Audits are increasing in popularity due to the level of assurance they provide for the information provided within financial statements. To obtain an adequate level of assurance, independent auditors need to perform extensive procedures.
Since it is humanly impossible for auditors to look at every dollar in a company, how do auditors obtain comfort over a set of financial statements? That’s where the use of materiality is key in all audits.
In this article, we will define materiality, go through how auditors determine materiality, explain the main methods used in calculating materiality and provide examples to illustrate the theory.
What is Materiality in Auditing? [Defined]
Materiality is the basis used by auditors in order to obtain reasonable assurance that the financial statements are free of misstatements. In an ideal world, auditors would test all accounts and transactions of a company to opine on their financial statements.
However, in practice, that’s impossible and inefficient. The use of materiality is therefore important in the audit process so that auditors focus their procedures on what really matters in order for them to complete the key objectives of an audit and provide their opinion.
An error or omission in the financial statements is considered material if it can influence the decision-makers when they make use of the financial statements. Decision makers can be the investors, lenders, suppliers or creditors, shareholders, regulators and so on.
The readers of the financial statements are always kept in mind when an audit is performed since the goal of an audit is to ensure they are not misled by the financial information and can always make informed decisions regarding companies.
How Do Auditors Determine Materiality?
There are no mandated ways to determine materiality. This is because what is considered material can change from one industry to another, one company to another and one person to another.
Therefore, independent auditors have to use professional judgment in determining the materiality threshold based on the type of company they are auditing and keeping in mind the interest of the users of the financial statements.
Materiality is generally expressed as a percentage exactly for the reason that what is material can differ from one company to another so a dollar amount wouldn’t be appropriate.
For example, a small company having a misstatement of $100 can consider that material versus total sales of $1,000 but that same $100 could be considered minimal versus sales of $1,000,000 from a bigger company. Using a percentage eliminates that issue.
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Popular Methods of Determining Materiality
While there are no written rules on how to determine materiality, common ways of determining materiality do exist and are adopted in industry. Let’s look at some popular methods of determining materiality.
- % of net pre-tax profit : Popular threshold used for operating companies due to the fact that performance is most important for a good portion of users of financial statements. This basis can be used as long as the company is not in a loss position.
- % of revenue : Similar to #1, this is also a popular threshold used for operating companies. Also serves as a good alternative if net results of the company are at a loss position.
- % of assets : Can be used if a company owns a significant amount of assets or if their balance sheet has significantly higher amounts than their income statement.
- % of net assets : Generally used in the financial services industry since net assets are essentially what belongs to investors (net assets = assets – liabilities), who are the main users of financial statements.
No matter the method used in determining materiality, using professional judgment and ensuring the interest of the users of financial statements are taken into consideration is paramount.
Example of Materiality Calculation
Let’s take the example of Carl’s Construction Company (“CCC”). CCC is going through an audit for the year ended June 30, 2023. At year-end date, CCC had the following financial information:
| Revenues | $150,000 |
| Net profit before tax | $5,000 |
| Assets | $100,000 |
By looking at the above information, the auditors start doing calculations using each of the above bases. They calculate 1% of revenues, 5% of net profit before tax and 1% of assets to arrive at the below materiality thresholds:
| Revenues | $15,000 |
| Net profit before tax | $250 |
| Assets | $10,000 |
The different materiality possibilities obtained above are analyzed by the auditor and they determine that the best option is to use revenues as a base and $15,000 as materiality.
This is because the materiality obtained from net profit before tax is not necessarily the best option as it could lead to unnecessary extra procedures and $250 is clearly trivial.
If the audit was performed for a banker, lending a loan to CCC, the better option could have been using assets as a base and $10,000 as materiality since assets are the most important element to the bank.
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Qualitative Factors of Materiality
Quantitative factors when determining materiality are important but auditors also need to take qualitative factors into consideration.
Sometimes, a misstatement in financial statements could be trivial but if the misstatement was a result of fraud, then it becomes material due to this qualitative factor.
When performing an audit, auditors need to understand the operations of a company in order to make the best professional judgment in relation to materiality.
Some accounts might be at higher risk than others and the auditors are able to set specific materiality thresholds to specific accounts. Examples of higher risk accounts are related party transactions, management’s compensation, accounts where there are high management estimates.
Recap on What is Materiality in Auditing
Materiality is the key to an audit. Here’s a summary of important concepts surrounding materiality:
- It’s the basis used by auditors to obtain reasonable assurance that financial statements are free of material misstatements.
- Information is considered material if it can alter the decision of users of financial statements.
- Materiality is determined using professional judgment of the auditor but common methods of determining materiality are % of net pre-tax profit, % of revenue, % of assets and % of net assets.
- Auditors take qualitative factors into consideration when determining materiality.
Final Thoughts on Materiality in Auditing
Understanding materiality is key in audit. There’s a high level of judgment used in determining materiality. Auditors always take quantitative and qualitative factors into consideration in order to ensure the best interest of the users of financial statements.
Even if you are not working in audit, having a general idea of how auditors opine on financial statements is helpful.
