Audit materiality is a concept to quantify the misstatements, omissions, and errors in financial statements that auditors couldn’t specify.
Performance materiality is a lower threshold than materiality that allows an aggregate review of misstatements in the company’s financial statements.
Material and performance materiality are important concepts to make auditors’ opinions of financial statements fair and correct.
To fully understand performance materiality, let us first discuss the materiality concept in auditing.
Materiality in Audit
The ISA 320 defines materiality in audit as:
“Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken based on the financial statements”
There are numerous definitions of materiality. Many auditing and accounting bodies have developed similar definitions. For instance, the IFRS defines materiality as:
“Information is material if omitting, misstating, or obscuring it could reasonably be expected to influence decisions that the primary users make based on those financial statements.”
Materiality is an auditing concept. The purpose of applying the materiality concept is to evaluate whether misstatements, errors, frauds, or omissions can affect the auditor’s opinion about the fairness and materiality of the financial statements.
Material misstatement can include:
- A misstatement in a line item in any of the financial statements
- Known and unknown misstatements in financial statements
- Erroneous or unreasonable estimates
- Omission of an important financial statement disclosure
Another key point with materiality is that different users of financial statements and readers of auditors’ opinions can have contrasting views. These users include shareholders, management, creditors, and regulators.
A material misstatement for one user may not have the same effect on another user. The auditor’s objective is to offer a true and fair opinion about the financial statements’ correctness and material in all respects.
What is Performance Materiality?
The ISA 320 defines performance materiality as:
“The amount set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.”
The performance materiality aims to reduce the impact of materiality. It uses a lower threshold that enables auditors to identify more misstatements.
In practice, auditors can’t evaluate each transaction individually. Thus, they use sampling and other techniques to evaluate the fairness and correctness of the financial statements.
Performance materiality is a similar concept that allows for the risk that there may be several smaller omissions or errors that the auditors couldn’t identify.
However, when aggregated, these smaller errors can cause a significant impact.
Performance materiality aims to reduce the aggregate impact of several smaller errors and misstatements.
The threshold can be set for different metrics differently. Generally, there are no set rules to set the performance materiality threshold.
It is a matter of professional judgment.
Determining Materiality and Performance Materiality in Audit
As discussed above, different users can have contrasting opinions about misstatements. Materiality determined by one user may not be material for the other.
Determining materiality depends on professional judgment. As stated in the definition, the auditor must consider the following key points:
- The size and nature of the misstatement
- Circumstances surrounding the entity
- The information requirements of the users
It is a subjective method to determine materiality. Thus, quantification of materiality judgments will be difficult with this approach.
One way to resolve the issue is to set the benchmark standards. These benchmarks can become starting points for determining the materiality and performance materiality.
Common benchmarks for materiality include:
- 0.5% – 1% of revenue
- 5% – 10% of profit after taxes
- 1% – 2% of assets or liabilities
Importantly, there are no rules to set these benchmark standards and which ones to use. Users will determine their preferred benchmarks and threshold materiality standards.
Suppose the following revenue and income figures are available for ABC company for its last three years.
|Item||2020 in ‘000 $||2019 in ‘000 $||2018 in ‘000 $|
|Profit Before Tax||230||435||360|
|Materiality at 1.5% of Revenue||187.5||174||150|
The users of this information can make a professional judgment on whether to use the revenue figure as a benchmark.
Then, whether the threshold of 1.5% of the revenue is appropriate or not.
For instance, another user may argue that profit before tax is a more suitable benchmark for assessing materiality than revenue figures. Or, the use of the 1.5% threshold should be reduced to 1% only.
Similarly, ABC company can set the performance materiality benchmark. A low threshold reduces the risk of undetected misstatements in the financial statements.
Auditors can then plan different responses depending on the performance materiality outcome.
Suppose ABC company sets the materiality at $ 150,000 and performance materiality at $ 100,000 of the net profit figures. Let us assume some calculated performance materiality and responses accordingly.
|Performance Materiality Value||Response|
|$ 70,000||There is no sufficient evidence for the material misstatement. The auditors may suggest no further action.|
|$ 130,00||Although the value is not staggering, auditors may suggest an analytical review of the profit figures.|
|$ 180,000||As the value is substantially above the performance materiality threshold, auditors may suggest sample testing for a few key transactions affecting the profit figures.|
The response to the performance materiality values will depend on the benchmark standards. For instance, if the same values would result from an evaluation of the gross revenue figures, these values may not have presented the degree of risk and such response from the auditors.
Undetected and Uncorrected Misstatements
Undetected and uncorrected misstatements aggregated can hurt the auditors’ work. Even if individual benchmarks do not show significant performance materiality, aggregated accounts do.
For example, if ABC company in our example had set the materiality and performance materiality benchmarks at $ 150,000 and $ 100,000 of the net profit figures.
