What Is Materiality in Auditing and Why Does It Matter?
Learn how materiality shapes audit decisions, influences financial reporting, and evolves with changing standards and stakeholder expectations.
Audits help maintain trust in financial reporting, but not every error or omission receives the same attention. Auditors must determine which issues are significant enough to influence the decisions of users like investors, regulators, and lenders. This judgment relies on the concept of materiality, which shapes how audits are planned, performed, and assessed.
Understanding materiality clarifies important aspects of an audit, from the scrutiny applied to specific accounts to the final opinion issued. It also shows why even small misstatements can sometimes have significant consequences depending on the context.
Defining Materiality
Materiality in auditing relates to the significance of an omission or misstatement in financial reports. Information is considered material if its absence or inaccuracy could reasonably be expected to influence the economic decisions of those relying on the financial statements. This concept acknowledges that while financial statements aim for accuracy, not every detail or potential error carries equal weight.
Major U.S. standard-setting bodies, including the Financial Accounting Standards Board (FASB) and the Public Company Accounting Oversight Board (PCAOB), generally align their definitions, largely influenced by U.S. Supreme Court decisions. Cases like TSC Industries, Inc. v. Northway, Inc. established that a fact is material if there’s a “substantial likelihood that a reasonable shareholder would consider it important.” The FASB echoes this, stating an omission or misstatement is material if “it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced.” Materiality is judged “in light of surrounding circumstances.”
This assessment involves both quantitative (size or dollar amount) and qualitative considerations. An item might be small in value but still material due to its nature. For instance, a small illegal payment could be material if it suggests potential future liabilities or loss of revenue. Other qualitative factors include effects on earnings trends, compliance with loan agreements, connections to fraud or illegal acts, or impacts on important business segments.
Determining materiality requires auditors to exercise professional judgment, informed by their understanding of the information needs of financial statement users as a group. Auditors assume users have reasonable business knowledge, understand audits involve materiality, recognize estimation uncertainties, and make sound judgments based on the information provided.
Impact on Audit Quality
Materiality directly shapes the quality of a financial statement audit by guiding auditor decisions. It influences the scope of the audit, the nature and extent of procedures, and the evaluation of identified misstatements. Materiality helps auditors focus efforts on areas most likely to contain errors significant enough to affect user decisions, enhancing the audit’s effectiveness.
During planning, auditors establish a preliminary materiality level for the financial statements as a whole, guided by auditing standards.1Public Company Accounting Oversight Board. AS 2105: Consideration of Materiality in Planning and Performing an Audit This assessment dictates the audit’s rigor. A lower materiality threshold means less tolerance for misstatement, prompting more extensive procedures to reduce the risk of issuing an incorrect opinion when statements are materially misstated.
The established materiality level affects the nature, timing, and extent of procedures during fieldwork. Auditors use materiality, along with a related concept called “performance materiality,” to determine sample sizes and identify accounts needing closer examination. Performance materiality is set below the overall level to reduce the probability that the total of uncorrected and undetected misstatements exceeds the main threshold. Areas with higher risk or specific significant accounts receive more focused testing.
Finally, materiality is central to evaluating audit results. Auditors accumulate identified misstatements (excluding trivial ones) and assess if they, individually or combined, exceed materiality levels. If the total approaches or surpasses the threshold, auditors may need to perform more procedures or ask management for corrections. The final conclusion on whether financial statements are presented fairly “in all material respects” depends on this evaluation. Auditors must also reassess materiality if new information emerges during the audit.
Key Considerations for Auditors
Auditors rely heavily on professional judgment when assessing materiality, considering several factors beyond just numbers. The auditor’s perception of users’ financial information needs is central to this judgment.
Financial Thresholds
While not solely about numbers, quantitative thresholds are part of the initial assessment. Auditors establish a preliminary dollar amount for materiality to guide planning, often based on benchmarks like pretax income or total assets. However, these are starting points, not rigid rules. The choice of benchmark and percentage depends on the company’s specifics and what users deem important. Professional judgment is applied, considering factors like earnings stability.
