When the risk of material misstatements is higher should materiality be higher or lower and explain why?

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.

When the risk of material misstatements is higher should materiality be higher or lower and explain why?

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:

Adopting Release: PCAOB Release No. 2010-004

Effective Date of Standard: For audits of fiscal years beginning on or after Dec. 15, 2010

Amendments: Amending releases and related SEC approval orders 

.01        This standard establishes requirements regarding the auditor's consideration of materiality in planning and performing an audit.1

Materiality in the Context of an Audit

.02        In interpreting the federal securities laws, the Supreme Court of the United States has held that a fact is material if there is "a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."2 As the Supreme Court has noted, determinations of materiality require "delicate assessments of the inferences a 'reasonable shareholder' would draw from a given set of facts and the significance of those inferences to him . . . ."3

.03        To obtain reasonable assurance about whether the financial statements are free of material misstatement, the auditor should plan and perform audit procedures to detect misstatements that, individually or in combination with other misstatements, would result in material misstatement of the financial statements. This includes being alert while planning and performing audit procedures for misstatements that could be material due to quantitative or qualitative factors. Also, the evaluation of uncorrected misstatements in accordance with AS 2810, Evaluating Audit Results, requires consideration of both qualitative and quantitative factors.4 However, it ordinarily is not practical to design audit procedures to detect misstatements that are material based solely on qualitative factors.

.04        For integrated audits, AS 2201, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, states, "In planning the audit of internal control over financial reporting, the auditor should use the same materiality considerations he or she would use in planning the audit of the company's annual financial statements."5

Objective

.05        The objective of the auditor is to apply the concept of materiality appropriately in planning and performing audit procedures.

Considering Materiality in Planning and Performing an Audit

Establishing a Materiality Level for the Financial Statements as a Whole

.06        To plan the nature, timing, and extent of audit procedures, the auditor should establish a materiality level for the financial statements as a whole that is appropriate in light of the particular circumstances. This includes consideration of the company's earnings and other relevant factors. To determine the nature, timing, and extent of audit procedures, the materiality level for the financial statements as a whole needs to be expressed as a specified amount.

Note: If financial statements for the audit period are not available, the auditor may establish an initial materiality level based on estimated or preliminary financial statement amounts. In those situations, the auditor should take into account the effects of known or expected changes in the company's financial statements, including significant transactions or adjustments that are expected to be reflected in the financial statements at the end of the period.

Establishing Materiality Levels for Particular Accounts or Disclosures

.07        The auditor should evaluate whether, in light of the particular circumstances, there are certain accounts or disclosures for which there is a substantial likelihood that misstatements of lesser amounts than the materiality level established for the financial statements as a whole would influence the judgment of a reasonable investor. If so, the auditor should establish separate materiality levels for those accounts or disclosures to plan the nature, timing, and extent of audit procedures for those accounts or disclosures.

Note: Lesser amounts of misstatements could influence the judgment of a reasonable investor because of qualitative factors, e.g., because of the sensitivity of circumstances surrounding misstatements, such as conflicts of interest in related party transactions.

Determining Tolerable Misstatement

.08        The auditor should determine the amount or amounts of tolerable misstatement for purposes of assessing risks of material misstatement and planning and performing audit procedures at the account or disclosure level. The auditor should determine tolerable misstatement at an amount or amounts that reduce to an appropriately low level the probability that the total of uncorrected and undetected misstatements would result in material misstatement of the financial statements. Accordingly, tolerable misstatement should be less than the materiality level for the financial statements as a whole and, if applicable, the materiality level or levels for particular accounts or disclosures.

.09        In determining tolerable misstatement and planning and performing audit procedures, the auditor should take into account the nature, cause (if known), and amount of misstatements that were accumulated in audits of the financial statements of prior periods.

Considerations for Multi-location Engagements

.10        For purposes of the audit of the consolidated financial statements of a company with multiple locations or business units, the auditor should determine tolerable misstatement for the individual locations or business units at an amount that reduces to an appropriately low level the probability that the total of uncorrected and undetected misstatements would result in material misstatement of the consolidated financial statements. Accordingly, tolerable misstatement at an individual location should be less than the materiality level for the financial statements as a whole.

Considerations as the Audit Progresses

.11        The auditor should reevaluate the established materiality level or levels and tolerable misstatement when, because of changes in the particular circumstances or additional information that comes to the auditor's attention, there is a substantial likelihood that misstatements of amounts that differ significantly from the materiality level or levels that were established initially would influence the judgment of a reasonable investor. Situations in which changes in circumstances or additional information that comes to the auditor's attention would require such reevaluation include:

  1. The materiality level or levels and tolerable misstatement were established initially based on estimated or preliminary financial statement amounts that differ significantly from actual amounts.
  2. Events or changes in conditions occurring after the materiality level or levels and tolerable misstatement were established initially are likely to affect investors' perceptions about the company's financial position, results of operations, or cash flows.

    Note: Examples of such events or changes in conditions include (1) changes in laws, regulations, or the applicable financial reporting framework that affect investors' expectations about the measurement or disclosure of certain items and (2) significant new contractual arrangements that draw attention to a particular aspect of a company's business that is separately disclosed in the financial statements.

.12        If the auditor's reevaluation results in a lower amount for the materiality level or levels or tolerable misstatement than initially established by the auditor, the auditor should (1) evaluate the effect, if any, of the lower amount or amounts on his or her risk assessments and audit procedures and (2) modify the nature, timing, and extent of audit procedures as necessary to obtain sufficient appropriate audit evidence.

Note: The reevaluation of the materiality level or levels and tolerable misstatement is also relevant to the auditor's evaluation of uncorrected misstatements in accordance with AS 2810.6