Audit risk - Materiality concept and calculation

Learning Outcomes

After studying this article, you will be able to define materiality in the context of external audit, identify how quantitative benchmarks and qualitative factors are applied, explain the calculation and adjustment of materiality, and describe how audit risk and materiality interact in audit planning and evidence evaluation for the ACCA FAU exam.

ACCA Foundations in Audit (FAU) Syllabus

For ACCA Foundations in Audit (FAU), you are required to understand the importance of materiality in planning and performing an external audit. This article focuses on:

• The meaning and purpose of materiality in audit
• How materiality is calculated using financial information
• The key quantitative benchmarks and qualitative factors influencing materiality
• The connection between audit risk and materiality
• Application of professional judgement in setting and revising materiality
• The role of performance materiality in audit procedures

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. Which of the following best describes materiality in an audit?
   1. The smallest error possible in the accounts
   2. Any transaction recorded by the business
   3. Information that could influence users' decisions
   4. All non-current asset purchases
2. If an auditor identifies several errors, each below performance materiality, what should they do?
   1. Ignore the errors
   2. Aggregate the errors and compare with overall materiality
   3. Only report the largest error
   4. Disregard any qualitative matters

3. True or False? An error can be material because of its nature even if its value is small compared to total revenue.

4. Briefly explain how higher assessed audit risk should influence materiality decisions in audit planning.

Introduction

Materiality is a fundamental concept that shapes every stage of an external audit. Auditors use materiality to decide which items require their focus and to evaluate the impact of errors or omissions. Materiality is not a rigid number: it reflects both the size (quantitative) and nature (qualitative) of items in the financial statements. Understanding materiality and how to calculate and apply it, including its relationship with audit risk, is critical for effective and efficient audit work and for success in the ACCA FAU exam.

Key Term: materiality
Information is material if its omission or misstatement could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.

THE CONCEPT OF MATERIALITY

Materiality means that not every error or omission in the financial statements will be significant to users. Auditors focus on those matters that could impact the users’ decisions. An item is material if, individually or combined with others, it might reasonably affect the judgement of financial statement users.

Materiality is not just about the absolute size of an amount. The type of transaction, legal or regulatory requirements, and the context all play an important role.

Quantitative and Qualitative Factors

Materiality is usually measured both quantitatively and qualitatively.

• Quantitative factors: Benchmarks such as profit before tax, revenue, or total assets are commonly used to set a materiality level in monetary terms.
• Qualitative factors: Some matters are material regardless of value (for example, fraud by management, failure to disclose legal requirements, or breaking key laws).

Key Term: quantitative benchmark
A percentage or monetary reference point, commonly derived from profit, revenue, or assets, used by auditors to set initial materiality levels.

Key Term: qualitative materiality
The importance of an item arising from its character or circumstances, not just its value.

SETTING AND CALCULATING MATERIALITY

Auditors do not use a fixed formula, but apply standard benchmarks to the most relevant measure for the entity. Examples of typical quantitative benchmarks include:

Which benchmark to use depends on the entity and the nature of its activities. For example, an asset-based business may use total assets, while a service business may use revenue or profit.

Professional judgement is applied to choose which benchmark is most appropriate, and to adjust the final materiality figure to fit specific risks or circumstances.

Key Term: professional judgement
The auditor’s application of experience and knowledge to make decisions appropriate to the audit situation.

MATERIALITY AND AUDIT RISK

Materiality and audit risk are closely connected in audit planning and procedures. The auditor’s aim is to design an audit that provides reasonable assurance that material misstatements will be detected.

• A higher audit risk (greater chance of material misstatement) leads to setting a lower materiality amount. This means more items and smaller errors will be investigated.
• A lower audit risk (stronger controls, fewer risks) allows a higher materiality level, which means less detailed audit work is needed.

Key Term: audit risk
The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

PERFORMANCE MATERIALITY

Auditors set a lower level, called performance materiality, to guide their detailed audit procedures. This is always less than the overall materiality, to reduce the risk that uncorrected and undetected errors combined do not exceed overall materiality.

Key Term: performance materiality
An amount set below overall materiality to reduce to an acceptably low level the risk that the total of errors found and not found exceeds the overall materiality level.

QUALITATIVE CONSIDERATIONS

Certain items are material due to their nature, regardless of value. Examples include:

• Non-disclosure of directors’ remuneration when required by law
• Related party transactions not reported
• Items that result in breaching loan covenants
• Errors that would convert a reported profit into a loss

Worked Example 1.1

An auditor is planning the audit of a retail company. The year-end figures show profit before tax of £300,000 and revenue of £6,000,000. Calculate an appropriate overall materiality and explain your decision.

Answer:
Using profit before tax as the benchmark, 5% gives: £300,000 × 5% = £15,000.
Using revenue, 1% gives: £6,000,000 × 1% = £60,000.
Since users are likely to focus on profitability, the auditor may select £15,000 as overall materiality, adjusting this if there are unusual risks or circumstances. The choice reflects professional judgement.

Worked Example 1.2

A set of accumulated audit errors totals £12,000. Overall materiality is £15,000. All errors individually are also below performance materiality. What must the auditor consider before concluding that the financial statements are not materially misstated?

Answer:
The auditor must consider qualitative factors. For example, if any error involves potential fraud or non-compliance with regulations, it could be material even if under £15,000. All errors should be discussed with management and considered in the audit opinion.

Worked Example 1.3

In the financial statements of a small entity, directors’ emoluments are understated by £6,000 out of total revenue of £2,000,000. Is this error material?

Answer:
Although the error is only 0.3% of revenue, non-disclosure or misstatement of directors’ emoluments is material because of statutory and user requirements. This is a case of qualitative materiality, so the auditor must require correction.

Exam Warning

A frequent error is to focus only on the percentage calculation for materiality and ignore qualitative aspects. Always consider both size and nature of errors before reaching audit conclusions.

Summary

Materiality directs audit effort towards areas that matter to the users of financial statements. Materiality depends on both the size and the circumstances of errors or omissions, and always involves professional judgement. Quantitative benchmarks provide guidance, but qualitative matters can override them. The materiality level, and performance materiality, must be reconsidered if new risks or errors are discovered during the audit.

Key Point Checklist

This article has covered the following key knowledge points:

• Define materiality and recognise its central role in audit planning and evidence evaluation
• Apply common quantitative benchmarks and understand when to use each
• Identify the importance of qualitative factors in determining materiality
• Explain the link between audit risk and materiality, including necessary adjustments for higher risk
• Describe the use and purpose of performance materiality
• Recognise that professional judgement is involved at every stage of determining and revising materiality

Key Terms and Concepts

• materiality
• quantitative benchmark
• qualitative materiality
• professional judgement
• audit risk
• performance materiality