Due to practical limitations, any auditor cannot carry out the examination of all the transactions and balances, so materiality ensures covering the transactions significant enough to influence the decisions of the users of the financial statements.
Also, materiality is an essential concept since, materiality and audit risk are directly related i.e., higher the level of materiality, higher is the audit risk and likewise.
SA-320 deals with the concept of materiality in Indian domain. It states that “Misstatements, including omissions, are considered to be material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements”. Further, size and nature of items are determinant of materiality. Materiality shall be considered both at financial statement level as well as individual transactions or account balances.
Generally, materiality would mean percentage of benchmark (such as sales, profits, net worth etc.) to be made part of audit assessment.
Types of Materiality
- Overall Materiality/ Planning Materiality: This materiality is applicable for financial statement level to ensure its correctness and completeness and free from material misstatements. It represents the aggregate of misstatements in the entire financial statement, in excess of which misstatements are required to be eliminated or reduced.
- Performance Materiality: It refers to amount set by the auditor in planning and actual performance of the audit. It is calculated as a percentage of overall materiality level (usually 50-75%). It depicts the level of misstatements above which general ledgers are to be verified.
- Audit misstatement posting threshold: It is similar to performance materiality. The only difference is that it is applied to individual transactions and not on a financial statement level. It is calculated as a percentage of performance materiality (usually 5%). It represents a level in excess of which individual transactions are to be verified.
Selection of Benchmarks for Determining Materiality
The determination of materiality level depends on complexity of transactions, volume of transactions and nature of transactions. Generally, following benchmarks shall be considered for the various entities in order to establish materiality level.
- In case of profit-oriented entity: Profit before tax
- In case of entity with low profits: Total revenue
- In case of entity financed with debt: Total assets
- In case of volatility in profit before tax: Gross profit
After selecting the benchmark to be considered for the calculation of materiality, an auditor needs to apply the percentage for the calculation of materiality. In ordinary circumstances, following percentages can be applied.
- Gross revenue: 0.5% to 1%
- Total assets: 1% to 2%
- Net profit: 5% to 10%
- Gross profit: 1% to 2%
- Shareholders’ equity: 2% to 5%
Suppose a company is a profit oriented one since it is in growing stages of its business cycle. Its profit before tax is Rs. 10,00,00,000. Now,
Planning materiality = 5% of Profit before tax = Rs. 50,00,000
Performance materiality = say 75% of planning materiality = Rs. 37,50,000
Audit misstatement posting threshold = say 5% of performance materiality = Rs. 1,87,500
Revision of Materiality
The materiality level may be revised in case auditor comes across some information during course of the audit, which would have caused the auditor to determine a different amount at the very beginning. Based on such relevant information, the auditor shall assess whether any change in materially amounts, is called for or not.
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