The materiality concept is used in both the accounting context for the preparation and presentation of financial statements and in the auditing context to assess the material of misstatements contained in the financial statements. Even though the materiality is used in a different context, they both respect the same principle:
- Misstatements or omission is said to be material in the financial statements if they could influence the users in making their economic decision. Misstatement or omission could be individual or aggregate.
- The misstatements or omission could be qualitative, quantitative or both.
Here is the definition of materiality in conceptual frameworks:
Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. In this text, we will discuss the identification of materiality in the financial statements based on quantitative factors, and qualitative factors.
We will also discuss how the materiality concept is used in the audit context. This includes applying the materiality in audit, setting the planning materiality, and performance materiality.
Concept of materiality
The materiality in the financial statements refers to the misstatements or omissions which the cause of them could influence the user’s economic decision. Here is the calculation of the number of misstatements that consider being material to the financial statements based on the quantitative methods:
- 5% to 1% of Sales Revenue
- 1% to 2% of Total Assets
- 1% to 2% of Gross profit
- 2% to 5% of Shareholders Equity
- 5% to 10% of Net Profit
These factors can help both auditors and accountants to quantify the number of misstatements, whether they are materially misstated or not. Based on the factors, we can say that the misstatements of sale revenues amount to 5,000 USD, equal to 0.1% of total sales revenues per year, does not significantly make the users of financial statements change their minds if it is adjusted to financial statements. In other words, this misstatement is not materially misstated. However, in assessing the materiality, we cannot use the misstatements of one nature of account to benchmark with another.
For example, if we found a misstatement on sales revenue, the class of account to be the benchmark with is sales revenue.
As we already said in the definition of materiality above, the misstatement or omission can be qualitative and quantitative. An auditor or accountant might find or note immaterial misstatements to financial statements. For example, the small illegal payment is considered immaterial to financial statements in terms of amount but might be material in nature. The following are the qualitative factors of materiality that could help auditors and accountants (practitioners) identify and assess.
Here are they:
- The misstatement or omission that reverses the loss to profit or profit to loss
- The potential effect of the misstatements on the company’s policy.
- The potential effect of the misstatements that incompliant with local regulation, laws, agreements, loan covenants, or similar.
- Misstatements or omissions that potentially affect the company’s future benefits.
- The misstatements that adversely turn one transaction or event to others which subsequently affect one the user’s information.
- The misstatements or omission that is really necessary for the users’ decision making.
When to apply materiality in an audit?
The materiality principle is not only in the financial context for preparing and presenting financial statements, but it is also used in the audit context in assessing the materiality misstatements in financial statements to assist them in issuing the correct audit opinion.
That is why the international standard on auditing requires the auditor to properly assess the risks of potential misstatements properly. ISA 315 is the auditing standard that deals with using materiality in an audit context. This standard requires the auditor to identify and assess the financial statements’ material misstatements by understanding the client’s internal control, environment, and related areas.
Normally, the auditor assesses and sets the materiality not only in the planning stage but also during the performing of audit (substantive) and at the concluding stages. The materiality can be changed from time to time based on the auditor’s knowledge of the client’s business and the risks related to financial statements.
For example, the planning materiality is assessed and set at the planning stages based on the auditors performing an understanding of clients’ environments and preliminary assessment of clients’ financial statements.
This planning materiality can be changed if auditors found the risks of material misstatements is higher than what they think at the planning stages. The planning materiality can also be changed at the conclusion stages once audits complete their testing and better understand client financial statements. Therefore, materiality is used in planning, substantive, and conclusion in the audit context. This materiality is subject to change based on audit knowledge and reassessment.
The definition of planning material was changed from materiality. Many practitioners get confused between materiality, planning materiality, performance materiality, and a tolerable misstatement.
To understand all of these, it is very important to know the development of this theory from time to time. The development of an international standard on auditing is the change from time to time, do so the definition of technical terms. The Materiality was changed to Planning Materiality, and Tolerable Misstatement was changed to Performance Materiality. Planning Materiality is the materiality that auditors assess and assess financial statements at the planning stages of an audit of financial statements.
In practice, the auditor uses quantitative factors to assess the materiality of financial statements—for example, 1% of total sales revenues. Once auditors set the planning materiality, they will subsequently set the performance materiality. Materiality to the financial statements has to be assessed and set by auditors at the planning stages before they could perform their audit work.
Performance materiality is the amount that auditors set to less than the planning materiality that they set to financial statements. For example, if planning materiality to financial statements equal to 1% of total sales revenue is 100,000USD, then auditors need to set the performance materiality to less than this amount.
Setting the performance materiality depends on the professional judgment that auditors make to financial statements. For example, performance materiality probably ranks from 40% to 60% of planning materiality.