Chapter Seven – Materiality

Summary

This chapter discusses materiality in relation to planning and executing an audit.

It also presents guidance to the audit team on how to select an appropriate
benchmark and measurement percentage to use in determining materiality.

Introduction
7.01 The audit team’s consideration of materiality requires professional judgment and
considers the needs of users of financial statements. Materiality is the magnitude
of a misstatement or an omission from the financial statements or related
disclosures that the audit team believes would make it probable that the
judgment of a reasonable person relying on the information would have been
changed or influenced by the misstatement or omission. Auditors are responsible
for obtaining reasonable assurance that financial statements and related
disclosures are free from material misstatements (they have no duty to detect
immaterial misstatements). Accordingly, an audit is designed to identify potential
misstatements that, individually or collectively, are material. This objective
requires the audit team to determine and document a materiality amount for each
audit.

The Role of Materiality in Audit Planning and Execution

Planning

7.02 Horizon requires that, during audit planning, the audit team makes and
documents an assessment of planning materiality for the financial statements
taken as a whole for purposes of:
 determining the extent and nature of risk assessment procedures
 identifying and assessing the risks of material misstatement
 determining the nature, timing and extent of further audit procedures

7.03 Planning materiality is determined by applying a percentage to a chosen

benchmark. Examples of benchmarks are total revenues, total assets, cash flows
and earnings before taxes.

7.04 Planning materiality does not establish a threshold below which identified
misstatements are always considered immaterial when evaluating their effect on
the auditor’s report. Chapter 20 provides guidance on financial statement
misstatements, their evaluation and the effect they have on concluding the audit,
 including consideration of qualitative factors that could make an otherwise
quantitatively immaterial item material.

Execution

7.05 If planning materiality alone was used to set the scope of audit procedures, it
would be possible that several misstatements, each of which is less than
planning materiality, could aggregate and result in a material misstatement of the
financial statements. For this reason, the audit team should determine tolerable
error (discussed below), which is an amount less than planning materiality.
Tolerable error is used to determine the scope of audit procedures and is
equivalent to performance materiality discussed in the international standards.

Planning Materiality
7.06 Setting planning materiality too low results in a tolerable error that is too low and
the potential for over-auditing and inefficiency. Setting planning materiality too
high results in tolerable error that is too high and the potential for not obtaining
sufficient, appropriate audit evidence. Audit teams avoid these two extremes by
making two critical audit judgments:
 selecting a suitable benchmark and
 determining a reasonable measurement percentage

Selecting a Suitable Benchmark

7.07 Materiality benchmarks are measures that are relevant to users (especially
investors and creditors) of financial statements. In addition, materiality
benchmarks are GAAP measures. Non-GAAP measures are rarely used even if
the users focus on these metrics as it would be inappropriate to base an audit of
financial statements on a non-GAAP measure. Because several approaches
used by investors and creditors relate to earnings, auditors usually presume that
the most relevant benchmark for a commercial entity ordinarily is earnings before
taxes. However, that presumption may be overcome by other factors.

7.08 Factors that the audit team considers in selecting a benchmark include:
 the elements of the financial statements (assets, liabilities, equity, revenues,
expenses)
 the financial statement measures defined in the financial reporting framework
(financial position, financial performance, cash flows)
 the nature of the entity and the industry in which it operates
 the size of the entity
 the nature of the entity’s ownership and how it is financed

7.09 Normally, loan covenants as well as regulatory and listing requirements should
not affect the audit team’s selection of a benchmark. A lender often negotiates
 covenants to protect itself in the event that the borrower’s financial condition
deteriorates. Such motivations do not define the best benchmark for determining
planning materiality. For example, the existence of an inventory covenant does
not imply that the lender believes inventory is the best benchmark or that the
lender is uninterested in earnings or other potential benchmarks.

7.10 Voyager provides various benchmarks depending upon the industry. One of the
benchmarks is appropriate for most entities. However, if another benchmark (for
example, cash flows) is more relevant to the entity being audited, it is acceptable
to use that benchmark in determining planning materiality. This is achieved in
Voyager by selecting the “Other” benchmark from the drop-down menu. Then in
the “Explanation for benchmark selection” box, document the benchmark used
and the rationale for selection. Instances for alternative benchmark selection
should be rare as the most relevant GAAP measures are assigned according to
the industry selected.

7.11 The audit team must document the considerations that result in the selection of a
benchmark.

7.12 The following guidelines are presented to assist audit teams in selecting an
appropriate benchmark. These guidelines are not meant to be strictly used in all
circumstances. The audit team must exercise their professional judgment.
(Earnings before taxes as used in these guidelines refer to the continuing
operations of the entity.)
 Public entities – earnings before taxes
 Commercial entities operating under normal circumstances – earnings
before taxes
 Entities with volatile earnings – normalized earnings before taxes. Earnings
before taxes ordinarily would not result in a reasonable planning materiality
because of the volatility. Audit teams should normalize earnings before taxes
by averaging recent years (at least three years). The audit team can also
determine the income the entity would earn in “normal” circumstances by
adjusting results for the effects of unusual or non-recurring items; for
example, a restructuring charge.
 Entities operating at breakeven levels – normalized earnings before taxes.
Measuring materiality using earnings before taxes for breakeven entities will
almost always result in an inappropriately low planning materiality. In some
circumstances where users do not focus on earnings, total revenues or total
assets may be suitable benchmarks.
 Entities reporting losses – Normalized earnings before taxes. An important
consideration is the actual composition of the losses. The audit team should
determine whether the losses are actually attributable to abnormal or unusual
items such as impairment write downs. If so, these items should be excluded
from normalized earnings. When losses occur from operations and are
expected to continue on an extended period (e.g., start-up operations,
declining industry), consider using total revenues or total assets. The reported
 loss (as a positive number) may be a suitable benchmark if it is the most
significant factor to users.
 Very small and closely-held entities – normalized earnings before taxes,
total revenues or total assets. Owners sometimes pay earnings out of closely-
held businesses beyond their ordinary salaries. Normalization in such
circumstances would include adding back such remuneration. In other
circumstances, users may focus more on assets that support debt and
therefore total assets is a more appropriate benchmark.
 Entities under buy/sell agreements – equity or total assets. Buy/sell
agreements frequently base the purchase price on equity or total assets. If
that is not the circumstance, earnings before taxes may be more relevant.
 Not-for-profit/governmental entities – total revenues, total contributions, or
total assets. Surrogates for earnings, such as the increase in net assets or
the excess of revenues over expenses are ordinarily not appropriate; as such
measures result in inappropriately low planning materiality levels.
 Employee benefit plans – change in net assets for defined benefit and
defined contribution plans. Claims and insurance premium payments for
health and welfare plans. Total assets can be used when the net change in
assets is not significant.
 Depository institutions – earnings before taxes or total assets.
 Mutual funds – net assets.

7.13 Because the selection of a suitable benchmark involves professional judgment

and has a significant impact on the audit, the audit team is encouraged to
consult, as appropriate.

Determining a Reasonable Measurement Percentage

7.14 After the audit team selects the suitable benchmark, they must determine a
reasonable measurement percentage to apply to the benchmark. Again, this
requires judgment.

7.15 Many auditing textbooks provide examples of measurement percentages

commonly used in practice. The following table presents measurement
percentage ranges to assist audit teams:
Measurement
Benchmark Percentage
Earnings before taxes:
Public entity 5%
Non-public entity 5% to 10%
Normalized earnings before taxes:
Public entity 5%
Non-public entity 5% to 10%
Total revenues ½% to 1%
Total assets ½% to 1%
Equity 1% to 2%
Net assets ½% to 1%
Change in net assets of benefit plans 3% to 8%
Total assets of benefit plans ¼% to ½%
 Claims and insurance premiums of
health and welfare plans 3% to 8%