Legal Obligations
Legal and regulatory requirements influence materiality judgments. Section 10A of the Securities Exchange Act of 1934, for example, requires specific actions if an auditor suspects an illegal act.2Public Company Accounting Oversight Board. Spotlight: Auditor Responsibilities Regarding Noncompliance With Laws and Regulations The auditor must assess its potential effect on the financial statements, regardless of the initial perceived financial impact. Qualitative factors, like the nature of the act, can make an item material even if the amount is small. Auditors must inform management and the audit committee, and failure by the company to act appropriately regarding a material illegal act could require reporting to the Securities and Exchange Commission (SEC). Compliance with laws and contracts are other qualitative factors.
Public Perception
Materiality is fundamentally tied to the perspective of financial statement users. Auditors must consider how a “reasonable investor” might perceive an omission or misstatement. They assess if information would significantly alter the “total mix” of available data. Qualitative factors are important here; a quantitatively small misstatement could be material if it masks earnings trends, affects regulatory compliance, involves fraud, or relates to a segment vital to the company’s image.3Securities and Exchange Commission. SEC Staff Accounting Bulletin No. 99: Materiality Potential impacts on reputation influence the auditor’s judgment.
Practical Calculation Methods
Auditors use practical methods, guided by professional judgment and standards, to set materiality levels. While definitions focus on influencing a reasonable person’s judgment, practice requires specific monetary amounts. Auditing standards require setting an overall materiality level during planning.
This calculation typically starts by selecting a benchmark from the company’s financial data, such as total revenue, total assets, or profit before tax. The choice depends on the company’s industry, structure, and key user metrics. For instance, profit before tax is common for profit-oriented firms, but its volatility might lead auditors to use normalized figures or more stable benchmarks like total revenue, especially for companies with low profits or undergoing restructuring.
Auditors then apply a percentage to the chosen benchmark, often using common ranges (e.g., 0.5% to 1% of total revenue or assets) but adjusting based on professional judgment and risk assessment. Higher assessed risk usually means a lower materiality level.
Building on overall materiality, auditors determine “performance materiality.” This is set lower than overall materiality to reduce the risk that the sum of uncorrected and undetected misstatements exceeds the main threshold, providing a buffer. Setting performance materiality involves judgment based on understanding the entity, past misstatements, and risk. It often falls between 50% and 85% of overall materiality, adjusted for risk. Performance materiality guides testing for specific accounts or disclosures. Auditors might also set separate, lower materiality levels for particularly sensitive items.
Future Trends in 2024 and Beyond
Auditing is evolving, and materiality application will likely adapt to technology and changing expectations. The integration of data analytics, artificial intelligence (AI), and machine learning offers potential to analyze large datasets more effectively, possibly refining materiality assessments. Technology might help identify anomalies indicating material misstatements less apparent through traditional methods, potentially leading to more dynamic materiality assessments adjusted for real-time data. Standard setters like the PCAOB are considering technology’s impact on auditing standards.
There’s also growing emphasis on incorporating non-financial information, especially Environmental, Social, and Governance (ESG) factors, into materiality judgments. Stakeholders increasingly demand transparency on sustainability performance. This prompts discussion among standard setters about considering ESG matters in materiality assessments. Frameworks from bodies like the International Sustainability Standards Board (ISSB) and regulations like the EU’s Corporate Sustainability Reporting Directive push companies to evaluate sustainability impacts from both financial and societal perspectives (“double materiality”). Auditors will need to navigate these evolving requirements.
These trends suggest future materiality application will involve a more holistic judgment process, potentially considering a wider array of information like forward-looking ESG data and insights from data analytics. International bodies like the International Auditing and Assurance Standards Board (IAASB) recognize these shifts and plan to review standards related to materiality, sustainability assurance, and technology to ensure they remain relevant and promote audit quality globally.4International Auditing and Assurance Standards Board. Elevating Trust in Audit and Assurance: IAASB’s Strategy and Work Plan for 2024-2027 This evolution reflects the need for materiality judgments to keep pace with business complexity, technology, and user information demands.