What is audit materiality and how is the threshold set?

During an audit, your auditor won’t treat every figure in your accounts as equally significant.

Instead, they use audit materiality to judge which errors or omissions could affect decisions made by shareholders, lenders, investors and others who rely on the financial statements. Materiality also helps the auditor decide where to focus their work.

However, this doesn’t mean that errors below a certain figure can simply be ignored. In this article, we look at how audit materiality works and how auditors set the threshold.

What is audit materiality?

Audit materiality is a measure of whether an error, omission or misleading disclosure could influence someone using the financial statements.

For example, shareholders might use the accounts to assess performance. A bank may rely on them when reviewing a loan. Potential investors could use them to decide whether to invest in the business.

An issue may be material on its own. Several smaller errors can also become material when considered together.

The Financial Reporting Council’s ISA (UK) 320 sets out how auditors apply materiality when planning and performing an audit.

Why do auditors use materiality?

A statutory audit provides reasonable assurance that the financial statements are free from material misstatement. It does not guarantee that every figure is exact or that the auditor will find every minor error.

Checking every transaction would rarely be practical. It would also make most audits prohibitively expensive.

Materiality allows the auditor to concentrate on the areas that could make a genuine difference to someone using the accounts. It influences the risks they investigate, the evidence they gather and the extent of their testing.

You can read more about how auditors reach their conclusions in our guide to audit evidence.

Is there a standard audit materiality threshold?

There is no single audit materiality threshold that applies to every company.

Auditors usually calculate an initial figure in two stages. First, they choose a financial benchmark that reflects the size and nature of the business. This might be:

• Profit before tax
• Revenue
• Total assets
• Net assets
• Expenditure

They then apply a percentage to that benchmark and consider whether the resulting figure is appropriate for the company.

The choice of benchmark depends on which measure is most relevant to users of the accounts. Profit before tax may be suitable for a consistently profitable trading company. However, it may give a misleading result if profits vary sharply from year to year or the company is close to breaking even. In those cases, revenue, assets or expenditure may provide a more useful measure of the company’s scale.

An FRC Audit and Assurance Sandbox paper describes this as a common approach: selecting a relevant benchmark, applying an expected percentage range and then using professional judgement to set the final materiality figure.

How do auditors determine materiality?

The calculation is only the starting point.

An auditor will also consider the circumstances of the company and the people who use its financial statements. Relevant factors may include:

• The size and nature of the business
• Whether profits are stable or volatile
• The company’s ownership and financing
• The information used by lenders or investors
• Loan covenants and other contractual requirements
• Areas involving significant judgement
• Sensitive transactions or disclosures
• Errors identified in previous audits

An auditor may also set a lower materiality level for a particular balance, transaction or disclosure.

For example, a relatively small omission involving directors’ remuneration or a related party transaction could matter to shareholders. The auditor may therefore apply a lower threshold to that disclosure than to the financial statements as a whole.

What is performance materiality?

Performance materiality is an amount set below the materiality figure for the financial statements as a whole.

Auditors use it because several smaller errors may add up to a material misstatement. There is also a risk that some errors will not be found.

Setting performance materiality at a lower level provides a safety margin. It reduces the risk that undetected and uncorrected errors will together exceed overall materiality.

Performance materiality helps the auditor plan the nature and extent of their work. A lower figure may lead to more testing, although risk and the quality of the available evidence also affect the audit approach.

There is no universal percentage for performance materiality. The auditor sets it using professional judgement and may revise it as the audit progresses.

Is planning materiality different?

The term planning materiality often refers to the overall materiality figure set when the auditor plans the engagement.

At this stage, the auditor identifies the areas most likely to contain a material misstatement. They then design procedures to address those risks.

Performance materiality is lower than this overall figure. It helps the auditor plan the detailed work needed within individual areas of the accounts.

What is a material misstatement?

A misstatement can be an incorrect figure, an omission or the use of an inappropriate accounting treatment.

It can also relate to the way information is classified, presented or disclosed.

A misstatement is material if it could reasonably influence decisions made by someone using the accounts. Auditors consider both individual errors and their combined effect.

For example, several small errors in different parts of the accounts may appear harmless when viewed separately. Together, they could overstate profit by a material amount.

Can a small error still be material?

Yes. Size is important, but it is not the only consideration.

A relatively small error or omission may be material because of its nature or circumstances. Examples could include an issue that:

• Changes a reported profit into a loss
• Affects compliance with a loan covenant
• Hides a change in earnings or another important trend
• Affects directors’ remuneration or a bonus target
• Involves fraud or suspected fraud
• Concerns a director or related party
• Results in a breach of a legal or regulatory requirement

This is why audit materiality cannot be reduced to a fixed percentage.

The central question is not simply, “How large is the error?” The auditor must also ask whether it could change how someone understands or uses the financial statements.

Does materiality mean auditors ignore small errors?

No. Materiality is not permission to keep inaccurate accounting records.

Auditors normally record the misstatements they identify unless they are clearly trivial. “Clearly trivial” refers to matters that are plainly inconsequential, both individually and when considered together. It does not simply mean that an error falls below overall materiality.

The auditor evaluates uncorrected errors at the end of the audit.

They may ask management to correct an error even when it remains below the overall threshold. Correcting it may improve the accounts, prevent errors accumulating or stop the same problem recurring next year.

Can the materiality threshold change during an audit?

Yes.

The auditor sets materiality during the planning stage using the information available at the time. They must reconsider it if new information would have led them to choose a different figure.

For example, the company’s final profit might differ significantly from the forecast used during planning. A major transaction or unexpected event could also change what matters to users of the accounts.

If the auditor lowers materiality, they may need to carry out additional work or reconsider evidence already obtained.

Preparing thoroughly before fieldwork begins can reduce avoidable delays. Our statutory audit checklist explains what finance teams should have ready.

How can materiality affect the audit opinion?

At the end of the audit, the auditor considers whether uncorrected misstatements are material individually or together.

A material misstatement may affect the audit opinion if management does not correct it. The outcome will depend on the nature and extent of the problem.

Our guide to qualified and other audit opinions explains the possible outcomes in more detail.

Materiality is therefore not a tolerance for careless accounting. It is a tool that helps auditors assess what could matter to users of the financial statements.

Need help with your statutory audit?

Audit materiality should form part of a well-planned and clearly explained audit.

Your auditor should help you understand the areas receiving the most attention, the issues identified and any corrections they recommend.

THP’s experienced Audit Services team works closely with directors and finance teams throughout the process. Every audit is led by a senior auditor, with clear communication from planning through to completion.

Get in touch with our friendly team to discuss an upcoming audit or obtain an instant audit fee estimate.