Materiality
Chapter Twelve
Syllabus topic 3, "Principles of Audit, Materiality, True and Fair view"
Pages 31 to 32 of 98
In one line
An item is material if its omission or misstatement could influence the decisions of a person relying on the financial statements.
The definition, and where it comes from
The Companies Act does not define materiality, but it depends on it throughout: section 143(2) requires a true and fair view, and a view is true and fair notwithstanding immaterial errors. Schedule III's general instruction on rounding off assumes it, and the accounting standards use it constantly.
The working definition is the one above, and it has two halves.
| Half | The test |
|---|---|
| Quantitative | Is the amount large enough to change a decision? |
| Qualitative | Is the item of a kind that would change a decision whatever the amount? |
The quantitative side
An auditor sets working thresholds so that the judgment is applied consistently. Common bases, none of them a rule:
| Base | Typical range |
|---|---|
| Profit before tax | A small percentage |
| Revenue | A smaller percentage |
| Total assets | A smaller percentage |
| Net worth | A small percentage |
Which base is chosen depends on the entity and on who reads the statements. For a company whose readers care about profit, profit is the base. For a loss-making company or one whose profit swings, revenue or total assets is steadier.
Do not quote a percentage in an examination answer as though it were a rule. Say that the auditor sets a threshold on an appropriate base and that the figure is a matter of judgment.
The qualitative side, which carries the marks
Some items are material whatever their size, and naming three of these turns an average answer into a good one.
| Item | Why material regardless of amount |
|---|---|
| Directors' remuneration | The Act requires it to be disclosed and members judge the board on it |
| A related party transaction | Its existence is the information, not its size |
| A transaction that is illegal or unauthorised | It bears on the integrity of the whole |
| An item that turns a profit into a loss | It changes the sign, which changes every decision |
| An item that breaches a loan covenant | A small figure with a large consequence |
| A small fraud by a senior officer | It bears on the reliability of everything he touched |
| Any amount the Act requires to be disclosed separately | The law has decided it matters |
The fourth row is the sharpest illustration. A misstatement of Rs 50,000 in a company with a profit of Rs 40,000 turns a loss into a profit. The amount is small and the effect is total.
What materiality governs
| It governs | How |
|---|---|
| The extent of the work | Higher materiality, less testing; lower materiality, more |
| Which items are examined | Balances below the threshold may be tested only analytically |
| Sample sizes | Directly |
| Whether a misstatement is reported to those charged with governance | Above a lower threshold, all are accumulated |
| Whether the opinion is modified | A material uncorrected misstatement modifies it; an immaterial one does not |
Materiality
The last row is the one to state. Materiality is not an academic idea; it is the line between a clean report and a qualified one.
Materiality and the audit risk
They move in opposite directions.
| If materiality is set | Then |
|---|---|
| Higher | Fewer misstatements matter, so less work is needed, and the risk of missing something that does matter is higher |
| Lower | More misstatements matter, so more work is needed, and the detection risk is lower |
So the auditor sets materiality at planning and reconsiders it during the work, because a lower actual result than expected can make a threshold set on budgeted profit too high.
Two levels an auditor uses
| Level | What it is for |
|---|---|
| Materiality for the financial statements as a whole | The overall threshold, set at planning |
| Performance materiality, a lower figure | Applied to individual balances and classes, so that the total of undetected small misstatements does not exceed the overall threshold |
Performance materiality exists because errors accumulate. Twenty balances each misstated just below the threshold add up to a misstatement far above it.
Quick revision
| The test | Could the omission or misstatement influence a user's decision |
| Two sides | Quantitative, the amount; qualitative, the nature |
| Material whatever the amount | Directors' remuneration, related party transactions, illegality, anything turning a profit into a loss, any statutory disclosure |
| What it governs | The extent of the work, the sample sizes, and whether the opinion is modified |
| Against risk | Higher materiality means less work and more risk |
| Two levels | Overall, and performance materiality, which is lower |
Test yourself
- Give the test for materiality.
- Name three items that are material whatever their size.
- A misstatement of Rs 50,000 in a company with a profit of Rs 40,000. Material?
- What is the relationship between materiality and the amount of audit work?
- Why is performance materiality set lower than overall materiality?
Answer in one sentence
1. An item is material if its omission or misstatement could influence the economic decisions of a person relying on the financial statements.
2. Directors' remuneration, related party transactions, and any transaction that is illegal or unauthorised.
3. Yes, because it turns a profit into a loss, which changes the sign of the result and therefore every decision taken on it.
4. They move in opposite directions: the higher the materiality threshold, the less work is needed and the greater the risk of missing something that matters.
5. Because misstatements accumulate, and several balances each misstated just below the overall threshold would together exceed it.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.