7.16 When considering which measurement percentage to use, audit teams should
consider factors such as the following:
 User expectations – A common measurement of materiality for public
entities is 5% of earnings before taxes, based on guidelines followed by
regulators and auditors. For non-public entities, the lower end of the range
may also be applicable when the users’ needs or perceptions are sensitive to
reported earnings.
 Prior year’s measures of materiality – Previous materiality judgments may
be useful when conditions are generally the same.
 Other measures of materiality – Other measures might reflect industry
standards such as prevailing return on investment benchmarks.
 The entity’s concept of materiality – The board’s or management’s views
on materiality may provide information that the audit team can benefit from in
making their assessment.
 Engagements with risk – The percentages at the lower ends of the ranges
should be selected for clients identified that present greater risk to the firm.

7.17 In selecting a measurement percentage, it is important to note that the

percentage will often increase as the entity size decreases. Using the higher end
of the range for small entities avoids using an inappropriately low planning
materiality and tolerable error. For example, using ½% of total revenues for an
entity with $2,000,000 in revenue would result in a planning materiality of
$10,000. It may be unlikely that $10,000 would affect a user’s decision about the
financial statements. Accordingly, it may be more appropriate to use a
measurement percentage from the higher end of the scale in this situation.

Tolerable Error
7.18 Tolerable error is an estimate of the maximum amount of misstatement an audit
team can accept in an individual account or group of related accounts. It is an
amount less than planning materiality. Tolerable error should be set at an amount
that will provide the audit team with reasonable assurance that material
misstatements, if they exist, will be detected. Horizon defines tolerable error as
60% of planning materiality.

7.19 Designing audit testing using tolerable error assists in minimizing the risk that
misstatements from individual accounts or groups of accounts will aggregate to a
material amount.

7.20 Tolerable error is smaller than planning materiality because multiple errors that
are less than planning materiality may exist and aggregate to a total exceeding
materiality. The concept of tolerable error also contemplates a “cushion” for
errors that may exist but will remain undetected or underestimated.
 Applying Materiality in Audit Execution
7.21 Planning materiality and tolerable error are important factors in setting the scope
of audit procedures, sampling and the other substantive tests of details. For
example, in the execution of analytical procedures, the audit team would
determine the effect that an error in the amount of tolerable error in one of the
components would have on a ratio under review. As another example, the audit
team uses tolerable error to determine which transactions to test for the
appropriate cutoff of revenue.

7.22 For sampling purposes, Horizon permits precision to be higher than 60% of
planning materiality because sampling error can be measured precisely for
statistical samples, and the sample size is increased to compensate for not
knowing the sampling error in non-statistical samples. Therefore, for statistical
samples, tolerable error is increased to an amount determined by reducing
planning materiality by the expected error in the population. The sample size
calculator in Voyager determines the appropriate sampling precision using
information provided by the audit team regarding:
 planning materiality
 tolerable error
 the expected error rate in the population
 type of sample (statistical or nonstatistical)

Considerations for Lowering Tolerable Error

7.23 In addition to tolerable error, the audit team also uses qualitative factors to
determine the scope of audit procedures and to evaluate the results. For
example, in determining items to examine the audit team could use qualitative
characteristics such as transactions with a related party, posting from a specific
source, special contracts or non-routine transactions. In addition, the audit team
might reduce scopes below tolerable error to make audit procedures less
predictable.

7.24 Some accounts and financial statement items have more risk than others and the
audit team may respond to the identified risk by lowering tolerable error for those
areas. For example, accounts requiring significant judgment, which might include
the allowance for doubtful accounts, and accounts typically used to conceal
fraud, which might include suspense accounts and write-off accounts. Horizon
encourages audit teams to use a lower tolerable error in these circumstances.
These judgments should be documented.

7.25 During the evaluation of audit evidence, tolerable error helps determine the
sufficiency of evidence to meet a given audit objective. For example, when
sampling is used, tolerable error helps the audit team determine if the sample
achieved the planned level of precision.
 Other Topics Related to Materiality

Accumulating Misstatements

7.26 During the execution phase of the audit, differences, including missing
disclosures should be accumulated on the summary of unrecorded
misstatements. At the completion phase of the audit, this schedule assists the
audit team in determining whether misstatements are immaterial, either
individually or in the aggregate.

