Materiality Threshold in Audits

What is the Materiality Threshold in Audits?

The materiality threshold in audits refers to the benchmark used to obtain reasonable assurance that an audit does not detect any material misstatement that can significantly impact the usability of financial statements.

It is not feasible to test and verify every transaction and financial record, so the materiality threshold is important to save resources, yet still completes the objective of the audit.

Materiality Explained

Materiality can have various definitions under different accounting standards, such as the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS). Other more specific accounting standards may apply in different circumstances.

Under U.S. GAAP, the definition for materiality is “The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” 

On the other hand, the definition under IFRS, “information is material if omitting, misstating, or obscuring it could reasonably be expected to influence decisions that the primary users make on the basis of those financial statements.”

Stated otherwise, materiality refers to the potential impact of the information on the user’s decision-making relating to the entity’s financial statements or reports.

Users of financial statements include:

• Shareholders
• Creditors
• Suppliers
• Customers
• Management
• Regulating entities

Example of Materiality Threshold in Audits

There are two transactions – one is an expenditure of $1.00, and the other transaction is $1,000,000.

Clearly, if the $1.00 transaction was misstated, it will not make much of an impact for users of financial statements, even if the company was small. However, an error on a transaction of $1,000,000 will almost certainly make a material impact on the user’s decisions regarding financial statements.

Determining Materiality

No steadfast rule exists for determining the materiality of transactions within financial statements. Auditors must rely on certain principles and professional judgment. The amount and type of misstatement are taken into consideration when determining materiality.

In the example above, there are two transactions of absolute dollar amounts. However, in practice, determining materiality is more effective on a relative basis.

For example, instead of looking at whether a transaction of $1.00 or $1,000,000 is considered to be material, the auditor will refer to the percentage impact that the misstatement may have on the financial statements.

So, for a company with $5 million in revenue, the $1 million misstatement can represent a 20% margin impact, which is very material.

However, if the company has $5 billion in revenue, the $1 million misstatement will only result in a 0.02% margin impact, which, on a relative basis, is not material to the overall financial performance of the company.

If the $1 million error was due to fraudulent behavior – perhaps an executive employee embezzling money from the company – this misstatement can be considered material since it involves potential criminal activity.

Therefore, it is crucial to consider not only the absolute and relative amounts of the misstatements but also the qualitative impacts of the misstatements.

Methods of Calculating Materiality

The International Accounting Standards Board (IASB) has refrained from giving quantitative guidance and standards regarding the calculation of materiality. Since there is no benchmark or formula, it is very subjective at the discretion of the auditor.

However, some academic bodies have developed calculation methods.

Norwegian Research Council Materiality Calculation Methods

The Norwegian Research Council funded a study on the calculation of materiality that includes single rule methods in addition to variable size rule methods.

Single Rule Methods:

• 5% of pre-tax income
• 0.5% of total assets
• 1% of shareholders’ equity
• 1% of total revenue

Variable Size Rule Methods:

• 2% to 5% of gross profit (if less than $20,000)
• 1% to 2% of gross profit (if gross profit is more than $20,000 but less than $1,000,000)
• 0.5% to 1% of gross profit (if gross profit is more than $1,000,000 but less than $100,000,000
• 0.5% of gross profit (if gross profit is more than $100,000,000)

There are also blended methods that combine some of the methods and use appropriate weighting for each element.

Discussion Paper 6: Audit Risk and Materiality (July 1984)

This published paper gives methods for ranges of calculating materiality. Depending on the audit risk, auditors will select different values inside these ranges.

• 0.5% to 1% of total revenue
• 1% to 2% of total assets
• 1% to 2% of gross profit
• 2% to 5% of shareholders’ equity
• 5% to 10% of net income

They can be combined into blended methods as well.

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