Audit materiality is a concept to quantify the misstatements, omissions, and errors in financial statements that auditors couldn’t specify.
Performance materiality is a lower threshold than materiality that allows an aggregate review of misstatements in the company’s financial statements.
Material and performance materiality are important concepts to make auditors’ opinions of financial statements fair and correct.
To fully understand performance materiality, let us first discuss the materiality concept in auditing.
The ISA 320 defines materiality in audit as:
“Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken based on the financial statements”
There are numerous definitions of materiality. Many auditing and accounting bodies have developed similar definitions. For instance, the IFRS defines materiality as:
“Information is material if omitting, misstating, or obscuring it could reasonably be expected to influence decisions that the primary users make based on those financial statements.”
Materiality is an auditing concept. The purpose of applying the materiality concept is to evaluate whether misstatements, errors, frauds, or omissions can affect the auditor’s opinion about the fairness and materiality of the financial statements.
Material misstatement can include:
Another key point with materiality is that different users of financial statements and readers of auditors’ opinions can have contrasting views. These users include shareholders, management, creditors, and regulators.
A material misstatement for one user may not have the same effect on another user. The auditor’s objective is to offer a true and fair opinion about the financial statements’ correctness and material in all respects.
The ISA 320 defines performance materiality as:
“The amount set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.”
The performance materiality aims to reduce the impact of materiality. It uses a lower threshold that enables auditors to identify more misstatements.
In practice, auditors can’t evaluate each transaction individually. Thus, they use sampling and other techniques to evaluate the fairness and correctness of the financial statements.
Performance materiality is a similar concept that allows for the risk that there may be several smaller omissions or errors that the auditors couldn’t identify.
However, when aggregated, these smaller errors can cause a significant impact.
Performance materiality aims to reduce the aggregate impact of several smaller errors and misstatements.
The threshold can be set for different metrics differently. Generally, there are no set rules to set the performance materiality threshold.
See also What is a Walkthrough In An Audit? And Why Is It Important?It is a matter of professional judgment.
As discussed above, different users can have contrasting opinions about misstatements. Materiality determined by one user may not be material for the other.
It is a subjective method to determine materiality. Thus, quantification of materiality judgments will be difficult with this approach.
One way to resolve the issue is to set the benchmark standards. These benchmarks can become starting points for determining the materiality and performance materiality.
Common benchmarks for materiality include:
Importantly, there are no rules to set these benchmark standards and which ones to use. Users will determine their preferred benchmarks and threshold materiality standards.
Suppose the following revenue and income figures are available for ABC company for its last three years.
The users of this information can make a professional judgment on whether to use the revenue figure as a benchmark.
Then, whether the threshold of 1.5% of the revenue is appropriate or not.
For instance, another user may argue that profit before tax is a more suitable benchmark for assessing materiality than revenue figures. Or, the use of the 1.5% threshold should be reduced to 1% only.
Similarly, ABC company can set the performance materiality benchmark. A low threshold reduces the risk of undetected misstatements in the financial statements.
Auditors can then plan different responses depending on the performance materiality outcome.
Suppose ABC company sets the materiality at $ 150,000 and performance materiality at $ 100,000 of the net profit figures. Let us assume some calculated performance materiality and responses accordingly.
The response to the performance materiality values will depend on the benchmark standards. For instance, if the same values would result from an evaluation of the gross revenue figures, these values may not have presented the degree of risk and such response from the auditors.
See also Inherent Limitations of Auditing: 7 Limitations You Should KnowUndetected and uncorrected misstatements aggregated can hurt the auditors’ work. Even if individual benchmarks do not show significant performance materiality, aggregated accounts do.
For example, if ABC company in our example had set the materiality and performance materiality benchmarks at $ 150,000 and $ 100,000 of the net profit figures.
The calculated materiality and performance materialities are $ 175,000 and 130,000 respectively.
Combined the materiality figure becomes $ 165,000. If we aggregate this figure with the materiality of $ 175,000, it becomes $ 240,000 which may pose a significant risk depending on the nature and size of ABC company.
The AU-C- 450.11 guides on handling the undetected or uncorrected misstatement materiality. The auditor should assess whether the uncorrected misstatements individually or combined are material or not.
Thus, the auditors will suggest a response after combining the undetected misstatements. Like performance materiality benchmarks, the effect of undetected misstatement may also depend on the evaluated standard.
Audit materiality and performance materiality are both concepts used in financial statement auditing, but they have different meanings and serve different purposes.
Audit materiality refers to the magnitude of an error or misstatement in the financial statements that, in the auditor’s opinion, could reasonably be expected to influence the decisions of the users of the financial statements.
Audit materiality is a threshold that is used to determine whether an error or misstatement is considered significant enough to require further investigation or disclosure in the financial statements.
Performance materiality, on the other hand, is a concept that refers to the amount of audit materiality that is allocated to a specific account or audit area.
Performance materiality is set at a lower level than audit materiality and is used as a benchmark to assess whether the individual misstatements or errors found during the audit are material enough to affect the overall accuracy of the financial statements.
The purpose of performance materiality is to help auditors focus on the areas of the financial statements that are most likely to contain material misstatements.
By setting performance materiality at a lower level than audit materiality, auditors can identify smaller errors and misstatements that could add up to a material misstatement in the financial statements.
See also 8 Types of Audit Evidence All You Should Know!Performance materiality is the amount of materiality the auditor sets for specific accounts or audit areas.
It is a lower level of materiality than audit materiality and is used as a benchmark to assess whether individual misstatements or errors are material enough to affect the overall accuracy of the financial statements.
An auditor uses performance materiality as a benchmark to assess whether individual misstatements or errors found during the audit are material enough to affect the overall accuracy of the financial statements.
The process of using performance materiality typically involves the following steps: