Materiality in Audit Engagement
In every unqualified audit report, you will encounter the term materiality in some way. Most commonly, it is seen as; “In our opinion, the financial statements are free from material misstatements and give a true and fair view”.
The term material refers to the concept of materiality which is one of the most important concepts of auditing. To understand the concept, you need to first understand why does materiality matter?
Businesses incur a variety of expenses and some expenses are of such a low value that they are not worth recording, or cannot be recorded accurately due to their nature. Bookkeepers and managers use professional judgments and estimation techniques to record such items and therefore, it ultimately affects the accuracy of the financial statements.
To cover up for the estimations, auditors set an amount or materiality level based on the company’s nature, revenue, profit, or any other benchmark that they see fit. Hence, materiality in auditing is the amount that is significant for the company and has the potential to affect the decisions of the users of financial statements.
Simply put, auditors are not interested in omissions of things like pens & staples worth $5 if the company has revenue of a hundred billion dollars. They will be pretty much interested in the undocumented sales worth $2 billion, which is 2% of the company’s total revenue and is a material amount.
Therefore, auditors set an amount or materiality level that they think is significant for the company, and if a misstatement or total misstatements when combined exceed that amount, an adverse audit report is prepared.
How Materiality Level is set?
Setting up the materiality level is indeed technical. There are no hard and fast rules as to how materiality should be set and is a pure matter of professional judgment for auditors.
Generally, things like the financial position of the client, their dealings, loan covenants, and other financial reflections are taken into consideration to decide what materiality level is right for the client. Before starting the audit engagement, auditors set two materiality levels. Overall materiality for the financial statements and performance materiality for specific processes, products, or departments.
Let’s say an auditor sets $1000 as the client’s overall materiality. That would mean, the total misstatements below this amount is not a big deal and the client still gets an unqualified audit report, but anything above this figure will indicate that something is seriously wrong with the company.
In the same way, the auditor will set performance-based materiality for major departments, processes, or products. Performance materiality is usually set as a percentage of overall materiality. For example, if a company has 3 major departments and the overall materiality level for the financial statements is $1000, the performance materiality level could be set as $33 for each department.
The above is just a demonstration of how performance materiality is calculated. It should not necessarily equal 100% of the overall materiality. Take that example again, the auditors could also set performance materiality at 50% of the overall materiality level for each department. Each department now has $50 materiality level which means, misstatements more than $50 in each department is significant.
As mentioned, there are no specific guidelines for calculating or setting up materiality level for an audit, and is totally a professional judgment for auditors that comes from experience. However, there is a 5-step approach that auditors follow to set up and use materiality level in audit engagements.
The 5-step Approach in Materiality
Step1: Auditors set materiality for the financial statements as a whole. This step is done before starting the audit engagement (in the planning stage).
Step2: The second step is to set up performance materiality for each major department, process, or product. Performance materiality is usually a percentage of tolerable misstatements of the overall materiality in a department. The bigger the department is, the higher percentage of overall materiality will be assigned.
*Using the overall and performance materiality levels
Step3: The auditors perform audit procedures to identify misstatements in the financial statements. The misstatements are of two types. Known misstatements; in which the exact misstated amount is known, and likely misstatement; which is an estimated misstatement.
Likely misstatements are further divided into two types.
- Difference between the management’s and auditor’s estimation judgments of account balances.
- Misstatement that an auditor finds in checking the samples, which is then applied to the whole activity to project the estimated overall misstatements.
Step4: Auditors then add up the misstatements (known and projected likely misstatements) to arrive at the final misstated figure.
Step5: The total misstated amount is compared with the materiality level of the financial statements. If the misstated amount does not exceed the materiality level, the auditors give an unqualified audit opinion, meaning that the financial statements seem OK. Otherwise, an adverse audit opinion is issued.
Why setting up materiality is important?
An audit is a reasonable type of assurance and does not guarantee 100% accuracy of the financial statements, which would be an absolute assurance. The audit report is a reasonable assurance due to the sampling involved and differences between the estimation techniques used by managers and auditors.
These variations are inevitable and inherent in audit engagements. But, how much room should the auditors give to these differences? How much is very much for a client? To answer these, auditors calculate a materiality level for the client based on their professional judgment and financial position of the client.
If there is no materiality level set for a client, the auditors wouldn’t know whether the misstated amount is significant enough to influence the decision of users of the financial statements. The pre-determined materiality acts as a benchmark for auditors.
Change in Materiality Levels
Materiality for a client is calculated at the start of the audit engagement but is subject to change later on during the audit. Think about this: Primarily, the materiality level is set according to the client’s financial position and dealings but what if the client enters into a new contract that results in a significant change in the financial statements. OR, withdraws from a contract, the effect of which was present in the financial statements.
Any new significant transaction or financial event that results in a change in financial statements may make the auditors believe that the materiality level might not be right for the client and they will increase/decrease it accordingly.
Therefore, materiality is variable and auditors can change it anytime during the audit engagement.
For example, if the auditors have set overall materiality of $50,000, 0.5% of net profit ($10 million). It would mean, misstatements above this figure will affect the decisions of users and the financial statements do not reflect the true & fair view.
If, however, the auditor finds out that net profit is understated by $2 million and the revised net profit balance is $12 million, they will increase the materiality accordingly. The new materiality level will be set to $60,000 to reflect the change in net profit.
Note that it doesn’t necessarily have to be tied up to the net profit figure. The auditors can also calculate materiality as a:
- % of revenue
- % of Gross Profit
- % of profit after interest and tax
- % of receivables
- % of loan notes
- etc etc…
It ultimately is a professional judgment for auditors and they can use any figure they think is the best fit for the engagement.
