Materiality

A misstatement is material if it could reasonably be expected to influence the economic decisions users make on the basis of the financial statements. Materiality is therefore a matter of professional judgement about users, not a number written into a standard.

ISA 320 asks the auditor to set overall materiality for the financial statements as a whole at the planning stage. In practice this starts with a benchmark and a percentage:

• Profit before tax from continuing operations is the usual benchmark for profit-oriented entities. Around 5% is a common rule of thumb, but ISA 320 gives it only as an example.
• Revenue or total expenses suit entities where profit is volatile, close to break-even, or not the focus (not-for-profits); percentages of around 0.5–1% are typical.
• Total assets or net assets suit asset-holding entities such as investment funds.

If profit is distorted by a one-off item, auditors often use normalised profit (excluding it) or an average of several years. The benchmark, the percentage and the reasons are all documented.

Performance materiality is set below overall materiality — commonly 50–75% of it — to reduce to an appropriately low level the probability that the total of uncorrected and undetected misstatements exceeds overall materiality. It is lower when risk is higher: a first-year audit, a history of misstatements, or weak controls point towards the lower end. Performance materiality drives the extent of testing and sample sizes.

ISA 450 also has the auditor accumulate all misstatements except those that are clearly trivial — a threshold often set at around 3–5% of overall materiality. "Clearly trivial" means inconsequential by size and nature; it isn't another word for "immaterial".

Materiality isn't only quantitative. A small misstatement can be material by nature: it turns a profit into a loss, hides a covenant breach, affects directors' remuneration or related-party disclosures, or masks a change in trend. And if the actual results turn out very different from the forecast used at planning, the auditor revises materiality (ISA 320.12) and reconsiders whether the work done is still enough.