Materiality
Materiality is one of the most important—and most tested—concepts in auditing. It shapes virtually every decision the auditor makes, from planning procedures to evaluating misstatements to forming the audit opinion. Materiality is not a fixed number pulled from a formula; it requires professional judgment applied in the context of the specific engagement.
This section covers the definition of materiality, the concept of performance materiality, the related idea of tolerable misstatement, and how the auditor sets and revises materiality throughout the engagement.
Materiality is addressed in AU-C 320 (AICPA) for nonissuers and in AS 2105 (PCAOB) for issuers. Both standards require the auditor to determine materiality for the financial statements as a whole during planning and to revise it as necessary during the audit.
Definition of Materiality
Materiality is the magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced.
In simpler terms: a misstatement is material if it is big enough to matter to someone making decisions based on the financial statements.
Key Characteristics of Materiality
- Materiality is assessed from the perspective of reasonable users of the financial statements—investors, creditors, regulators, and other stakeholders
- Both the size (quantitative) and the nature (qualitative) of a misstatement are relevant
- Materiality is determined in the context of the financial statements as a whole, not in isolation
- Setting materiality is a matter of professional judgment, not a mechanical calculation
Materiality is not solely about dollar amounts. A small misstatement can be material if it:
- Turns a profit into a loss (or vice versa)
- Causes a debt covenant violation
- Involves fraud or illegal acts
- Affects management compensation or bonus calculations
- Masks a change in earnings trend
Example: Gies Co. has total revenues of $50 million and net income of $2 million. A $50,000 misstatement might seem immaterial quantitatively. However, if that misstatement changes net income from a gain to a loss—or causes Gies Co. to violate a debt covenant requiring a minimum current ratio—it could be qualitatively material regardless of its dollar amount.
Performance Materiality
Performance materiality is the amount (or amounts) set by the auditor at less than materiality for the financial statements as a whole. Its purpose is to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality.
Why Performance Materiality Exists
If the auditor set a single materiality level and designed all procedures to detect misstatements only at that level, there would be a risk that multiple smaller misstatements—each below the materiality threshold—could aggregate to an amount that exceeds materiality. Performance materiality builds in a safety margin.
Setting Performance Materiality
Performance materiality is always lower than overall materiality. The specific amount depends on the auditor's judgment, considering:
- The nature and extent of misstatements identified in prior audits
- The auditor's expectations about misstatements in the current period
- The degree of uncertainty in the audit (higher uncertainty = lower performance materiality)
Think of performance materiality as a "working materiality" or "safety cushion." It is used during the audit to design procedures and evaluate results. Overall materiality is used at the end of the audit when evaluating the total effect of identified misstatements.
Example: The auditor sets materiality for Kingfisher Industries' financial statements at $500,000. Based on prior audit experience—Kingfisher had several misstatements identified in the prior year—the auditor sets performance materiality at $350,000. This means the auditor will design procedures sensitive enough to detect misstatements of $350,000 or more, providing a buffer to account for undetected or uncorrected misstatements that could aggregate above $500,000.
Tolerable Misstatement
Tolerable misstatement is the application of performance materiality to a particular sampling procedure. It represents the maximum amount of misstatement in an account balance or class of transactions that the auditor is willing to accept and still conclude that the audit objective for that account or class has been achieved.
Relationship to Performance Materiality
| Concept | Level | Purpose |
|---|---|---|
| Materiality | Financial statements as a whole | Benchmark for evaluating total misstatements at the end of the audit |
| Performance materiality | Below overall materiality | Reduces the risk that aggregate misstatements exceed materiality; used to design audit procedures |
| Tolerable misstatement | Applied to individual account balances or transaction classes | Maximum acceptable misstatement in a single account when using sampling |
Example: Illini Entertainment has overall materiality set at $200,000 and performance materiality at $140,000. When the auditor designs a sampling plan for testing accounts receivable, the tolerable misstatement for that sample is set at $140,000 (equal to performance materiality). If the projected misstatement from the sample exceeds $140,000, the auditor concludes that the account may be materially misstated and performs additional procedures.
In practice, tolerable misstatement is often set equal to performance materiality for individual accounts, but the auditor may use lower amounts for accounts that are more susceptible to misstatement.
Setting and Revising Materiality Levels
Establishing Materiality During Planning
The auditor establishes materiality during the planning phase of the audit. Common benchmarks used as a starting point include:
| Benchmark | Typical Range | When Used |
|---|---|---|
| Net income (before tax) | 5–10% | For-profit entities with stable earnings |
| Total revenue | 0.5–1% | Entities with volatile or near-zero earnings |
| Total assets | 0.5–1% | Asset-intensive industries (banking, real estate) |
| Total equity | 1–2% | Entities where equity is the key focus |
| Total expenses | 0.5–1% | Not-for-profit entities |
These percentages are guidelines, not rules. The auditor must exercise professional judgment in selecting the appropriate benchmark and percentage. The choice should reflect the needs and perspectives of the primary users of the financial statements.
Example: MAS Inc. is a not-for-profit organization with total expenses of $10 million. The auditor selects total expenses as the appropriate benchmark and applies a percentage of 1%, resulting in preliminary materiality of $100,000. Performance materiality is set at $70,000.
Revising Materiality During the Audit
Materiality is not a one-and-done calculation. The auditor must revise materiality if, during the course of the audit, information comes to light that would have caused the auditor to determine a different amount initially.
Common reasons for revising materiality include:
- Changes in the entity's financial results — For example, if materiality was based on estimated net income and actual net income is significantly different from the estimate
- Discovery of new information — Such as previously unknown related-party transactions or significant accounting errors
- Changes in circumstances — Such as a major acquisition, disposal, or restructuring during the year
When materiality is revised, the auditor must also reconsider performance materiality and evaluate whether the nature, timing, and extent of further audit procedures remain appropriate.
Example: BIF Partners initially sets materiality for Illini Security's audit at $250,000, based on estimated net income of $5 million. During fieldwork, the auditor discovers that actual net income will be approximately $2 million due to an unexpected impairment charge. BIF Partners revises materiality downward to $150,000, recalculates performance materiality to $100,000, and expands substantive testing to address the lower threshold.
If the CPA exam asks "when should the auditor revise materiality?"—the answer is whenever the auditor becomes aware of information that would have resulted in a different materiality amount initially. Materiality is a living number that reflects current knowledge about the entity.
Summary
| Concept | Definition | Key Point |
|---|---|---|
| Materiality | Magnitude of misstatement that would influence a reasonable user | Set for the financial statements as a whole; considers both quantitative and qualitative factors |
| Performance materiality | Amount set below overall materiality | Provides a safety margin so aggregate uncorrected/undetected misstatements don't exceed materiality |
| Tolerable misstatement | Application of performance materiality to a sampling procedure | Maximum acceptable misstatement in a single account balance or transaction class |
| Revision | Adjustment of materiality during the audit | Required when new information would have changed the original determination |