Performance materiality, also known as tolerable error or tolerable misstatement, is a concept used in auditing. It refers to the amount of misstatement or error in a company’s financial statements that auditors deem acceptable without affecting the overall “true and fair” view of the statements.
Performance materiality is usually set at a level less than overall materiality for the financial statements as a whole. This allows auditors to target and scrutinize areas of the accounts where the risk of material misstatement is greater.
The concept of performance materiality allows for some flexibility during the audit process. For instance, if an auditor discovers errors that collectively exceed the performance materiality level, it indicates a potential risk that the financial statements as a whole might be materially misstated. This could lead the auditor to perform additional testing, or to suggest adjustments to the financial statements.
The specific amount set for performance materiality can vary depending on factors such as the size of the company, the nature of its operations, and the auditor’s professional judgment. It’s worth noting that this concept is intended to help guide the audit process, rather than to provide a definitive threshold for materiality.
Example of Performance Materiality
Imagine a company with total assets of $10 million. An audit firm is conducting an audit of the company’s financial statements. The audit firm sets the overall materiality level at 1% of total assets, which amounts to $100,000. This means that any misstatements or errors which in total exceed $100,000 would be considered to materially affect the understanding of the financial statements.
However, to provide a margin of safety and guide the audit process, the audit firm decides to set the performance materiality at 0.7% of total assets, which amounts to $70,000. This lower threshold serves as a guide for the auditors in evaluating the significance of any errors discovered during the audit process.
Suppose the auditors find several errors during their audit, which, when added together, amount to $60,000. Even though this total is less than the overall materiality level of $100,000, it exceeds the performance materiality level of $70,000.
The excess over the performance materiality level indicates a potential risk of material misstatement in the financial statements. As a result, the auditors might decide to perform additional tests or procedures to investigate the cause of the errors. They may also discuss these findings with the company’s management and suggest making adjustments to the financial statements to correct the errors.