What is considered material to the financial statements?

Both the amount (quantity) and nature (quality) of misstatements are relevant to deciding what is material.

How does materiality apply in an audit?

The objective of a financial statement audit is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. This is a separate responsibility and a separate decision from that made by the entity itself when preparing the financial statements. In auditing, materiality means not just a quantified amount, but the effect that amount will have in various contexts. During the audit planning process the auditor decides what the level of materiality will be, taking into account the entirety of the financial statements to be audited. Materiality relates to both the content of the financial statements and the level and type of testing to be done. The decision is based on judgements about the size, nature and particular circumstances of misstatements (or omissions) that could influence users of the financial reports. In addition, the decision is influenced by legislative and regulatory requirements and public expectations.

If, during the audit, the auditor acquires information that would have caused it to determine a different materiality level, it will revise the materiality level accordingly.

Benchmark used to obtain reasonable assurance that an audit does not detect any material misstatement that can significantly impact the usability of financial statements

The materiality threshold in audits refers to the benchmark used to obtain reasonable assurance that an audit does not detect any material misstatement that can significantly impact the usability of financial statements.

It is not feasible to test and verify every transaction and financial record, so the materiality threshold is important to save resources, yet still completes the objective of the audit.

Materiality Explained

Materiality can have various definitions under different accounting standards, such as the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS). Other more specific accounting standards may apply in different circumstances.

Under U.S. GAAP, the definition for materiality is “The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” 

On the other hand, the definition under IFRS, “information is material if omitting, misstating, or obscuring it could reasonably be expected to influence decisions that the primary users make on the basis of those financial statements.”

Stated otherwise, materiality refers to the potential impact of the information on the user’s decision-making relating to the entity’s financial statements or reports.

Users of financial statements include:

• Shareholders
• Creditors
• Suppliers
• Customers
• Management
• Regulating entities

Example of Materiality Threshold in Audits

There are two transactions – one is an expenditure of $1.00, and the other transaction is $1,000,000.

Clearly, if the $1.00 transaction was misstated, it will not make much of an impact for users of financial statements, even if the company was small. However, an error on a transaction of $1,000,000 will almost certainly make a material impact on the user’s decisions regarding financial statements.

Determining Materiality

No steadfast rule exists for determining the materiality of transactions within financial statements. Auditors must rely on certain principles and professional judgment. The amount and type of misstatement are taken into consideration when determining materiality.

In the example above, there are two transactions of absolute dollar amounts. However, in practice, determining materiality is more effective on a relative basis.

For example, instead of looking at whether a transaction of $1.00 or $1,000,000 is considered to be material, the auditor will refer to the percentage impact that the misstatement may have on the financial statements.

So, for a company with $5 million in revenue, the $1 million misstatement can represent a 20% margin impact, which is very material.

However, if the company has $5 billion in revenue, the $1 million misstatement will only result in a 0.02% margin impact, which, on a relative basis, is not material to the overall financial performance of the company.

If the $1 million error was due to fraudulent behavior – perhaps an executive employee embezzling money from the company – this misstatement can be considered material since it involves potential criminal activity.

Therefore, it is crucial to consider not only the absolute and relative amounts of the misstatements but also the qualitative impacts of the misstatements.

Methods of Calculating Materiality

The International Accounting Standards Board (IASB) has refrained from giving quantitative guidance and standards regarding the calculation of materiality. Since there is no benchmark or formula, it is very subjective at the discretion of the auditor.

However, some academic bodies have developed calculation methods.

Norwegian Research Council Materiality Calculation Methods

The Norwegian Research Council funded a study on the calculation of materiality that includes single rule methods in addition to variable size rule methods.

