What is 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.
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. I've thrown in a couple of videos as well.
Material misstatements. That’s what auditors look for.
So let’s define audit materiality and consider its use.
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.
So how is materiality defined?
What is Materiality?
The Financial Accounting Standards Board defines materiality 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, 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.
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.
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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