What is Materiality in Audit?
Definition of Materiality in Audit
In auditing, materiality refers to how significant an item is in the financial statements, and whether the exclusion or inaccuracy of the item could potentially impact the users of the financial statements.
The materiality concept helps auditors to establish the threshold at which these exclusions or inaccuracies become important enough to require further investigation and correction in the financial statements.
It is important to note that not all errors or discrepancies in the financial statements would affect the overall accuracy of those statements.
For example, the omission of £50,000 of costs for a company that spends £400m a year would probably not be ‘material’ (ie it would not be significant).
However, the omission of £50,000 of costs in another company that spends £200,000 a year might be considered to be ‘material’.
Auditors are not expected to uncover every minor mistake in the financial statements, given the large amount of data they review, and the limited timescale in which they operate.
Instead, they would just focus their efforts on identifying issues that could have a significant impact on the financial statements as a whole.
Factors Affecting Materiality
Knowing how to determine materiality in an audit is an extremely important step in the audit process, as this will determine the areas that auditors give extra scrutiny to.
There is no all-encompassing approach to determining materiality, as it can vary from company to company based on specific circumstances.
Auditors would usually consider both quantitative and qualitative factors when determining materiality:
Quantitative Factors
Quantitative factors involve measurable values and benchmarks such as absolute numbers and percentages.
Quantitative factors could include:
- Size of the Item: The numerical value of an item relative to a financial benchmark (ie total assets, net income etc).
Generally, larger amounts are more likely to be considered material.
For example, £50,000 misstatement in a line item where total assets are £5m million might be considered less significant than £50,000 in a line item where total assets are £500,000.
- Percentages: The percentage value of a financial benchmark (ie total assets, net income etc)
For example, auditors might set materiality at 5% of net income, so a misstatement of £50,000 in a company with a net income of £1m would likely be considered material.
- Trends and Ratios: Analysing trends and financial ratios can provide insight into the relative significance of items.
A sudden change in a key ratio might indicate materiality.
For example, a sudden 20% increase in inventory compared to the previous year could raise concerns about materiality, especially if it deviates significantly from industry benchmarks.
Qualitative Factors
Qualitative factors involve non-numerical considerations such as the nature and context of items in financial statements.
These factors focus on the characteristics and circumstances of the financial information, which can provide more background into understanding any potential materiality.
Qualitative factors could include:
- Nature of the Item: Higher risk items, such as related-party transactions may be considered material even if the amount is small.
For example, related-party transaction typically come under scrutiny, regardless of the amount, as it might be deemed material due to the potential for conflicts of interest.
- Impact on Users’ Decisions: Items that could influence the decisions of users, such as investors or creditors, are more likely to be deemed material.
For example, a misstatement in revenue recognition, even if numerically small, could be considered material if it significantly affects the decision-making of investors relying on accurate revenue figures.
- Precision and Reliability of Information: If the information is unclear or unreliable, auditors may consider it more likely to be material.
For example, accrual estimates with a high level of uncertainty might be deemed material.
Materiality Examples
To help understand the concept of materiality in audit further, let’s look at a couple of real-world examples:
Example 1 – Misstatement Size
A company has a net income of £1m, and auditors set materiality at 5%.
They identify an error in the way the company is recognising revenue which amounts to £40,000.
As the materiality in this case has been set at £50,000 (£1m x 5%), it would not be considered material as the £40,000 error is below this threshold.
Example 2 – Nature of a Transaction
Auditors note a related-party transaction involving a company’s CEO purchasing £10,000 of inventory from the company at a below-market price.
Transactions between a company and its key management personnel, such as the CEO, are classified as related-party transactions.
These transactions can pose a risk of conflicts of interest and require careful scrutiny to ensure fairness and compliance with accounting standards.
Auditors may deem a small monetary value material if the nature of the transaction is significant.
Example 3 – Industry Benchmark Deviation
Whilst auditing a manufacturing company, auditors might consider a deviation from industry benchmarks as material when assessing various financial metrics.
One such metric is inventory turnover, which measures how efficiently a company is managing its inventory, and more specifically, the frequency with which a company sells and replaces its inventory.
If the company’s inventory turnover is significantly lower than the industry average, even if the absolute amount is not large, it could be considered material as it may indicate operational or financial inefficiencies.
What is Performance Materiality?
In addition to materiality, auditors also consider “performance materiality“.
While materiality sets the overall threshold for what is material in the financial statements, performance materiality looks at the level of materiality applied to individual account balances, such as the ‘Accounts Payable’ account for example.
This allows auditors to focus on areas with a higher risk of impacting the overall accuracy and reliability of the financial statements.
For example, imagine an audit is being conducted for a company with total assets of £500m and the auditors set the materiality threshold at of 5% of total assets, or £5m.
During the audit, the auditors identify a discrepancy of £1,000,000.
While this error may seem large in isolation, the impact on the overall financial statements would be relatively minor, as it only accounts for only 0.2% of the total assets.
In this instance, the auditors might determine that the discrepancy is not material enough to influence the decisions of stakeholders using on the financial statements.
During the same audit, focus turns to the “Accounts Receivable” account, which has a balance of £10m.
Given the risk associated with customers’ creditworthiness and potential bad debts, the auditors decide to set a performance materiality threshold of 3% for this account.
This means that discrepancies that exceed £300,000 (3% x £10 million) within the Accounts Receivable account would be considered material and require further investigation.
The auditors discover discrepancies totaling £400,000 within the Accounts Receivable account.
Although this amount falls below the overall materiality threshold of £5m, it exceeds the performance materiality threshold of £300,000 for the specific account.
As a result, the auditors acknowledge that these discrepancies are significant within the Accounts Receivable account and deserve a closer investigation.