Materiality, in the context of a financial statement audit, is a concept that refers to the magnitude of an omission, misstatement, or error that, individually or in aggregate, could reasonably be expected to influence the economic decisions of users made based on the financial statements. Auditors use materiality to plan and perform audit procedures, evaluate the effect of identified misstatements, and form an opinion on whether the financial statements are free from material misstatement.
Materiality includes both quantitative and qualitative considerations:
- Quantitative considerations: Quantitative materiality typically involves setting a threshold based on a percentage of a relevant financial statement benchmark, such as revenue, net income, total assets, or equity. This threshold helps auditors in planning the audit scope, determining the nature, timing, and extent of audit procedures, and evaluating the impact of misstatements on the financial statements. The specific percentage and benchmark used may vary depending on the industry, size, and nature of the entity, as well as the auditor’s professional judgment.
- Qualitative considerations: Qualitative materiality factors take into account the nature and context of a misstatement rather than just its size. Qualitative factors can make an item material, even if it is quantitatively immaterial. Some qualitative factors that auditors may consider include:
- Misstatements that affect compliance with regulatory requirements, loan covenants, or contractual agreements.
- Misstatements that impact earnings trends, such as a change from a profit to a loss or vice versa.
- Misstatements that influence key financial ratios or metrics used by investors, creditors, or other stakeholders.
- Misstatements that affect the entity’s ability to meet analysts’ expectations or industry benchmarks.
- Misstatements that involve fraud, whether due to fraudulent financial reporting or misappropriation of assets.
- Misstatements that relate to the improper recognition, measurement, presentation, or disclosure of financial statement elements.
- Misstatements that involve significant transactions with related parties or that lack commercial substance.
- Misstatements that conceal illegal acts or transactions.
Materiality, as it relates to the financial statements and related disclosures as a whole, involves evaluating the combined impact of quantitative and qualitative factors on the financial statements. Auditors need to exercise professional judgment when determining materiality levels, taking into account the needs and expectations of the financial statement users, as well as the specific circumstances of the entity being audited.