Single Rule Methods:

• 5% of pre-tax income
• 0.5% of total assets
• 1% of shareholders’ equity
• 1% of total revenue

Variable Size Rule Methods:

• 2% to 5% of gross profit (if less than $20,000)
• 1% to 2% of gross profit (if gross profit is more than $20,000 but less than $1,000,000)
• 0.5% to 1% of gross profit (if gross profit is more than $1,000,000 but less than $100,000,000
• 0.5% of gross profit (if gross profit is more than $100,000,000)

There are also blended methods that combine some of the methods and use appropriate weighting for each element.

Discussion Paper 6: Audit Risk and Materiality (July 1984)

This published paper gives methods for ranges of calculating materiality. Depending on the audit risk, auditors will select different values inside these ranges.

• 0.5% to 1% of total revenue
• 1% to 2% of total assets
• 1% to 2% of gross profit
• 2% to 5% of shareholders’ equity
• 5% to 10% of net income

They can be combined into blended methods as well.

Related Readings

Thank you for reading CFI’s guide to Materiality Threshold in Audits. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

Applying the materiality requirements in International Standards on Auditing (ISAs) can be challenging. As highlighted in inspection findings, reviews and from experience in practice, it’s an area where improvement could be made.

Materiality in the audit of financial statements.

Published jointly by Audit and Assurance Faculty and International Standards (formerly International Accounting, Auditing and Ethics (IAAE)) this guide takes a practical look at the ISA requirements on materiality, highlighting the challenges and providing practical illustrations.

Materiality is first and foremost a financial reporting, rather than auditing, concept. It isn’t defined in ISA 320 Materiality in planning and performing an audit but the ISA highlights the following key characteristics:

• Misstatements are considered to be material if they could influence the decisions of users of the financial statements
• Judgements about materiality are based on surrounding circumstances, including the size and nature of the misstatement
• Judgements are based on the users’ common needs as a group.

Why is materiality important?

As the basis for the auditor’s opinion, ISAs require auditors to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement. The concept of materiality is therefore fundamental to the audit. It is applied by auditors at the planning stage, and when performing the audit and evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements.

Who is the guide aimed at and how does it help?

This guidance is aimed at auditors in all jurisdictions where ISAs are applied. It is intended to be of particular help to smaller audit firms. The guidance takes a look at the ISA requirements on materiality and uses practical illustrations to highlight good practice, key challenges and common pitfalls. It has been put together by a working group of experienced auditors. It is intended to help audit firms better understand, and appropriately apply, materiality when planning and performing audits and evaluating misstatements.

Key themes

Determining materiality

While not set in stone, typically there are three key steps to determining overall materiality (materiality for the financial statements as a whole):

• Choosing a benchmark
• Determining a level of this benchmark
• Justifying the choices.

The guide looks at these steps and the potential challenges that arise. It provides guidance on when it might be appropriate to set specific levels of materiality for individual balances, classes of transactions or disclosures, what to do with short/long periods of account or situations where materiality might need to be reassessed. The guide also explains what performance materiality is, providing guidance on how it might be determined.

Applying materiality to the evaluation of identified misstatements

This section of the guide looks at the practical issues around:

• Accumulating misstatements during the audit;
• Categorising misstatements according to their nature;
• Assessing the materiality of misstatements; and
• Considering the impact of misstatements on the audit.

Materiality in group audits

Just as auditors would for a single entity audit, group auditors must use judgement to determine group materiality and group performance materiality. However, a key difference is that group auditors also have to determine levels of component materiality for components that have audits or reviews for the purposes of the group audit. The guide takes auditors through practical illustrations covering how to determine component materiality and component performance materiality, a clearly trivial threshold, component materiality for associates and joint ventures and the effects of changes in group materiality.

Communications with management and those charged with governance

There will be a number of communications with management and those charged with governance during the audit in relation to materiality and the misstatements identified and the guide focuses on what might need to be communicated at the planning stage, as the audit progresses and in the final stages of the audit.

Documentation

Auditors need to document materiality, the evaluation of misstatements and the rational for both. This section of the guide examines the documentation requirements and provides practical illustrations.

To comment on this publication or find out more about the issues raised contact Louise Sharp (Manager, International Standards).

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