Meaning of materiality
There is no specific definition of materiality under U.S. Generally Accepted Accounting Principles (GAAP). However, the gist per the Conceptual Framework for Financial Reporting under International Financial Reporting Standards states that information is to be considered material if it influences the decisions of stakeholders who depend on the financial information of the reporting entity. Materiality varies in nature or magnitude, or both, to which information relates to.
The materiality in the context of the audit shall include the following:
- Misstatements that can influence the decision of users of balance sheet
- Professional judgment is based on the nature and size of misstatements.
Determining the benchmark for materiality
The benchmark for materiality shall be based primarily on professional judgment. Some auditing bodies have prescribed recommendations for setting up benchmarks related to materiality. Then the general benchmark is basically an amount exceeding 5% of profit before tax from continuing operations for a profit-oriented manufacturing business and 1% of total income or expenses in the case of a not-for-profit entity. It does stress that higher or lower.
Auditors tend to use various ranges based on their personal experience. However, these ranges are more or less the same in the industry. Auditors base their decisions on the basis of the economic value of transactions.
Specific levels of materiality for individual balances, classes of transactions, or disclosures
Under select cases, balance, class of transaction, or disclosure in the financial statements would warrant a lower level of materiality based on the amount, and the users can be persuaded to make a different decision, one that may not be rational or without complete knowledge. The following factors need to be considered in order to assess materiality in the audit:
- If all the relevant laws affect the expectations of users
- Disclosure requirements in certain industries like research and development in pharmaceutical industries
- Disclosure requirements in case of business combinations
The total value of investments in the Equity scheme offered by the government is $100m, and the total contributions receivable from active members are only $50,000.
In this case, applying any kind of percentage won’t be useful for such an investment company. Auditors shall determine materiality by setting a lower amount for such member contributions and similar debtors and creditors.
Determining performance materiality
“Performance materiality is the amount set by auditors at below overall materiality to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality.” – ISA320.
It serves two basic purposes: reducing aggregation risk and providing some security against the risk of internal control not detecting irregularities. The audit techniques require performance materiality to be a percentage of overall materiality. The higher would be the level of assessed risk and lower the percentage. Auditors use performance materiality in two ways.
It can be used in the early auditing schedule to identify areas of special focus and how much time needs to be allocated thereon. The other would be to use it midway through the audit, based on the auditor’s judgment. This would include sampling and how many items to include in the sampling. If lower materiality is set for some accounts and balances, auditors would also need to lower performance materiality in such cases.
Assessing the materiality of misstatements
The auditor shall assess every misstatement and its impact on relevant classes of transactions, accounts balances, or disclosures. This shall also include if such a transaction has included the materiality level that has been set.
The auditors need to assess if misstatements are material according to their size and nature. Auditors need to consider qualitative assessment, balance sheet classifications, disclosure of misstatements, and impact on prior period financial statements while assessing the materiality of misstatements.
Reassessing materiality during the audit
Auditors need to be proactive as well as reactive. They need to set the benchmarks at the beginning, and when circumstances arise where it would be necessary to change the benchmark, they also need to be reactive. Auditors should revise overall materiality during an audit if they know the audit procedures being carried on.
This may happen when they realize they have set a different benchmark with respect to the amount. This happens if the materiality is determined prior to year-end information. If the auditors realize that lower materiality is set than required in the present scenario, they have to reassess the materiality. Auditors would then revise performance materiality considering the impact on audit procedures’ nature, time, and extent.