Materiality and audit strategy - Overall and performance mat...

Learning Outcomes

After reading this article, you will be able to define materiality for the audit, explain the purpose and calculation of overall and performance materiality, and understand how their levels affect audit strategy. You will be able to apply materiality concepts to exam scenarios, justify materiality thresholds, and discuss the effect of both size and nature on materiality decisions, as required by ISA 320.

ACCA Audit and Assurance (AA) Syllabus

For ACCA Audit and Assurance (AA), you are required to understand the principles governing materiality and its application within the audit process. In particular, you should focus on:

• The concept of materiality in auditing, according to ISA 320.
• Distinguishing between overall materiality and performance materiality.
• Factors influencing the setting of materiality thresholds (including both quantitative and qualitative considerations).
• How auditors select benchmarks and percentages for materiality.
• The effect of materiality determination on audit planning, evidence gathering, and evaluation of misstatements.
• Applying performance materiality to ensure immaterial errors do not aggregate into material misstatement.
• Implications of misstatements identified during the audit for reporting and audit conclusion.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Define overall materiality in an audit and explain its primary purpose.
2. What is performance materiality, and how does it differ from overall materiality?
3. State two qualitative factors that might make a misstatement material, regardless of size.
4. If profit before tax is volatile year-on-year, which benchmark(s) might be more appropriate for setting materiality?
5. In a scenario where several trivial errors are found, explain the risk if performance materiality is set too high.

Introduction

Materiality is a central concept in audit planning and execution. It determines which misstatements matter to the users of financial statements and which are so minor that they can be disregarded. International Standard on Auditing (ISA) 320 provides auditors with guidance for setting materiality at the overall level and for specific procedures, ensuring that the audit work is focused and efficient.

Key Term: materiality
Misstatements, including omissions, are considered material if they could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.

The Concept of Materiality

Materiality guides the auditor in deciding what to pay attention to during the audit. A matter is material if knowledge of it would impact users’ decisions—typically investors, creditors, or regulators. Materiality judgments involve both size (quantitative factors) and nature (qualitative factors).

Material by Size

Auditors use benchmarks—such as profit before tax, revenue, or total assets—to establish a preliminary threshold for materiality. Common starting points include:

• 5% of profit before tax
• ½–1% of revenue
• 1–2% of total assets

Adjustment is made for client circumstances, industry norms, risk, and volatility.

Material by Nature

Some items are material due to their type, regardless of amount. Examples:

• Related party transactions
• Director’s remuneration
• Compliance with loan covenants
• Errors that change a net profit into a net loss or vice versa

Key Term: qualitative materiality
An item is material by its nature or circumstances, regardless of its numerical value.

Setting Overall Materiality

The auditor determines overall (financial statement) materiality at the planning stage and may revise it later if information changes. This level determines the threshold for assessing whether the financial statements as a whole are free from material misstatement.

Multiple benchmarks may be calculated, with judgment used to select the most appropriate one for the client.

Factors Affecting the Choice of Benchmark

• Main users and their main concern (profitability, asset base, turnover)
• Financial statement line items that drive decision-making
• Volatility of earnings or assets
• High inherent or control risks

Worked Example 1.1

Scenario:
A company has revenue of $12 million, profit before tax of $200,000, and total assets of $5 million. Profits are low and fluctuate year to year.

Question:
Which benchmark should the auditor use for overall materiality and why?

Answer:
If profit is small and volatile, using 5% of profit before tax would produce an unrealistically low materiality level. In such cases, ½–1% of revenue ($60,000–$120,000) or 1% of total assets ($50,000) are more stable and appropriate benchmarks. The auditor might choose $60,000 as preliminary overall materiality.

Performance Materiality

ISA 320 requires the auditor to set a figure below overall materiality—called performance materiality—to reduce to a low level the risk that the aggregate of undetected and uncorrected misstatements exceeds overall materiality.

Key Term: performance materiality
An amount set below overall materiality to reduce the probability that undetected misstatements in aggregate will exceed overall materiality for the financial statements as a whole.

Performance materiality acknowledges the likelihood of both known and unknown errors across many balances. It is typically set at 50–75% of overall materiality, depending on assessed risk.

Key Term: trivial misstatement
A misstatement so small it is considered clearly inconsequential, even when aggregated with others.

Worked Example 1.2

Scenario:
If overall materiality is $100,000, the audit team sets performance materiality at $60,000. During the audit, three unrelated errors are found—$20,000, $18,000, and $25,000. Are further procedures needed?

Answer:
Individually, each misstatement is below performance materiality, but together they total $63,000—over performance materiality. Additional audit procedures may be required, and all errors are reported to management (unless deemed clearly trivial).

Revising Materiality During the Audit

Materiality can change if conditions alter. For example, if draft figures are different from final financial statements, or if emerging risks require greater auditor skepticism, the auditor may need to revise materiality. Any revision is documented, and the audit strategy is updated accordingly.

Worked Example 1.3

Scenario:
An audit begins using draft profit of $500,000 (materiality: $25,000). Final audited profit is only $200,000.

Answer:
Materiality should be re-evaluated using the updated figure. Using $200,000 as a base results in a new materiality of $10,000. The auditor must consider whether additional audit work is needed on previously tested balances in light of the new, lower threshold.

The Role of Materiality in Audit Strategy

Materiality and performance materiality levels influence:

• Design of audit procedures (extent of work)
• Determination of sample sizes
• Risk assessment and focus areas
• Evaluation of audit findings

Errors below performance materiality may still need reporting if, in aggregate or by nature, they become material.

Key Term: audit strategy
The high-level approach in planning the audit—including the determination of scope, timing, direction, and allocation of resources.

Evaluating Misstatements

All identified misstatements, other than those deemed clearly trivial, are documented and considered by the auditor. The aggregate of corrected and uncorrected misstatements must not exceed overall materiality for the financial statements to be considered fairly presented.

Exam Warning

Small misstatements can add up: if you ignore multiple 'immaterial' errors, the combined effect may cross the materiality threshold. Always consider aggregate impact, not just individual errors.

Summary Table – Types of Materiality

Key Point Checklist

This article has covered the following key knowledge points:

• Define materiality and explain its role in audit planning and evidence evaluation.
• Distinguish between overall materiality and performance materiality, including how each is calculated and applied.
• Recognise when qualitative matters make a misstatement material, regardless of size.
• Explain the process for revising materiality during the audit and updating the audit approach.
• Identify the relationship between materiality, evidence gathering, and audit opinion formation.
• Understand the need to aggregate misstatements and assess total impact against materiality thresholds.

Key Terms and Concepts

• materiality
• qualitative materiality
• performance materiality
• trivial misstatement
• audit strategy