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Audit Materiality

The significance of an amount, transaction, or financial (mis)statement

What is Audit Materiality?

Audit materiality is one of the most important concepts for auditors. Misstatements, including omissions, are considered to be material if, individually or in the aggregate, they are reasonably expected to influence the economic decisions of users of the financial statements. Materiality in audit comprises both quantitative and qualitative aspects.

 

Audit Materiality

 

Quantitative Considerations

When dealing with materiality in quantitative aspects, we must consider the following five steps:

  • Set a preliminary judgment of materiality
    1. This is usually done at the planning stage of an audit
    2. The general rule of thumb is either 1) 5-10% of normalized net income (normalized excludes one-time gains/losses and discontinued operations) or 2) 0.5-2% of total assets
  • Consider performance materiality
    1. Materiality more on a line item basis, i.e., accounts receivable, inventory, etc.
  • Estimate the misstatement in a cycle or account
  • Estimate the total aggregate misstatements
  • Compare this total with the criteria for judgment of materiality to determine if, overall, the financial statements are materially misstated

 

Qualitative Considerations

There are numerous qualitative factors to consider in an audit as well. For example, if a company does not provide adequate disclosures regarding contingent liabilities or related party transactions, this may be considered to be material. In addition, an inaccurate description of an accounting policy may also be material. For example, assume a company chooses to use 50 years to amortize an asset  – but in the note disclosures, it’s useful life is stated to be only five years.

Small errors in financial statements can also lead to severe covenant violations. For example, if the company enters into a covenant with their local bank to maintain a current ratio of 1.0, a minute $2,000 misstatement can change the ratio sufficiently to make it appear the company is in compliance when, in fact, it is in violation of the covenant.

 

Types of Misstatements

When dealing with material misstatements, there are several types of misstatements that auditors must consider. If auditors choose to stratify (i.e., pick out high-value or key items in a balance), these misstatements are known as IMOs. That is, they are Identified Misstatements Other than those derived from representative samples. When auditors follow ordinary sampling to examine data, misstatements in this group are known as IMRs – Identified Misstatements (obtained from) Representative samples. Take a look at the table below.

 

Name of MisstatementDescription
Identified Misstatement (IM)Actual misstatements; Can arise from either representative samples (IMR) or other than representative samples (IMO)
Likely Misstatements (LM)The extrapolated/projected effects of the IMRs
Likely Aggregate Misstatements (LAM)The sum of the IMOs and the likely misstatements (LM)
Further Possible Misstatements (FPM)Possible misstatements as a result of sampling risk (the sample is not representative of the population) and non-sampling risk (auditor failure)
Maximum Possible Misstatements (MPM)The sum of LAM and FPM

 

Example

Let’s say that in this example, inventory is audited using sampling. The identified misstatement in the sample is $1,200 (an overstatement) and the likely misstatement in the entire population (obtained by extrapolating from the misstatement in the sample) is $2,000. Accounts payable is then audited with no sampling and $25,000 of understatements are identified. Further Possible Misstatements (FPMs) are estimated at $2,000.

The materiality level has been set at $30,000, after tax.

In these situations, the easiest way to approach it is to assemble an adjustments schedule. An adjustment refers to what changes should be made to account for the misstatements. Take a look at the following schedule and note that credit balances are put in parenthesis.

 

Adjustment NeededType of MisstatementIncome Statement DR (CR)Balance Sheet DR (CR)
DR COGSLM20,000
CR Inventory(20,000)
DR ExpensesIMO25,000
CR Accounts Payable(25,000)
TOTALLAM45,000(45,000)
Tax Effect(18,000)18,000
LAM (after tax)27,000

 

Comparing the $30,000 materiality threshold to the $27,000 in identified misstatements, we can conclude that the financial statements are not materially misstated. However, we must note that sampling was used when auditing inventory and so there is the potential for further possible misstatements. After adding the FPM value of $2,000, we see that $29,000 is still below the threshold and, thus, we can still reach the same conclusion.

 

Related Readings

We hope you’ve enjoyed reading CFI’s explanation of audit materiality. To learn more, see the following CFI resources:

  • Auditor’s Report
  • Forensic Audit Guide
  • Audited Financial Statements
  • Audit Legal Implications

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