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Audit Materiality is a quantitative value used to verify whether an account balance or transaction is worth performing testing procedures in an audit context. There is no specific formula for arriving at the Materiality numbers, and they also depend on who uses the financial statements under audit.
Table of contents
What’s the purpose of calculating Audit Materiality?
Given the time constraints, testing every transaction is impossible as part of an entity audit. Further, conducting an end-to-end transaction audit affects the Engagement economics as well.
So, the audit team needs a value to determine the significance of the account balance or transaction for testing.
For example, if the GL balance is $1,000. Does this balance require testing?
The answer would be no.
Such thresholds can be calculated only after considering the purpose of the financial statement from the standpoint of users of those financial statements.
For example, suppose the primary users of financials are Banks or Financial Institutions. In that case, they are interested in the Cash Flow available for financing activities or Profit before paying interest and taxes (PBIT). So, any of this will be an appropriate benchmark for calculating the Materiality in this scenario.
What are the steps in calculating the Materiality?
Based on the users of financials, the first step is to decide upon the benchmark, and then the second step is to apply a specific percentage to the quantitative value of the benchmark.
Here, the benchmark is an account balance or FS line item to which a certain percentage is applied to arrive at the Materiality number. Let’s say the equity balance is the benchmark. The audit team decided to use 5% of equity as materiality.
Also, read the article on performance materiality to understand the difference between materiality and performance materiality.
Runners Insight
The number of benchmarks for calculating the materiality value is not limited. Applying more than one benchmark depends on various factors, such as the users of Financials, the Industry in which the entity operates, and the Auditor’s professional judgment.
How do we arrive at materiality numbers if there is more than one benchmark?
The procedure is the same as having one benchmark. After applying the above two steps, the numbers derived from both benchmarks are averaged to arrive at final figures.
Also Read: Distribution Journal Entry
Example:
Now that we understand the theoretical part of Materiality, let’s look at an example of calculating the materiality numbers.
The financial information of the “Flop Company” is:
- Profits before interest and tax = $5,000,000
- Cash Flows available for financing activities = $2,000,000
- Success Audit firm audits the Flop company for the first time.
Based on the Auditor’s Professional Judgment, the percentages considered for PBIT and CF are 0.5%- 2% and 1%- 3%, respectively.
Considering the history of misstatements and the first year of the audit, the audit team shall use a lower Percentage for materiality calculation.
Benchmark Amounts:
PBIT Benchmark = $5,000,000*0.5% = $25,000
CF Benchmark = $2,000,000 *1% = $20,000
Therefore, the Average benchmark value = (25,000+20,000)/2 = $22,500
Runners Insight
If the Materiality chosen is in a lower range, then the testing procedures will be more extensive than if a higher range is determined. The audit team can decide whether a simple or weighted average works for the audit based on professional judgment. Therefore, it’s not just one input. It depends on various factors, as described in this article.
Frequently Asked Questions
What are the qualitative factors for calculating audit materiality?
Qualitative factors such as research or analyst reports also play an essential role in calculating Materiality. There isn’t any correct benchmark for all the audited entities, and the appropriateness of benchmarking varies from one entity to another.
The entity’s industry and the auditor’s professional judgment are also considered.
Runners Insight
Materiality does not apply to just one account balance or a statement in the financial statements; it applies to all the financial elements under audit.
Can Audit Materiality be set for a particular account balance?
The answer is yes. The team can calculate audit materiality for a specific account balance depending on the circumstances.
How about an example here?
Let’s assume errors or misstatements were present in CY or PY for the Long-term debt. Then, the audit team notes that the Materiality set for financials will not be appropriate for this debt balance. This is because the materiality number is so high that it will not detect any errors or misstatements, which might affect auditors’ opinion of the financial statements when considered in aggregate.
Conclusion for Audit Materiality:
Audit Materiality is a quantitative value that depends on the benchmark chosen and a percentage applied to it. Materiality helps the auditor perform testing procedures only on significant account balances. Therefore, audit materiality is one of the steps for planning an audit.
