liked it.
Great and Clear explanation. Thanks you for sharing these videos.
James, you’ll need to modify your audit opinion. An unmodified opinion is not permissible is material errors are preseent.
Thanks, Arshad. Glad you liked it.
Hi Hall,
What should one do if the passed audit adjustments exceed the overall materiality level at the financial statement as a whole?!
Excellent! Simple, professionally referenced, concise yet hugely informative. I certainly got more clarity on materiality from this article than reading all those standards, audit tools and materials out there. Thank you Charles.
Thanks much Ahava. I have updated the definition. Have a great day.
Excellent article!
One comment, which does not impact anything else said above:
In August 2018 the FASB revised its definition of materiality to the following:
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.
This aligns with the definition of materiality used by the United States judicial system, the auditing standards of the PCAOB, GASB, and the SEC. The ASB has just begun a project to align the definition of materiality in GAAS to the definition used by others in the US. For more information, go to https://www.aicpa.org/research/standards/auditattest/asb/asb-meeting-agenda-materials-201903.html
Jim. Thanks for your comment. I agree with you. There is much judgment. I find that gray areas (like materiality) make accountants and auditors nervous. We all seem to love sureness, but our profession demands subjective decisions. Alas, this is where the art (of auditing) comes into play.
Charles, great article. I like having your overviews of these areas that are so central to what we do, but don’t always think about.
Over the years, I’ve changed my thoughts about materiality from “how to do compute this one number called materiality” to looking much more at the context. What if the Controller stole $9,999 and our “materiality” was $10K? A purposefully absurd question to illustrate a point. When accessing a fraud risk, we would use a materaility number, but if looking at an actual incidence of potential fraud, there probably is no materiality.
Another one of those audit areas where there is no one right number and we have to make judgements as best we can.
We also use the PPC worksheet.
Armando, are you referring to the proposed FASB standard “Notes to the Financial Statements”? That standard, if passed, will give entities a greater ability to leave immaterial disclosures out of the statements.
The main provisions of the amendments in this proposed Update are summarized as follows:
1. Materiality would be applied to quantitative and qualitative disclosures individually and in the aggregate in the context of the financial statements as a whole; therefore, some, all, or none of the requirements in a disclosure Section may be material.
2. Materiality would be identified as a legal concept.
3. Omitting a disclosure of immaterial information would not be an
accounting error.
I use PPC format, I establish the percentages. An important point to consider, that I observe and document, is who will be the users of the financial statements. If a Single Audit, I establish the materiality by each grant, at a significant reduced level as grantors do no appreciate โpassed as immaterialโ unless it is clearly inconsequential. I discuss the materiality level with management before I implement it. While the audit is in process I may reduce the materiality level if I note that the risks of errors or irregularities are significant higher than what was originally planned; however, many times it is limited to particular class of transactions or account balance.
Charles, will you update us? I believe that the materiality level is becoming the responsibility of management and we the auditors accept/question whether the level is appropriate.