Know All-about the Concept of Materiality in Audit

Table of Contents

1. Introduction

2. Factors affecting Materiality

3. Types of Materiality

4. Overall Materiality

4.1 Determining Overall Materiality

4.2 Selecting an appropriate benchmark

4.3 Identifying appropriate financial data

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1. Introduction

The concept of materiality is fundamental to the entire audit process and is applied by the auditor:

• • in determining the nature, timing and extent of risk assessment procedures;
  • in identifying and assessing the risks of material misstatement;
  • in determining the nature, timing and extent of audit procedures to gather sufficient appropriate audit evidence;
  • in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements
  • in forming the opinion in the auditor’s report on the financial statements

SA 320 “ Materiality in Planning and Performing an Audit” explains materiality:
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.

Materiality applies not only to amounts in the financial statements, but also to disclosures that are non-quantitative.

For example, non-disclosure or inadequate disclosure of accounting policy for a material financial statement area may influence the economic decision of the user of financial statements.

Materiality is a relative rather than an absolute concept. A misstatement of a given magnitude might be material for a small company, whereas the error of the same amount could be immaterial for a large one.

For example, an unadjusted misstatement of Rupees one lakh on account of non-provisioning for doubtful debtors will result in material misstatement of financial statements of a company having a turnover of Rupees Ten lakhs and a net profit of Rupees One lakh. However, the same unadjusted misstatement will be not be material to the financial statements of a company having a turnover of Rupees thousand crores and a profit of Rupees fifty crores.

The auditor may consider the following illustrative factors in assessing whether an amount is material:

(i) the potential impact of the misstatement on trends, especially trends in profitability;
(ii) a misstatement that changes a loss into profit or vice versa (for example recording a provision for doubtful trade receivables may result in marginal profit before tax turning into a loss);
(iii) the potential impact of the misstatement on the entity’s compliance with debt covenants (for example current ratio), other contractual agreements, and regulatory provisions;
(iv) the existence of statutory or regulatory reporting requirements (for example interest payable to parties covered under MSMED Act, 2006 and disclosures thereof);
(v) a misstatement that has the effect an variable pay or compensation of key management personnel (for example, by satisfying the requirements for targeted turnover or net profit before tax);
(vi) the sensitivity of the circumstances surrounding the misstatement (for example, consider whether the misstatements involve fraud or possible illegal acts);
(vii) the significance of the financial statement item affected by the misstatement;
(viii) the motivation of management with respect to the misstatement, for example:

(a) an intentional misstatement to ‘manage’ earnings;
(b) an indication of a possible pattern of bias by management when developing and accumulating accounting estimates;

2. Factors affecting Materiality

Calculation of Materiality is not simply following the firm’s guidance or a rule of thumb.

For example consider that an engagement team calculates materiality as 5% of adjusted profit before tax after excluding exceptional items. While the firm may have materiality guidelines limiting the engagement team’s choices, the selection of materiality would still require considerable professional judgment.

For instance, how did the engagement team decide that 5% was appropriate, and that net income was an appropriate base?

In determining overall materiality:

• • The auditor makes judgments in light of the circumstances surrounding the entity and which are affected by the size and nature of the misstatement, or a combination of both;
  • Judgments about matters that are material to users of the financial statements are based on a consideration of the common financial information needs of users as a group, not each user individually (such as a bank, debenture-holder, or shareholder).

Dive Deeper:
[FAQs] on Material Cost | Cost and Management Accounting

3. Types of Materiality

1. Overall Materiality
When establishing the overall audit strategy, the auditor determines materiality for the financial statements as a whole. It is a threshold, above which, the financial statements would be materially misstated. This is called “materiality for the financial statements as a whole” or simply overall materiality.

2. Performance Materiality
Performance Materiality is set at an amount less than the overall materiality and acts like a “safety buffer” to lower the risk of aggregate uncorrected and undetected misstatements being material for the overall financial statements. Performance materiality enables the auditor to respond to specific risk assessments (without changing the overall materiality), and to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality.

3. Specific Materiality
Specific materiality is established for classes of transactions, account balances, or disclosures where misstatements of lesser amounts than overall materiality could reasonably be expected to influence the economic decisions of users, taken on the basis of the financial statements. (For example; potential investors may be interested in revenue)

4. Specific Performance Materiality
Specific performance materiality is the same concept as performance materiality, except that it is set in relation to specific materiality and not overall materiality.

4. Overall Materiality

Overall materiality is based on the auditor’s professional judgment as to the maximum amount of misstatement(s) that if not corrected in the financial statements will not affect the economic decisions taken by a financial statement user. If the amount of uncorrected misstatements, either individually or in the aggregate, is higher than the overall materiality established for the audit, it implies that the financial statements are materially misstated.

The overall materiality amount is one of the factors by which the ultimate success or failure of the audit will be judged.

