Why auditor use performance materiality

It is also intended to clarify the relationship of materiality in an auditing context to its underlying statistical sampling concepts. The authors hope it will help auditors understand these relationships and concepts, to better use them in their audits and help standards setters and others interested in strengthening auditing standards refocus their agendas on the weaknesses in the current standards. This article will not discuss the recent, highly controversial FASB proposals on accounting materiality.

The distinction between auditing materiality as used in planning for scope determination and accounting materiality as a limiting threshold for waiving adjustments, including with respect to omitted or misstated disclosures is important. It is muddied, however, by the use of accounting definitions for auditing purposes, and the distinction is neither clearly set forth nor illustrated in the auditing literature, nor is it typically discussed in most publicly available nonauthoritative sources.

Simply described, the purpose of auditing materiality is to provide a framework for how much the auditor needs to look for misstatements, while accounting materiality helps the auditor decide what to do with the known and projected misstatements that are found. Because there is no discussion of this distinction in the auditing literature, auditors are prone to confuse those concepts.

The hidden distinction is most easily illustrated and recognized in a statistical sampling context. An authoritative discussion of materiality for audit planning i. Among other things, SAS 47 provided that once planning materiality is determined, a smaller waived adjustment threshold is established. Although unstated in the standard, a waived adjustment threshold is an accounting materiality concept i.

Such aggregate value may be reduced based on qualitative considerations relative to individual proposed adjustments. Unfortunately, both definitions speak only to a limit on unadjusted measurement and disclosure deficiencies rather than to a determination of audit scope.

Audit planning materiality, however, is usually expressed as a multiple of what is described as an accounting materiality because if accounting materiality were to be used for audit planning, it would generally result in significant audit inefficiencies, which in some cases could translate into audit ineffectiveness.

For example, by using a small materiality for a sampling procedure, a large sample size for a substantive test, say, several hundred selections, would likely result. The auditor may adjust the sampling parameters so as to reduce the selection to a more workable number, say, items and possibly try to compensate for the reduction by substituting a less effective substantive procedure, which may inadvertently increase detection risk.

Alternatively, some auditors may arbitrarily reduce sample size without applying compensating procedures; this is highly risky. AU-C A13 AS A2 and AU-C Per AU-C A14 AS These matters are quite complex, and the authors think the literature should be substantially expanded to be useful in this area. This is mainly because performance materiality is calculated based on materiality.

Auditors must first determine the materiality for a particular business, before calculating performance materiality. When setting materiality and performance materiality, auditors must consider several factors, such as the risks of material misstatement in the financial statements and the efficiency of internal controls of the business.

While materiality and performance materiality are closely related to each other, there are still some differences between them. First of all, materiality refers to the idea that a single misstatement in the financial statements of a business can affect the ability of users to make economic decisions based on those financial statements.

On the other hand, performance materiality does not consider the effect of a single misstatement but an aggregate of misstatements. Furthermore, auditors set materiality based on the needs and expectations of the users of the financial statements. This may require auditors to determine the overall risk of misstatement in the financial statements.

In contrast, auditors set performance materiality based on the assessment of audit risk. There are three types of audit risk namely inherent risk, control risk and detection risk. Performance materiality is a crucial concept in an audit. This is because it is closely related to materiality, and can help auditors avoid audit risks. Therefore, auditors can easily reduce the risk of providing an incorrect opinion by using performance materiality. Similarly, auditors cannot only rely on materiality because there is still a chance that some misstatement may occur in immaterial items.

Performance materiality aggregates all those items that are immaterial to check if the aggregate of those items is material. To calculate it, auditors must first calculate materiality. ISA allows auditors to calculate materiality based on benchmarks. Auditors can base materiality on either pre-tax profit, revenue or total assets of a business based on which aspect of the business they deem is more crucial.

A purposefully absurd question to illustrate a point. When accessing a fraud risk, we would use a materaility number, but if looking at an actual incidence of potential fraud, there probably is no materiality. Another one of those audit areas where there is no one right number and we have to make judgements as best we can. Thanks for your comment. I agree with you.

There is much judgment. I find that gray areas like materiality make accountants and auditors nervous. We all seem to love sureness, but our profession demands subjective decisions. Alas, this is where the art of auditing comes into play. Excellent article! One comment, which does not impact anything else said above: In August the FASB revised its definition of materiality to the following: 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.

Simple, professionally referenced, concise yet hugely informative. I certainly got more clarity on materiality from this article than reading all those standards, audit tools and materials out there. Thank you Charles.

Hi Hall, What should one do if the passed audit adjustments exceed the overall materiality level at the financial statement as a whole?! An unmodified opinion is not permissible is material errors are preseent. Please log in again. The login page will open in a new tab. After logging in you can close it and return to this page. So what is materiality in auditing? So how is materiality defined? What is Materiality in Auditing? The Financial Accounting Standards Board provides the materiality definition as follows: 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.

So, consider that material misstatements include: the omission of a significant disclosure an incomplete disclosure a known financial statement line misstatement an unknown financial statement line misstatement an unreasonable estimate Also keep in mind that financial statement readers—management, owners, lenders, vendors—make decisions. Tweet 2. Share March 9, at am.

Charles Hall says:. March 9, at pm. Jim Bennett says:. April 5, at pm. February 27, at am. August 5, at pm. August 9, at am. November 9, at am. It is assessed as part of the audit planning and returned to and reviewed all the way through the process of auditing. It is commonly calculated by using a percentage to a selected benchmark.

Performance materiality is the amounts established by the auditor below the normal materiality of financial reports to decrease the probability that the aggregate of uncorrected and undetectable misstatements exceeds the level of financial reports as a whole. It is generally the amount set below the overall materiality. It can also refer to the amount established by the auditor below the materiality levels of certain transaction classes.

Balances of accounts or revelations.