Materiality

Definition

Materiality is a concept, a threshold, an intangible. What makes misstatement material to one user of the accounts may not be material to another user. The precise definition is as follows:

"Misstatements, including omissions, are considered to be material 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" (ISA 320 Materiality in Planning and Performing an Audit)

The significance of materiality?

The bottom line is that the auditor is responsible for providing an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. If financial statements contain material misstatement they cannot be deemed to show a true and fair view and are therefore an unreliable basis for users' decision making.

As a result the focus of an audit is identifying the significant risks of material misstatement in the financial statements and then designing procedures aimed at identifying and quantifying material misstatement.

Determining materiality

The most significant misunderstanding about materiality is that it is a purely financial concern. However, disclosures in the financial statements pertaining to possible future legal claims, for example, could influence users' decisions and may be purely narrative. In this case a numerical calculation is not relevant.

The guidance in ISA 320 states that the determination of materiality is a matter of professional judgement and that the auditor must consider:

• The circumstances surrounding the entity;
• Both the size and nature of misstatements; and
• The information needs of the users as a group.

This is an obviously subjective and potentially complex process but is vital in ensuring that materiality is considered in light of the client's needs, instead of just applying an arbitrary calculation. However, ISA 320 does recognise the need to establish a financial threshold to guide audit planning and procedures. For this reason it does allow the use of standard benchmarks but only as a starting point. The auditor must then consider all the factors listed above. Traditional benchmarks include:

• ½  - 1% of turnover
• 5 - 10% of profit before tax
• 1 - 2% of gross assets

The practical application of materiality

It is unlikely, in practice, that auditors will be able to design tests that identify individually material misstatements. It is much more common that misstatements in aggregate (i.e. in combination) become material. Auditors also have to consider that they can only test on a sample basis, so they have to evaluate their findings and determine how likely it is that errors identified in the sample are representative of material errors in the whole population under scrutiny.

For this reason materiality, as determined for the financial statements as a whole, may not be the best guide in determining the nature and extent of audit tests. To this end ISA's introduce two further concepts: performance materiality and tolerable misstatement that guide the way an auditor performs, and evaluates the results of, their tests.

Performance materiality

This is defined in ISA 320 as:

"The amount set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole."

In using this lower threshold to perform audit procedures the auditor is more likely to identify misstatements, the effect of which can be considered in combination.

Tolerable Misstatement

This is defined in ISA 530 Audit Sampling as:

 "A monetary amount set by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that the monetary amount set by the auditor is not exceeded by the actual misstatement in the population."

It is the practical application of performance materiality to an audit sample. If the total of errors in the sample selected exceeds tolerable misstatement the auditor considers that the risk of a material misstatement from the whole population is high and therefore tests a greater sample size. If the total of errors in the sample is less than tolerable misstatement then the auditor may be reasonably confident that the risk of material misstatement in the whole population is low and no further testing will be required.

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Tags:	materiality;performance materiality;tolerable misstatement