Definition:
Performance materiality (PM)
- It is a quantitative value
- which ensures that the aggregate amount of uncorrected and undetected misstatements
- shall not exceed the materiality level for the financial statements as a whole.
Refer below to understand this statement with an example.
Factors Considered for Calculating Performance Materiality:
Performance Materiality (PM) is calculated as a percentage of materiality.
The Percentage is subjective and dependent on several factors, including:
- Knowledge obtained from the prior year’s audit of the same entity,
- Understanding of the client and its industry,
- Auditor Professional Judgement,
- Misstatements or errors noted during the previous year’s audit, etc.
As stated differently, the audit team shall choose a percentage that helps in all the aggregate misstatements and does not exceed the PM.
This article includes examples of performance materiality and theoretical components to help readers understand the PM idea thoroughly.
A basic idea of Materiality and the requirements for performing audits are prerequisites for a clear understanding of the Performance Materiality Concept.
Later on, we can dive into the concept of Performance materiality.
Table of contents
- Definition:
- Factors Considered for Calculating Performance Materiality:
- Further Understanding :
- Do you want to understand this with an example?
- Why and What of Materiality?
- Let us apply the concept of Materiality to our real-life scenario.
- First Point that drives the use of Performance Materiality:
- The second point that drives the use of Performance materiality
- Performance Materiality Calculation:
- Conclusion :
Further Understanding:
An auditor plans and performs the audit to give an opinion in respect of the following
- Whether Financial statements represent a true and fair view or
- Records/account balances are correct
So, audited information shall be free from Misstatements.
Note: Misstatements are incorrect information in the books or totally false information. Therefore, it’s an error.
Do you want to understand this with an example?
“Always Trouble” Company recorded the director’s housewarming party in the Company’s books. This is a personal expenditure, and recording it in the company’s books of account is incorrect.
It’s a misstatement. In other words, we can say this is an error in the accounting.
Why and What of Materiality?
Have you wondered why determining Materiality is a prerequisite for performing an Audit?
Here’s the answer:
The short answer is that it helps determine the audit’s nature, timing, and extent.
The Long Answer is
The Auditor will not be able to perform the testing for 100% of the transactions in the books of accounts. This is practically impossible. Here comes Sampling as a rescue technique. Testing a representative portion of the Population is the sampling process; hence, the results from testing are applicable to the whole population. So, the sampling technique avoids performing testing for the whole population. Materiality amount indirectly supports the process of determining the number of Samples. We will learn more in this next section.
Note: Sampling is applicable only for homogeneous populations.
How about an example here?
For instance, assume a company called Failure Partners has a turnover of $10 million in the current financial year. The number of invoices raised by the company for the sales is 1 million. This information is for only one of the several account balances that are under audit. Assume there are some 100 GL accounts in the company’s books. Then, the number of invoices or similar supporting documents equals 100 million (Approximately).
Runners Insight
Can the Auditor test each voucher and inspect the relevant supporting documents for all the account balances?
The answer would be no. In other words, the audit team can’t vouch for and trace all those amounts to support. So, the sampling procedure helps the auditor by reducing the extent of testing, and thereby, the auditor obtains reasonable assurance that the financial information is true and fair.
Also Read: Trade vs Non-Trade Payable
Let us apply the concept of Materiality to our real-life scenario.
Do we worry if we lose just $1 or $100? The answer would be $100, right?
Now, we will think of this in audit terms. Will the auditor worry if the company does not record an expense of $100 or $10,000? The answer would be absolutely $10,000.
The higher the number, the greater the risk for the Auditor.
So, the Auditor determines the Materiality for each company under audit. This helps to filter out the material account balances that are of audit importance. Even if there are errors in the account balances that are immaterial, it will not affect the audit opinion on the financials or financial information under audit. Hence, the auditor will not be concerned about those immaterial balances
From the above, we gained a good understanding of Materiality and its application during the audit. Now, let us understand the performance materiality concept. The two points below help us understand the need for performance materiality. Later, we will understand the performance materiality definition.
First Point that drives the use of Performance Materiality:
Performance Materiality is a key metric used to determine the number of samples that need to be tested.
Dividing the Population (which means the account balance the Auditor is testing) by a threshold is the first step in sample calculation. Here, the threshold employed is Performance Materiality. Based on Multiple values of PM, the Auditor will decide the number of samples to test.
Are you wondering why we shouldn’t take Materiality here instead of performance materiality?
Read the Calculations section below to understand this.
Runners Insight
The number of Samples to test will also depend on other factors like the risk of the account balance tested and whether Internal Controls in the entity are designed and operating effectively. Said differently, if the risk is lower and controls at the entity process operate effectively, the number of samples considered for testing will be lower. The actual number depends on the auditor’s professional judgment or can be driven by applicable statutes.
As we try to understand the use of PM, we will apply multiple PMs as the only factor for deriving sample size, assuming the other factors do not contribute much to the sample size calculation. Other factors that could influence this include the inherent risk of the account balance, industry practice, past misstatements, control deficiencies, etc.
Example:
Assume the following data for an entity “Losses Hub Company”:
- Materiality is $40,000
- Performance Materiality is $26,000
- Account Balance Population is $14,000
Note: The auditor determines materiality based on benchmarks such as revenue, net profit, or cash flows. Therefore, Materiality is the percentage of that benchmark that is most appealing to the entity, as per the Auditor’s Professional Knowledge.