The calculated materiality and performance materialities are $ 175,000 and 130,000 respectively.
These standalone figures do not present a staggering risk. However, suppose there was undetected materiality of:
- $ 60,000 in revenue
- $ 30,000 in COGS
- $ 50,000 in fixed assets
- $ 25,000 in accounts payable
Combined the materiality figure becomes $ 165,000. If we aggregate this figure with the materiality of $ 175,000, it becomes $ 240,000 which may pose a significant risk depending on the nature and size of ABC company.
The AU-C- 450.11 guides on handling the undetected or uncorrected misstatement materiality. The auditor should assess whether the uncorrected misstatements individually or combined are material or not.
The auditors should consider the following points as suggested in AU-C 450.11:
- “The size and nature of the misstatements, both about particular classes of transactions, account balances, or disclosures and the financial statements as a whole, and the particular circumstances of their occurrence” and
- “The effect of uncorrected misstatements related to prior periods on the relevant classes of transactions, account balances, or disclosures and the financial statements as a whole”.
Thus, the auditors will suggest a response after combining the undetected misstatements. Like performance materiality benchmarks, the effect of undetected misstatement may also depend on the evaluated standard.
What is the difference between audit materiality and performance materiality?
Audit materiality and performance materiality are both concepts used in financial statement auditing, but they have different meanings and serve different purposes.
Audit materiality refers to the magnitude of an error or misstatement in the financial statements that, in the auditor’s opinion, could reasonably be expected to influence the decisions of the users of the financial statements.
Audit materiality is a threshold that is used to determine whether an error or misstatement is considered significant enough to require further investigation or disclosure in the financial statements.
Performance materiality, on the other hand, is a concept that refers to the amount of audit materiality that is allocated to a specific account or audit area.
Performance materiality is set at a lower level than audit materiality and is used as a benchmark to assess whether the individual misstatements or errors found during the audit are material enough to affect the overall accuracy of the financial statements.
The purpose of performance materiality is to help auditors focus on the areas of the financial statements that are most likely to contain material misstatements.
By setting performance materiality at a lower level than audit materiality, auditors can identify smaller errors and misstatements that could add up to a material misstatement in the financial statements.
What are the factors affecting performance materiality?
Performance materiality is the amount of materiality the auditor sets for specific accounts or audit areas.
It is a lower level of materiality than audit materiality and is used as a benchmark to assess whether individual misstatements or errors are material enough to affect the overall accuracy of the financial statements.
The factors that affect performance materiality include:
- Overall materiality: The overall materiality of the financial statements is a significant factor in determining performance materiality. The auditor may use a percentage of the overall materiality, such as 50%, as a benchmark for performance materiality.
- Risk assessment: The auditor’s risk assessment of the financial statements and the audit areas is also a factor in determining performance materiality. Higher risks in certain accounts or audit areas may require lower performance materiality to identify smaller errors and misstatements that could add up to material misstatements.
- Complexity and volatility of the account: The complexity and volatility of an account or audit area can also affect performance materiality. More complex and volatile accounts may require lower performance materiality to identify smaller errors and misstatements that could impact the accuracy of the financial statements.
- Quality of internal controls: The quality of internal controls over an account or audit area can also impact performance materiality. Stronger internal controls may allow for higher performance materiality, while weaker internal controls may require a lower performance materiality to identify smaller errors and misstatements.
- Nature of the account or transaction: The nature of the account or transaction can also impact performance materiality. Some accounts or transactions may be inherently more risky or complex, requiring lower performance materiality to identify smaller errors and misstatements.
How does an auditor use performance materiality?
An auditor uses performance materiality as a benchmark to assess whether individual misstatements or errors found during the audit are material enough to affect the overall accuracy of the financial statements.
The process of using performance materiality typically involves the following steps:
- Setting overall materiality: The auditor sets an overall materiality level for the financial statements, which is typically a percentage of a relevant benchmark such as net income or total assets.
- Determining performance materiality: The auditor then sets performance materiality for specific accounts or audit areas. Performance materiality is typically set at a lower level than overall materiality, usually around 50% to 75% of overall materiality, to identify smaller errors and misstatements that could add up to a material misstatement in the financial statements.
- Assessing individual misstatements: The auditor identifies individual misstatements or errors in the financial statements during the audit.
- Evaluating the impact of individual misstatements: The auditor evaluates the impact of each misstatement or error on the financial statements based on their professional judgment and the level of performance materiality.
- Accumulating misstatements: The auditor accumulates all identified misstatements or errors to assess whether they add up to a material misstatement in the financial statements.
- Communicating with management: If the accumulated misstatements are deemed to be material, the auditor communicates with management to request adjustments to the financial statements to correct the misstatements.
- Reporting to the audit committee: The auditor reports to the audit committee any misstatements or errors that are deemed to be material and the actions are taken to address them.