A company has revenue of ₦100 million and profit of ₦8 million. The auditor finds a mistake of ₦50,000 in the stationery expense and another of ₦600,000 in inventory. The first is far too small to change a decision. The second is 7.5% of profit and could.
Materiality is the idea that separates them. It decides how much work the auditor does, how many items are tested and which errors must be corrected before the report is signed.
This topic covers the meaning of materiality, the assumptions about users in International Standard on Auditing (ISA) 320, overall and performance materiality, benchmarks, qualitative factors, revision and documentation, and a full worked illustration. The previous topic covered risk assessment and the next covers audit risk.
In 30 seconds
Material: omission or misstatement could influence users' economic decisions. ISA 320: set materiality for the financial statements as a whole at planning, set lower levels for particular areas if needed, set performance materiality below overall, revise as the audit proceeds and document. Benchmarks: profit before tax 3 to 7%, revenue 1 to 3%, equity 3 to 5%, total assets 1 to 2%. Performance materiality: overall materiality weighted down for risk, for example 80%, 70% or 60%. Qualitative factors can make small errors material.
Key terms in plain English
| Term | What it means |
|---|---|
| Materiality | The size or nature of an error that could change a user's decision |
| Overall materiality | The level set for the financial statements as a whole |
| Performance materiality | A lower level used to reduce the risk of accumulated errors |
| Benchmark | The base, such as profit or revenue, to which a percentage is applied |
| Qualitative factor | A reason why an error matters apart from its size |
| Misstatement | An error or omission in the financial statements |
Syllabus check
This topic is in syllabus area A, process of audit and assurance (20% of marks). It covers:
- the concept of materiality (ISA 320)
- planning an audit
- the evaluation of misstatements
CAMA 2020 and materiality
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 404(1) and (2) | The auditors report on whether the statements give a true and fair view and the Fifth Schedule matters | The opinion is given "in all material respects" |
| s. 405 | Corporate responsibility for financial reports | Management corrects material misstatements it is told of |
| s. 407(3) | Right of access to books and information | Needed to test items above the materiality levels |
The rules in more depth
What materiality is
Materiality reflects the fact that users find financial statements useful even though they are not 100% accurate. The statements are useful provided they contain no material errors. The International Accounting Standards Board's Framework says that information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
Assumptions about users
ISA 320, Materiality in Planning and Performing an Audit, lets the auditor assume that users:
- have a reasonable knowledge of business and will study the information diligently;
- understand that the statements are prepared and audited to levels of materiality;
- recognise the uncertainties inherent in some amounts, such as provisions; and
- make reasonable economic decisions on the basis of the information in the statements.
When the auditor applies materiality
The auditor applies materiality when planning and performing the audit and when evaluating the effect of misstatements on the financial statements and so on the opinion. At planning, risk and materiality are the two factors that decide what audit work is to be done.
Overall materiality, specific materiality and performance materiality
- Overall materiality is the level for the financial statements as a whole, often called the materiality level or threshold.
- Lower thresholds for particular areas are set at the same time where needed, for example for directors' remuneration.
- Performance materiality is a lower level that recognises a danger: if each area is audited to detect errors above the overall level, the many small errors left undetected could add up to more than overall materiality. Performance materiality is therefore set below overall materiality. There may be more than one level, because it can vary by area.
As the audit goes on, the auditor revises materiality, the area thresholds and performance materiality if he learns something that would have led to different levels at the start. The documentation records all the levels set and every revision.
Setting the level: quantitative benchmarks
Materiality is usually based on quantitative factors expressed as a percentage of a benchmark, such as 1% of revenue or 5% of profit before tax. Typical ranges are:
| Benchmark | Usual percentage |
|---|---|
| Profit before tax | 3 to 7% |
| Revenue | 1 to 3% |
| Equity (net assets) | 3 to 5% |
| Total assets | 1 to 2% |
The choice of benchmark depends on what users care about most. For a profit-making business it is often profit before tax. For a company with volatile or very low profit, revenue or total assets is more stable. For a not-for-profit body, expenditure or revenue is commonly used.
Qualitative factors
Some errors are material whatever their size. Many auditors take the view that some figures must be absolutely correct, for example issued share capital and directors' remuneration. Other qualitative factors are errors that turn a profit into a loss, that hide a breach of a loan covenant or a legal requirement, that affect management bonuses, that involve related parties or that arise from fraud.
A small fraud by a senior manager matters more than the same sum lost to a clerical slip, because it says something about management's integrity.
A worked illustration
The draft statements of XYZ Limited show revenue of ₦100 million, profit before tax of ₦8 million, inventory of ₦4 million and trade payables of ₦3 million.
- Overall materiality. The auditor could use 0.5% of revenue, which is ₦500,000, or 5% of profit before tax, which is ₦400,000. Suppose the profit basis is chosen: ₦400,000.
- Performance materiality. The auditor assesses inventory as high risk and trade payables as low risk. A method is to apply risk weightings to overall materiality: 80% for low risk, 70% for moderate and 60% for high.
- Inventory.
60% × ₦400,000 = ₦240,000. - Trade payables.
80% × ₦400,000 = ₦320,000.
The auditor tests inventory to find errors above ₦240,000 and payables to find errors above ₦320,000. In the same way, a materiality level for inventory valuation could be set at 5% of profit before tax, and an error above that figure would be material.