Calculations:
We will determine the multiple of the threshold, which is the first step of the sampling process
Scenario I: Multiple of PM’s = $14,000/$26,000 = 0.5384 ~ 1 (Round up Value)
What if we use Materiality instead of PM?
Scenario II: Multiple of M’s = $14,000/$40,000 = 0
In the Second Scenario, the Multiple of Materiality is 0. The Auditor will not perform an
audit of that GL balance. However, in the first scenario, the Auditor will test it as the PM Multiple is 1.
So, having a lower denominator will help the Auditor to perform more testing. This results in
a lower risk of misstatements in the audit. Testing of higher samples will provide more reliable audit evidence.
Pro Tip: It’s always a good practice to round up the Performance Materiality Multiple for
performing testing. So, even if the value is 0.2, it’s better to round up the number to one and do an Audit
The second point that drives the use of Performance materiality
We shall understand the types of misstatements first. There are two types of misstatements.
- Detected Misstatements
- Undetected Misstatements
Detected misstatements could be corrected or uncorrected.
Corrected Misstatements are the ones that management agreed to correct as adjustments (also called true-ups) made after books are closed.
Example: Auditors find that the company records the next year’s expenses in the current year. The audit team informs management about the error, and the finance manager corrects it by posting the entry as prepaid expenses. Therefore, there is no audit risk for these misstatements because they are corrected misstatements.
Uncorrected Misstatements are the ones that management is aware of, but not willing to correct.
What could be such an instance of uncorrected Misstatements?
For instance, we will continue with the same above example with an amount of $5K. Management believes that it is of immaterial value and is reluctant to correct it. The audit team’s Point of view is that it shall be corrected with due regard to its nature. Such errors are called uncorrected misstatements.
Undetected Misstatements: Similar to the above, these misstatements do not come to auditors’ attention. Auditors cannot detect all the Misstatements (either Errors or Omissions), so they are called undetected misstatements.
The audit team will be unable to test 100% of the population. Sampling procedures are adopted. As such, there is a chance of not picking transactions with errors or misstatements, which results in detected misstatements.
Now, we will come back to the second point regarding the use of performance materiality.
There could be a chance that the Undetected Misstatement exceeds Materiality. Therefore, Auditors need a buffer point to be conservative while assuring that the Financials are true and fair. Performance materiality gives that buffer.
A lower threshold will result in more sample testing, leaving less room for undetected misstatements. Said differently, testing more samples increases the chance that the aggregate of such undetected misstatements will not exceed the Materiality. So, Performance materiality helps the Auditor ensure minimal undetected misstatements.
How about an example here?
For example, consider the following:
Materiality is $40,000
Uncorrected misstatements and undetected misstatements are $10,000 and $35,000.
The Total number of Misstatements is $45,000, which is higher than the Materiality. If the Auditor had used Performance Materiality (the Lower level of the threshold for testing) instead of Materiality, the Auditor might have detected more misstatements. To conclude, irrespective of whether those are detected/undetected or corrected/uncorrected, sampling based on performance materiality results in less probability of undetected misstatements.
Now let us read the Performance materiality definition with due consideration of the above example
PM ensures that the aggregate amount of uncorrected and undetected misstatements shall not exceed the materiality level for the financial statements as a whole.
The above example helps us understand the PM definition. In other words, we can conclude that performance materiality reduces auditor risk.
Above all, an audit assures the users of financial information that there are no material misstatements in the financials. Performance materiality helps achieve this objective.
Performance Materiality Calculation:
Calculation of the Performance materiality is based on a percentage of materiality. However, arriving at that percentage is a subjective matter and depends on the following:
- Prior year Misstatements
- Nature and Extent of such misstatements
- Results of the Risk assessment performed
- Auditor’s understanding of the entity and its environment
We will understand the PM Calculation with an example. Let us assume that XYZ Company has a net income of $100 M. From understanding the Company and previous year audits, we have determined that the company’s net income is an appropriate benchmark.
Net Income = $100M
Material Percentage = 2%
Materiality = $100M *2% = $2M
Note: Auditors’ Professional Judgment is a key consideration when determining the applicable percentage on the Materiality benchmark. Another key factor for Performance Materiality calculation is the industry in which the entity operates. For instance, 2% of Net income is appropriate for the trading industry. However, 1% of Net income might be appropriate for the IT industry. So, there is no fixed formula to determine this percentage. It all depends on the factors mentioned above.
The auditor determines that tolerable misstatements shall not exceed 20% of materiality. A tolerable misstatement is the auditor’s monetary amount that does not exceed the aggregate of actual misstatements. So, the Performance Materiality is 80% of materiality.
Therefore, Performance materiality is $2M*80% = $1.6M
Conclusion:
Performance Materiality is the first safety measurement level that alerts the audit team to potential misstatements or errors. The audit team determines the performance Materiality number to be less than the Materiality number. Since not all misstatements may be detected during the audit procedures, detected and undetected misstatements could exceed the Materiality number. Consequently, the audit team uses a threshold lower than that of Materiality for sampling procedures, which leads to testing a larger number of samples.
We hope this article helped you understand Performance materiality, its definition, and calculations. If you have any questions, please let us know in the comments.