7.27 The audit team should determine an amount that would be trivial to the financial
statements and differences smaller than this amount need not be included on the
summary of unrecorded misstatements. This amount should be such that small
audit differences, either individually or in their aggregate, could not cause a
material misstatement from both a quantitative and qualitative perspective. While
some amounts may clearly not be material from a quantitative perspective, the
qualitative aspects of materiality cannot be evaluated unless the differences are
captured. For this reason, the amount used as the posting threshold for
differences to be included in the summary of unrecorded misstatements would
not ordinarily exceed 2% of planning materiality. The amount used should be
documented in the workpapers.

7.28 Fraudulent financial reporting, misappropriation of assets involving key

management or management override of controls are always significant,
regardless of how they were discovered or their quantitative amount, and require
follow-up. In addition, such items could influence our judgments in other areas of
the audit and should be included in the summary of unrecorded misstatements
and in the design effectiveness assessment.

7.29 Similarly, illegal acts discovered in executing audit procedures may not be
quantitatively material, but may result in a material contingent liability.
Transactions that are not illegal acts may also have similar characteristics if for
example they represent a breach of contract terms that could lead to a material
penalty or loss of income.

Multi-Location Audits

7.30 Tolerable error should be adjusted when some portions of financial statements
are not being subjected to audit tests (e.g., if accounts receivable will not be
confirmed or inventory will not be observed at all divisions or units). In these
cases, Voyager will adjust tolerable error based on the value of the population
that will be tested as a percentage of the total population value. The audit team
enters both the total and tested population values into the sampling component.
Voyager uses this information to properly adjust the tolerable error and sample
size. The effect of this modification is to employ the same aggregate sample size
 that would have been used had all locations been subjected to testing, although
the sample size will increase for any location subjected to sampling.
For example, a sample of 90 inventory items is required when tolerable
error is $225,000 and total inventory is $9,000,000. If procedures are
applied at all locations and amounts are evenly distributed (based on total
monetary amount) across three locations, the allocation of the sample size
to each of the three locations is 30 per location.
Now, assume the audit team will only perform observation procedures at
two of the three locations making the inventory balance subject to
sampling $6,000,000. Because only two-thirds of the inventory balance
will be subject to testing, tolerable error used to calculate the sample size
should be adjusted as follows:
$225,000 x .667 = $150,000
Since the ratio of tolerable error to total inventory (2.5%) in the first
situation is the same as the ratio of adjusted planning materiality to
inventory subject to sampling in the second situation, the aggregate
sample size is the same. However, because only two locations are to be
subject to observation tests, the sample size at each location has
increased from 30 to 45.

Consolidated Entities

7.31 Planning materiality relates to the financial statement level on which a report is
issued. Accordingly, if the report relates only to consolidated financial
statements, consolidated amounts should be used to compute planning
materiality. If a separate report is to be issued for a unit of a client, planning
materiality should be determined separately for the audit of financial statements
to which that report relates. However, planning materiality for a unit of an entity
should not exceed planning materiality computed for consolidated financial
statements.

Reassessing Planning Materiality

7.32 Ordinarily, the audit is planned before the period end and the audit team
determines materiality at that time. Due to changing circumstances, the entity’s
actual results of operations and financial position may be substantially different to
what was anticipated at the interim date. The most likely example is when an
entity divests of a significant division late in the year and the resulting entity is
much smaller than when planning materiality was determined. In cases such as
this, the assessment of planning materiality may also change and the audit team
should consider revising their assessment of it. This reassessment may adjust
the scope of testing to the appropriate precision.
7.33 Circumstances requiring a decrease in planning materiality are not common. It is
not necessary for the audit team to recompute planning materiality at the
conclusion of the audit unless circumstances discussed in the previous
paragraph are present. If the relative size of the entity has remained substantially
unchanged, then there is no need to address this in the workpapers. The audit
team can continue to use the planning materiality when performing concluding
procedures.