How AS 2105 Defines Audit Materiality
AS 2105 establishes the disciplined framework auditors use, blending quantitative analysis with qualitative insights to shape the focus of an audit.
Auditing Standard (AS) 2105, from the Public Company Accounting Oversight Board (PCAOB), provides the framework for how auditors of public companies consider materiality. The standard directs an auditor’s focus toward errors or omissions in financial statements that could influence the economic decisions of a reasonable person. Rooted in legal precedent, AS 2105 guides auditors to concentrate on areas most likely to contain significant misstatements. This approach ensures the audit is efficient and provides reasonable assurance to investors and other stakeholders by focusing on what truly matters.
The Core Concept of Materiality in Auditing
Materiality is defined from the perspective of financial statement users, such as investors. AS 2105 uses a U.S. Supreme Court definition stating a fact is material if there is “a substantial likelihood that the…fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” This means an error is not judged in isolation but on whether it would change an investor’s perception of the company within the context of all available information. This requires what the Supreme Court called “delicate assessments” of how a reasonable person would interpret the facts.
For example, a $100,000 accounting error in a multi-billion dollar corporation’s revenue would likely be immaterial, as it is unlikely to alter an investor’s view of the company’s overall financial health. However, the same $100,000 error could be highly material if it has a significant contextual impact. If the misstatement allows the company to meet its quarterly earnings forecast or avoid violating a debt covenant, its importance is magnified. In these cases, the error’s effect on performance indicators or contractual obligations makes it material to a reasonable investor.
Establishing Key Materiality Levels
AS 2105 requires auditors to establish a specific, quantified materiality level for the financial statements as a whole. This figure represents the maximum misstatement that can exist without affecting a reasonable user’s decisions. This overall materiality level directly influences the audit plan, as a lower threshold requires the auditor to perform more detailed testing to detect smaller errors.
After setting overall materiality, the auditor determines tolerable misstatement for specific accounts and disclosures. Tolerable misstatement is the maximum error an auditor will accept in an account balance and is set lower than overall materiality. This lower threshold acts as a buffer, reducing the probability that the sum of individually immaterial errors will exceed the overall limit. It also helps the auditor determine the necessary sample size for a given test, such as calculating how many customer accounts need to be tested to obtain sufficient evidence.
Factors Influencing Materiality Judgments
The determination of materiality is a judgment involving both quantitative and qualitative factors tailored to each company’s circumstances.
Quantitative Factors
The process often begins with quantitative benchmarks, where auditors apply a percentage to a key financial statement figure like pre-tax income, total revenues, or total assets. For a stable, profitable company, an auditor might use 5% of income before taxes as a starting point. For a start-up with little income, total revenue or assets might be a more relevant base.
Qualitative Factors
Qualitative factors can make a quantitatively small misstatement material and may lead an auditor to set a lower materiality threshold. These circumstances can significantly impact how a reasonable investor views the financial statements. Important qualitative factors include misstatements that:
- Allow a company to meet analysts’ earnings expectations.
- Help maintain a trend of earnings growth.
- Impact management’s compensation.
- Could cause the company to violate the terms of a loan agreement.
- Involve the risk of fraud, related-party transactions, or illegal acts.
Reassessing Materiality Throughout the Audit
Materiality levels established at the start of an audit are not final. AS 2105 requires auditors to reassess these levels as the audit progresses in response to new information. A reassessment might be triggered if the company’s actual financial results differ significantly from preliminary figures used for planning. The discovery of new risk factors, such as a major lawsuit, could also necessitate a change.
If a reevaluation leads to a lower materiality level, the auditor must consider the effect on work already performed and modify the audit plan. This often means expanding the scope of audit procedures for the remainder of the engagement. More transactions may need to be tested to ensure the auditor obtains sufficient evidence based on the new threshold.