What is Audit Materiality?
The term “audit materiality” refers to the mechanism of selecting a benchmark that can be used to reasonably assure if the audit doesn’t notice any misstatement in accounting then it won’t significantly misguide the users of the financial statements. The US GAAP doesn’thave any concrete definition for audit materiality, while IFRS states that any transaction can be considered as material if its omission or misstatement from the financial statements can potentially influence the decision of the various stakeholders.
The audit materiality is considered to be the first and foremost pillar in financial reporting. It can be defined on the basis of the following characteristics:
- Misstatements and omissions are considered to be material if they can potentially influence the decisions of the users of the financial statements.
- At times decisions on materiality are judgments made on the basis of the surrounding circumstances coupled with the size and nature of the misstatement.
- In some cases, audit materiality decisions are judgments made on the basis of the common needs of the user group.
How to Determine Audit Materiality
As already mentioned above, there is no steadfast framework available for the determination of audit materiality of any transaction within the financial statements. However, auditors often rely either on their professional judgment or certain guidelines (discussed later in the article under “Audit Materiality guidelines”). Consequently, it is important the auditor has a thorough knowledge of how to apply the concept of materiality as it is all relative and is significantly impacted by the size and surrounding circumstances. The determination of materiality takes into account the amount and type of misstatement.
Examples of Audit Materiality
Following are the examples are given below:
Let us take the simple example of two companies with revenue of $1billion and $5 million. The auditors in both the companies unearthed a misstatement of $2 million. Comment on the materiality of the misstatement in both the cases. In the case of the company with revenue of $1 billion, the misstatement of $2 million only results in a 0.2% margin impact, which is not that material compared to the company’s overall financial performance. On the other hand, the misstatement of $2 million for the company with $5 million revenue represents a 40% margin impact, which is very significant beyond any doubt. As such, this can be considered as material.
Let us take the example of an auditor who has set a materiality threshold of 1% for revenue. While auditing the financial reports of ASD Inc. for the year 2019 the auditor discovered an understatement of revenue by $1 million that occurred due to some operational error However, later the auditor realized that it was deliberately done to evade taxes. Determine the materiality of the misstatement if the revenue of ASD Inc. is $200 million.
As per the materiality threshold of the auditor, the misstatement of $1 million is not a material error as it is less than 1% of the company’s revenue, i.e. $2 million (= 1% * $200 million). However, the company had understated its revenue by $1 million to evade tax, which is a fraudulent activity. Therefore, the auditor may deem the misstatement to be material because it involves a potential criminal activity.
Importance of Audit Materiality
The concept of audit materiality is very important, which is based on both qualitative as well as quantitative aspects. The auditor is responsible for correctly determining the materiality of misstated financial information. In case the auditor discovers any material misstatement in the financial reporting of a company, it his or her responsibility to bring it to the client’s notice for rectification. In this way, the auditors help the end-users of the financial statements who take their economic decisions on the basis of the disclosures in the financial reporting, such as related party transactions, contingent liabilities, any material change in accounting policies, etc.
Relevance of Audit Materiality
An auditor needs to decide on the level of materiality based on the entirety of the financial statements, which includes the content of the financial statements as well as the kind of testing. The ultimate decision of the auditor is based on his or her judgment about the misstatement’ssize, nature, surrounding circumstances, and impact on the users of the financial statements.
Audit Materiality Guidelines
Although there is no defined framework, there is some guidance provided on the basis of certain studies as mentioned below.
1. Norwegian Research Council
This study includes a single rule and variable size rule methods. These methods provide guidance for the determination of the materiality threshold on the basis of some or all criteria using appropriate weightage.
Single Rule Method
- 1% of total revenue
- 5% of pre-tax income
- 1% of equity
- 5% of total assets
Variable Size Rule
- For gross profit < $20,000, 2%-5% of gross profit
- For $20,000 <gross profit < $1,000,000,1%-2% of gross profit
- For $1,000,000 < gross profit < $100,000,000, 0.5%-1% of gross profit
- For $100,000,000 < gross profit, 0.5% of gross profit
2. Methods from Discussion Paper 6
This paper on audit risk and materiality was issued in July 1984. Under these methods, there is a defined range for the determination of materiality.
- 5%-1% of revenue
- 1%-2% of gross profit
- 5%-10% of net profit
- 2%-5% of equity
- 1%-2% of total assets
So, it can be seen that the concept of audit materiality is very important as it forms the basis of the scope of the audit work. Eventually, the ultimate opinion of the auditor in the financial statements prove to be the economic decision making tool for the shareholders and other end-users of the financial statements.
This is a guide to Audit Materiality. Here we also discuss the definition and importance of audit materiality along with examples and guidelines. You may also have a look at the following articles to learn more –