For example, consider that overall materiality was set at an amount of ` 25 millions. If, as a result of performing audit procedures:

(i) No misstatements were identified—an unmodified opinion will be issued;
(ii) A few small (immaterial) misstatements were identified and not corrected: an unmodified opinion will be issued;
(iii) Uncorrected misstatements exceeding materiality (of ` 25 millions) were found and management recorded some or all proposed adjustments such that remaining uncorrected misstatements were less than materiality (of ` 25 millions): an unmodified opinion may be issued subject to auditor’s assessment of misstatements;
(iv) Uncorrected misstatements exceeding materiality (of ` 25 millions) were found and management was unwilling to make the necessary adjustments: a qualified or adverse opinion will be required;
(v) Uncorrected errors exceeding materiality (of ` 25 millions) exist in the financial statements but were not detected by the auditor — then there is an audit risk of issuing an inappropriate unmodified audit opinion.

4.1 Determining Overall Materiality

There are three steps in determining overall materiality:

i. Selecting an appropriate benchmark;
ii. Identifying appropriate financial data for the selected benchmark;
iii. Determining the percentage to be applied to the selected benchmark;

4.2 Selecting an appropriate benchmark

Overall materiality is based on the common financial information needs of the various users as a group and therefore, the possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered.

In selecting the most appropriate benchmark to determine materiality, the auditor should develop an understanding of the users of the financial statements specific to their client. Some of the benchmarks commonly used include: revenue, profit before taxes, total assets or expenses. The auditor makes a judgment on which benchmark to use by understanding what the users of the financial statements are most likely to be concerned about. For example, if an entity is financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity’s earnings. An illustrative list of factors that affect the selection of an appropriate benchmark by the auditor includes:

• • Elements of the financial statements (assets, liabilities, equity, income, expenses);
  • Whether there are items on which the users tend to focus (for example, the users may tend to focus on EBITDA);
  • Past history with audits (whether numerous adjustments are required?);
  • The nature of the entity and the industry (for example retail sector or company engaged in real estate);
  • The entity’s ownership structure and the way it is financed (for example if the entity is mainly financed by equity investors who are concerned with financial performance, net profit before taxes may be an appropriate benchmark);
  • The relative volatility of the benchmark (for example, does the pre-taxation profit fluctuates significantly from year to year?).

The users of the financial statements include: investors, creditors, suppliers, employees, customers, state institutions, public in general. However, in every case, the users, who are interested in financial statements and its information, are different.

Some users of the financial statements and their needs are illustrated below:

Commonly used benchmarks

(a) Profit before tax
Users of the financial statements of profit-orientated entities (for example listed entities) are generally concerned with reported earnings both at the pre-taxation and post-taxation levels. When profit before tax is used as a benchmark, it is appropriate to exclude abnormal items such as unusual profits and losses, and exceptional items. In situations where there significant fluctuations in profit before tax from one year to another, auditor may find it useful to consider materiality in relation to ‘normalized’ pre-taxation profit. ‘Normalized’ pre-taxation profit might be arrived at by taking an average of pre-taxation profit over a period of several years. Consider following illustrations:

Illustration 1

In this example, both the revenue and profit before tax are increasing from year to year and the profit before tax as percentage of sales is fluctuating. The company estimates the turnover for FY 2020-21 to be ` 2,800 crores based on 11 months actual sales and orders in hand.

The auditor considers that it is more appropriate to use ‘normalised’ profit before tax to determine materiality. The auditor considers average profit before tax of past three years, that is ` 266 crores to calculate materiality.

Illustration 2

In this example, the profit before tax is fluctuating on year on year basis both in absolute terms and as percentage of sales. The auditor notes that the company is rationalising its operations and has been retrenching workers in the past three years. However, there is no further retrenchment in FY 2020-21.

Accordingly, the auditor considers it appropriate it to first compute normalised profit by excluding retrenchment costs and then use the average of three years’ normalised profit before tax to calculate materiality Therefore the auditor considers ` 1,832.06 lakhs as the benchmark for calculating materiality.

(b) Turnover
Though most users of financial statements are generally concerned with profitability, this is not the only consideration, particularly in companies where profit before tax is volatile. For some industries, for example retail, revenue is a significant factor in management reporting and important to investors. In such cases, revenue may be considered to be an appropriate benchmark for determining materiality.

(c) Total Assets/Net Assets
Total assets (as well as net assets) might be an appropriate benchmark for determining materiality for an entity with significantly higher values in the balance sheet compared to its income statement (such as an investment property entity or an investment company having significant income from assets held).

(d) Other benchmarks
Other benchmarks may be considered appropriate for calculating materiality depending on the facts of the entity. Some other commonly used benchmarks include:

• • • Gross Profit
    • Total Expenses
    • Shareholders’ equity

4.3 Identifying appropriate financial data

Identifying the financial data is not as straightforward as it appears. It may be necessary to consider materiality before the financial statements to be audited are prepared, for example when planning is done prior to the year-end. In other cases, planning takes place after the draft financial statements to be audited have been provided, but it may be apparent that those statements require significant modification. In such situations materiality is based on a reasonable expectation of the amounts in the eventual financial statements. This may be obtained by extrapolating amounts either from interim management reports or from interim financial statements (for example nine months financial results) or the financial statements of one or more prior annual periods, as long as these are adjusted for major changes in the entity’s circumstances, such as a significant merger.