Materiality in Auditing: Meaning, Benchmarks & Practical Use

Materiality is one of the terms used widely in our day to day audit procedures. This article aims to break down the concept of Materiality.

What is materiality?

SA 320 states that “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“.

It can said that materiality enables the auditor to decide which misstatements, including omissions are significant enough to influence the decision of the users of the financial statements.

For example, let’s say Ms. K is analyzing the FS of PK Ltd. She notes that PK Ltd have reported a profit before tax from continuing operations of Rs. 10 crore. If there is a misstatement of Rs. 10,000 – it will not affect her decision to invest in PK ltd.

But just imagine, what if there is a misstatement of Rs. 1 crore? This would certainly affect the economic decision of Ms. K on the basis of financial statements.

Determination of Materiality:

The next question that arises to each and everyone is – How is the materiality determined?.

To be very honest, there is no hard and fast rule. It is based on the professional judgment of the auditor after considering the various factors such as the nature of industry, the economic environment in which the entity operates etc.

In order to determine the materiality – we need benchmark and benchmark percentage.

Benchmark and Benchmark % :

Auditors choose a benchmark such as profit before tax, gross profit, total revenue, total equity etc., and then apply a percentage on the benchmark to arrive at the materiality.

So, next question that arises is – how would I choose a benchmark? As it is stated earlier, it is based on the auditor’s professional judgement.

Appropriate benchmark:

The benchmark is chosen based on the type of entity. SA 320 has stated in various paragraphs that the auditor may choose certain benchmark for certain type of entities. However, the auditor should exercise professional judgement in selection of the appropriate benchmark. The below table is the summary of SA 320 with respect to benchmark that may be chosen by the auditor.

Determination of benchmark % :

SA 320 does not specify the % on benchmark and once again, it is left to the professional judgement of the auditors.

• If assessed risk is high, then the lower percentages for calculating materiality will be selected.
• If assessed risk is low, then the higher percentages will be used.

It is noteworthy that there is a relationship between the percentage and the chosen benchmark. A percentage applied to profit before tax from continuing operations will normally be higher than a percentage applied to total revenue since PBT is smaller than total revenue (because revenue minus expenses = profit).

Calculation of Materiality for PK ltd:

Let’s calculate the materiality for PK Ltd. Assume PK Ltd is a manufacturing based entity. The entity has been an audit client for number of years and the engagement risk is considered to be low. During the previous year, the engagement team assessed its internal control as very effective. There have been no significant changes in the entity’s business, management or internal control during the period.

Based on the above, the auditor (i.e) the engagement partner determines that the profit before tax from continuing operations would be the appropriate benchmark. In addition, since the assessed risk of material misstatement is low due to effective internal control – the auditor has chosen 10% to be applied on the chosen benchmark.

Materiality for PK ltd would be as follows:

• Benchmark X Percentage
• Profit before tax from continuing operations X Benchmark %
• Rs. 10,00,00,000 X 10%
• Rs. 1,00,00,000

Therefore, Materiality threshold is Rs. 1 Crore. Any misstatements above Rs. 1 Crore, either in individual or aggregate would cause the financial statements to be materially misstated.

(In the above case, if the auditor determines that the risk of material misstatement is high, then he may have chosen a lower percentage of 3-5% instead of 10%).

In addition to the above, to ensure that even the smallest undetected or uncorrected misstatements don’t collectively cross the overall threshold, auditors determine a lower limit called Performance Materiality. Hence, this is where Performance Materiality comes into play.

Performance Materiality:

Performance materiality is set at a lower level than overall materiality, providing a safety margin and helping ensure that even if some misstatements are not detected, the total misstatement remains below the overall materiality threshold. It is the primary benchmark for the auditor to assess the nature, timing and extent of risk assessment procedures and plan and perform associated audit procedures to mitigate those risks.

Once again, the % of performance materiality is left to be decided by the professional judgement of the auditor and SA 320 does not state anything in this regard. Yet, it is clearly understood that Performance materiality is always and always lower than Overall Materiality.

In the example of PK Ltd, let’s say the auditor chooses 75% of the overall materiality as the performance materiality, then the calculation would be as follows:

• Rs. 1,00,00,000 X 75%
• Rs. 75,00,000

Any misstatements below the performance materiality of Rs. 75,00,000 are less likely to affect the overall financial statements materially because setting this lower limit ensures that even accumulated uncorrected misstatements and undetected misstatements would not exceed the overall materiality of Rs. 1 crore.

Clearly Trivial Threshold (CTT):

The term “trivial” generally means something “not worth considering.”

The auditors may set an amount below which misstatement would be clearly trivial. This means that such misstatement below the CTT would not need to be accumulated because such items are so small and inconsequential that even when taken together, they would not have any material impact on the financial statements.

As per the Implementation guide to Materiality in planning and performing an audit, upto 5% of materiality is often considered as clearly trivial.

For instance, if the materiality for PK Ltd. is Rs. 1 crore, then the auditor may set a CTT at up to 5% of materiality, which is Rs. 5 lakh. Any misstatements below Rs. 5 lakh would be considered clearly trivial and need not be accumulated, as they are not expected to affect the financial statements in any way.

However, when there is any uncertainty about whether an item is clearly trivial, it should not be treated as trivial.

Conclusion:

In conclusion, think of these three concepts of materiality as how we deal with money in real life.

Materiality is like saying: “If Rs. 1000 goes missing from my wallet, I will notice and check because that is very significant”

Performance Materiality is like saying: “I won’t wait for Rs. 1,000 to go missing but I will start checking even when Rs. 700 is gone, so that the total unnoticed small differences will not cross Rs. 1000.” In other words, performance materiality is a buffer to ensure that the differences will never cross the main limit i.e overall materiality.

Clearly Trivial Threshold is when you see Rs. 2 is missing from your wallet but you also know that it doesn’t matter enough to chase.

Each of these layers helps the auditor to strike a perfect balance in order to ensure that the audit remains both efficient and effective, without getting lost in immaterial details.

But our journey doesn’t end here! Even after setting all these thresholds, what happens when the auditor actually identifies misstatements during the audit? How are they evaluated, accumulated, or communicated to management?

That is exactly what we will covered in the next article- Evaluation of Misstatements (SA 450).

Reference materials:

1. Quick link to access Center for Audit Quality Directorate of ICAI’s utility for determining materiality: https://docs.google.com/forms/d/e/1FAIpQLSduJ9FHpl3Kkx5HHF65N3jGiYP2US_JyMw6nNE7D2K5NtOvRw/viewform?pli=1&pli=1)

2. ICAI’s Implementation Guide to Materiality in Planning and Performing an Audit

3. SA 320 – Materiality in Planning and Performing an Audit