Materiality in Audit

Definition

In an audit, materiality is the concept or expression that refers to the matter that is important in the financial statements. In this case, a matter is material if it can affect the economic decision making of the users of financial statements.

Likewise, the misstatements on financial statements are considered material if they can influence the economic decisions of users taken on the basis of the financial statements.

In the audit, materiality is viewed as the threshold that auditors determine in order to focus their attention on the matters that have a significant impact on financial statements as a whole.

Hence, any matter or misstatement that is not material is usually not detected or ignored by auditors. This is due to auditors cannot perform the audit tests on all the transactions and balances in the client’s accounts.

One purpose of financial statement audit performed by the independent auditors is to examine whether the financial statements contain any material misstatement. Likewise, the auditors only give a clean opinion on financial statements if they contain no material misstatement. In other words, they give a true and fair view in all material respects.

Types of Materiality in Audit

In the audit work, auditors must calculate materiality for financial statements as a whole, which is known as overall materiality, and performance materiality in order to use as guidance in performing the audit.

Types of Materiality in Audit
Overall Materiality	Overall materiality is the materiality that auditors estimate and determine for the whole financial statements in the planning stage of the audit by using their professional judgment. Auditors then use this materiality in developing the overall audit strategy in order to perform the audit work in an effective and efficient manner. If there is any unexpected event that arises during the audit work, materiality may need to be changed so that it reflects the risks that auditors face. So, auditors may need to review overall materiality throughout the whole audit process and revise if they think it is necessary.
Performance materiality	Performance materiality is the materiality that auditors estimate and determine at the lowest level so that they can be sure that small errors or omissions adding up do not exceed the overall materiality. While overall materiality is set for financial statements as a whole, performance materiality is set for particular classes of transactions, account balances, or disclosures. Auditors will need to use performance materiality throughout their audit work in the engagement in order to perform audit procedures on various transactions and balances of the client. For this reason, performance materiality is sometimes called “working materiality”.

Types of Materiality in Audit

Overall Materiality

Overall materiality is the materiality that auditors estimate and determine for the whole financial statements in the planning stage of the audit by using their professional judgment. Auditors then use this materiality in developing the overall audit strategy in order to perform the audit work in an effective and efficient manner.

If there is any unexpected event that arises during the audit work, materiality may need to be changed so that it reflects the risks that auditors face. So, auditors may need to review overall materiality throughout the whole audit process and revise if they think it is necessary.

Performance materiality

Performance materiality is the materiality that auditors estimate and determine at the lowest level so that they can be sure that small errors or omissions adding up do not exceed the overall materiality. While overall materiality is set for financial statements as a whole, performance materiality is set for particular classes of transactions, account balances, or disclosures.

Auditors will need to use performance materiality throughout their audit work in the engagement in order to perform audit procedures on various transactions and balances of the client. For this reason, performance materiality is sometimes called “working materiality”.

Qualitative and Quantitative Factors of Materiality in Audit

Quantitative Materiality

In an audit, materiality is a matter of professional judgment that auditors need to decide for any audit engagement. There is no professional standard that states how much amount or percentage auditors should use for calculation of materiality.

However, there is a rule of thumb that auditors can use together with their professional judgments to decide the level of materiality in audit. Auditors may use a range of the percentages and benchmarks as a basis for quantitative factors of materiality as follow:

0.5% to 1% total revenues or expenses
1% to 2% total assets
5% to 10% net profit

For the benchmark to use, it will usually depend on what type of company auditors face. For example, for a commercial business, auditors may use net profit as a benchmark; but for a not-for-profit organization that doesn’t have a profit figure, auditors may need to use other benchmarks such as total assets or total expenses.

Qualitative Materiality

The rule of thumb above is considered quantitative factors. However, auditors need to consider both quantitative and qualitative factors when assessing materiality in audit.

In the table below are the three qualitative factors that auditors usually need to consider when determining the materiality in audit.

Qualitative factors of materiality in audit
Nature of transaction or issue	Although materiality usually concerns with a big dollar amount auditor is dealing with, some small transactions or issues may be material too if they involve illegal activities such as fraud, thief or bribery.
Audit circumstance	Some audit circumstances may require auditors to exercise more care when deciding materiality in audit engagements. Examples of such circumstances include: those involving a lot of uncertainties of future events, those involved with public interest such as listed companies, those companies that give incentive to management that meets earning target, etc.
Possible cumulative effects	Auditors need to consider the probability that the aggregate of uncorrected and undetected misstatements could exceed overall materiality for the financial statement. For example, if an overall misstatement is $100,000, the five individual misstatements of $25,000 will exceed the overall misstatement.

Qualitative factors of materiality in audit

Nature of transaction or issue

Although materiality usually concerns with a big dollar amount auditor is dealing with, some small transactions or issues may be material too if they involve illegal activities such as fraud, thief or bribery.

Audit circumstance

Some audit circumstances may require auditors to exercise more care when deciding materiality in audit engagements.

Examples of such circumstances include:

those involving a lot of uncertainties of future events,
those involved with public interest such as listed companies,
those companies that give incentive to management that meets earning target, etc.

Possible cumulative effects

Auditors need to consider the probability that the aggregate of uncorrected and undetected misstatements could exceed overall materiality for the financial statement.

For example, if an overall misstatement is $100,000, the five individual misstatements of $25,000 will exceed the overall misstatement.