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General

Audit Materiality

By May 13, 2022September 22nd, 2023No Comments
Audit Materiality

The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. This is achieved by the auditor giving an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework.

Audit Materiality is an important part of audit, since the auditors cannot test every transaction. The auditor has to plan and perform the audit to detect misstatements that, individually or in combination with other misstatements, would result in material misstatement of the financial statements. Misstatements are considered material if it has an influence on the economic decision of the users of the financial statement of the company. Misstatements could be material due to quantitative or qualitative factors.

Standards on Auditing (SA) – 320 issued by the Institute of Chartered Accountants of India deals with the Auditor’s consideration of materiality in planning and performing an audit of financial statements.

Materiality in the context of an Audit

Financial reporting frameworks discuss materiality in different terms, which includes

  • Misstatements, including omissions, if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements;
  • Judgements about materiality are made in the light of surrounding circumstances, and are affected by the size or nature of a misstatement, or a combination of both; and
  • The common financial information needs of users as a group.

The objective of the auditor is to apply the concept of materiality appropriately in planning and performing audit procedures.

Overall Materiality

Overall materiality is the level which represents the significant level in the financial statements of the company, which can influence the decision making of the users of the financial statements of the company as a whole.

Factors that may affect the identification of an appropriate benchmark include the following:

  • The elements of the financial statements (for example, assets, liabilities, equity, revenue, expenses);
  • Items on which the attention of the users of the particular entity’s financial statements tends to be focused (for example, profit, revenue or net assets);
  • The nature of the entity, where the entity is at in its life cycle, and the industry and economic environment in which the entity operates.
  • The entity’s ownership structure and the way it is financed and
  • The relative volatility of the benchmark.

In relation to the chosen benchmark, relevant financial data ordinarily includes financial results and financial positions for the prior period, the period to-date financial results and financial position, and budgets or forecasts for the current period, adjusted for significant changes in the circumstances of the entity, industry or economic environment in which the entity operates.

Auditors need to use their professional judgement to determine an appropriate benchmark and the chosen benchmark needs to be justifiable, with the rationale clearly documented.

Performance materiality

“Performance materiality” is the materiality level that is less than the overall level of the materiality. This materiality level is reduced from “overall materiality level” to consider the risk of several smaller errors or omissions which the auditor was unable to find. 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.

Usually audit methodologies require performance materiality to be a percentage of overall materiality. The higher the assessed risk, the lower the percentage.

Specific Materiality

Specific materiality is the materiality level set to identify potential misstatements for particular classes of transactions, account balances or disclosures. It is the level which is lesser than the overall materiality. In such classes of transactions, account balances or disclosures, any misstatement of lesser amount than the overall materiality may affect the economic decisions of the users of the financial statement of the company. These may exist in different areas in the company, some of the factors include

  • Statutory requirement (like related party transaction)
  • The key disclosures in relation to the industry in which the entity operates
  • Whether attention is focused on a particular aspect of the entity’s business that is separately disclosed in the financial statements

Examples

Let’s suppose Mr. A, Auditor, set an overall materiality of 1% of revenue for ABC Company. For 2021, the company reports annual revenue of ₹100 million, then its overall materiality is set at ₹1 million. On this, a lower level of performance materiality is determined, say 75% of overall materiality. The performance materiality will be ₹0.75 million.

Suppose, the company has transactions with related party amounting to ₹0.25 million. Despite the transaction amount being lower than the overall materiality and performance materiality, such transaction will be considered material due to its nature. This is an example of specific materiality.

Revision of audit materiality

When, because of changes in the particular circumstances or additional information that comes to the auditor’s attention, there is a substantial likelihood that misstatements of amounts that differ significantly from the materiality level that were established initially would influence the judgment of the users of the financial statement of the company, the auditor should re-evaluate the established materiality level.

If the auditor’s re-evaluation results in a lower amount for the materiality level than initially established by the auditor, the auditor should

  • evaluate the effect, if any, of the lower amount or amounts on risk assessments and audit procedures and
  • modify the nature, timing, and extent of audit procedures as necessary to obtain sufficient appropriate audit evidence.

Documentation

The documentation includes an explanation as to how the judgements were made in determining materiality, including:

  • overall materiality;
  • performance materiality;
  • any lower amounts of specific materiality for particular classes of transactions, account balances or disclosures (and any related performance materiality for these items);
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