Materiality and the rest of the audit
Materiality is linked to risk. A lower level means more testing, larger samples and more items examined. A higher level means less. It is also used at the end, when the auditor compares uncorrected misstatements, singly and together, with the levels set, to decide whether the financial statements are materially misstated and whether the opinion must be modified. A later topic treats the evaluation of misstatements.
Auditors also make a clearly trivial threshold, below which errors are not even accumulated, so that the team is not buried in tiny items.
Worked examples
Example 1: the calculation. Revenue is ₦600 million and profit before tax is ₦40 million. Use 5% of profit before tax and a 75% performance materiality.
- Overall materiality.
5% × ₦40 million = ₦2 million. - Performance materiality.
75% × ₦2 million = ₦1.5 million.
Example 2: choice of benchmark. A newly formed company has a small loss in its first year.
- Profit before tax is not stable or useful as a base.
- Revenue or total assets is a better benchmark.
Example 3: a qualitative factor. The auditor finds that the managing director's pay is understated by ₦900,000. The overall materiality is ₦5 million.
- On size alone the error is below materiality.
- Directors' pay is a figure that must be accurate and a legal disclosure under company law, so the error is material by nature.
Example 4: revision. During the audit, the company's profit turns out to be half of the draft figure used to set materiality.
- The auditor would have set a lower level if he had known.
- Materiality and performance materiality are revised downwards and the extra work and the revision are documented.
How to score full marks
- Quote the definition: could influence the economic decisions of users.
- Show the working: benchmark, percentage, result, then performance materiality.
- Say why performance materiality is lower: undetected errors can accumulate.
- Add a qualitative point where the facts allow.
Common mistakes in the exam
- Setting performance materiality above overall materiality.
- Treating materiality as a single fixed sum for the whole audit.
- Using a benchmark that is unsuitable for the entity.
- Ignoring qualitative factors.
Quick revision
- Material: could influence users' decisions.
- Overall, specific and performance materiality.
- Benchmarks: 3 to 7% profit, 1 to 3% revenue, 3 to 5% equity, 1 to 2% assets.
- Performance materiality: 60%, 70%, 80% weightings.
- Revise and document.
Practice questions
Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.
Question 1. Information is material if its omission could:
- Influence users' economic decisions
- Change the auditor's fee
- Delay the audit
- Reduce tax
Show the answer
A. The standard definition.
Question 2. Performance materiality is set:
- Above overall materiality
- Below overall materiality
- Equal to nothing
- At zero
Show the answer
B. To reduce the risk that small errors add up.
Question 3. A common benchmark for materiality is:
- Profit before tax
- The audit fee
- Number of staff
- Office rent
Show the answer
A. 3 to 7%.
Question 4. Revenue is typically used at:
- 1 to 3%
- 10 to 20%
- 50%
- 100%
Show the answer
A. 1 to 3%.
Question 5. A qualitative factor that may make an error material is:
- It involves directors' remuneration
- It is a round number
- It is typed in red
- It is old
Show the answer
A. Some figures must be exact.
Question 6. Overall materiality of ₦400,000 with a 60% weighting gives performance materiality of:
- ₦160,000
- ₦240,000
- ₦320,000
- ₦400,000
Show the answer
B. 60% × ₦400,000.
Question 7. Materiality must be revised if:
- Information arises that would have led to different levels
- The fee changes
- Staff change
- The year changes
Show the answer
A. As the audit progresses.
Question 8. When setting materiality, ISA 320 lets the auditor assume that users:
- Understand statements are prepared and audited to levels of materiality
- Want no errors at all
- Never read the statements
- Are accountants only
Show the answer
A. One of the four assumptions.
Question 9. The auditor applies materiality:
- At planning only
- At planning, in performing the audit and in evaluating misstatements
- At the report only
- Never
Show the answer
B. Throughout.
Question 10. Higher materiality generally means:
- Less audit work
- More audit work
- No audit
- A longer report
Show the answer
A. Fewer errors count as material.
Question 11 (10 marks). Explain the concept of materiality and the assumptions ISA 320 allows the auditor to make about users of financial statements. (6 marks)
Question 12 (10 marks). Explain overall and performance materiality and compute them for a company with profit before tax of ₦50 million, using 5% for overall materiality and a 70% weighting for performance materiality. (6 marks)
Question 13 (10 marks). Explain why qualitative factors must be considered as well as quantitative factors when assessing materiality. (4 marks)
Model answers
Show the model answer to Question 11
Information is material if omission or misstatement could influence the economic decisions of users; statements are useful although not 100% accurate. (2) Users: reasonable business knowledge and diligence; understand statements are prepared and audited to materiality; recognise uncertainty in some amounts; make reasonable decisions. (4)
Show the model answer to Question 12
Overall: for the statements as a whole; performance: lower, to reduce the risk that undetected errors add up beyond overall materiality, and may vary by area. (3) Overall = 5% × ₦50 million = ₦2.5 million; performance = 70% × ₦2.5 million = ₦1.75 million. (3)
Show the model answer to Question 13
Some figures must be exact, such as directors' pay and share capital; errors that change a profit to a loss, hide a covenant breach or a law breach, involve related parties or arise from fraud can be material at any size. (4)
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