AU-C Section 320: Materiality in an Audit

An audit of financial statements provides assurance that they are presented fairly, but this assurance is not absolute. The concept of materiality is a practical tool that allows auditors to focus on what truly matters to those who use these financial statements. The professional standard governing this concept is AU-C Section 320, Materiality in Planning and Performing an Audit. This standard provides a framework for auditors to apply materiality, guiding them in planning the scope of their work and in evaluating the results of their procedures.

The purpose of AU-C Section 320 is to ensure that the audit is both effective and efficient. By establishing a materiality threshold, auditors can concentrate their efforts on areas with a higher risk of significant errors, rather than pursuing every minor inaccuracy. This approach shapes the entire audit strategy, from initial risk assessment to the final evaluation of uncorrected errors.

The Core Concept of Materiality

Materiality is a concept of professional judgment, viewed through the lens of a financial statement user. A misstatement, or a collection of them, is considered material if it is probable that it would have changed or influenced the economic decisions of a reasonable person relying on those statements. This is a qualitative and quantitative assessment, where the auditor must consider what information is important to investors, creditors, and other stakeholders.

To illustrate, a $100,000 error in the financial statements of a multi-billion dollar corporation would likely be considered immaterial. That same $100,000 error for a small, local business could be profoundly material, potentially altering a bank’s decision to lend money.

This concept has an inverse relationship with audit risk, which is the risk that the auditor expresses an inappropriate opinion. If an auditor sets a lower materiality level, they must perform more extensive and detailed audit procedures, thereby reducing the overall audit risk. Conversely, a higher materiality level implies that more audit risk is being accepted, as smaller misstatements may go undetected.

Determining Materiality for the Financial Statements

When beginning an audit, one of the first steps is to determine materiality for the financial statements as a whole. This figure acts as the primary threshold for the engagement. The process starts with selecting an appropriate benchmark, which is an element of the financial statements that users focus on. For a profit-oriented company, a common benchmark is pretax income from continuing operations.

Other benchmarks may be more suitable depending on the entity’s nature and industry. For example, total revenue might be used for a high-growth company, while a not-for-profit entity might use total expenses or assets. The choice of benchmark requires professional judgment.

Once a benchmark is selected, the auditor applies a percentage to it to calculate the initial materiality figure. Common practice involves applying a range, such as 3% to 5% for pretax income. For other benchmarks like total assets or revenue, the percentage is lower, often in the 0.5% to 2% range. This calculation provides a quantitative starting point.

Auditors must also consider qualitative factors that could render a smaller misstatement material. For instance, a misstatement that, while quantitatively small, causes the company to violate a debt covenant would be material. An error that allows a company to meet analysts’ earnings expectations or triggers a management bonus would also be considered material.

Establishing Performance Materiality

After setting materiality for the financial statements as a whole, the auditor must then establish performance materiality. Performance materiality is an amount set by the auditor at less than the overall materiality level. Its purpose is to create a buffer, reducing the probability that the aggregate of uncorrected and undetected misstatements exceeds the overall materiality threshold.

Performance materiality is used to assess risks and to determine the nature, timing, and extent of specific audit procedures. For example, if overall materiality is set at $100,000, performance materiality might be set at $60,000. This lower figure would then be used to decide whether a misstatement found in a particular account balance, like inventory, requires further investigation.

The determination of performance materiality involves professional judgment. Auditors calculate it by applying a percentage to the overall materiality figure, often in the range of 50% to 75%. The percentage chosen depends on the auditor’s assessment of the risk of material misstatement. A higher-risk engagement would warrant a lower performance materiality, leading to more rigorous testing.

An auditor may also set a specific materiality level for particular classes of transactions or disclosures that is even lower than performance materiality. This might occur for areas of high interest to users or with unique risks, like related-party transactions.

Revising Materiality Judgments During an Audit

Materiality is not a static figure. AU-C Section 320 requires the auditor to revise materiality judgments if new information comes to light that would have caused them to determine a different amount initially. This ensures the audit plan remains responsive to changing circumstances.

Circumstances that might necessitate a revision of materiality include significant changes in the company’s financial performance, a major business acquisition, or the identification of new risks not apparent during the planning phase. For example, if a company’s year-end pretax income is substantially lower than the figure used for the initial materiality calculation, the auditor must lower the materiality threshold.

When materiality for the financial statements as a whole is revised downward, the auditor must also reconsider the appropriateness of performance materiality. A lower materiality threshold means the auditor’s tolerance for misstatement has decreased. As a result, the auditor may need to expand the scope of their testing by increasing sample sizes or performing additional audit procedures.

Documentation of Materiality

A component of complying with AU-C Section 320 is the thorough documentation of all materiality judgments in the audit workpapers. This documentation serves as a record of the key decisions made during the audit and provides support for the auditor’s conclusions. The standard requires recording a clear audit trail.

The auditor is required to document:

• The materiality level established for the financial statements as a whole, including the benchmark that was used and the percentage that was applied to it.
• The level or levels set for performance materiality, including how this figure was derived and the justification for the percentage used.
• If determined, specific lower materiality levels for particular classes of transactions, account balances, or disclosures, along with the rationale.
• Any revisions made to these materiality levels as the audit progressed, including the revised amounts and the reasons for the change.