Materiality in an audit: overall materiality, performance materiality and the clearly trivial threshold (ISA 320 and 450)

The director of "Moviy Ko'l Konserva" LLC asked the auditor, Kamola: "You saw a 2.4 million soum error and said nothing, but you had a serious conversation about an 18 million soum error. What is the criterion?" There is a criterion, and it is set as a figure right at the start of the audit. In this article we calculate the three thresholds and the procedure for dealing with errors found, using one company.

Conditions: the company and all figures are hypothetical, compiled by the author. Amounts are in thousand soum. The percentages for performance materiality and the clearly trivial threshold are not a requirement of the standard and are chosen only for explanation.

In Uzbekistan the international standards on auditing are the standards of auditing activity (Law "On Auditing Activity", Article 9). Materiality is covered by ISA 320, the evaluation of misstatements identified by ISA 450.

What is materiality and why is it needed?

A misstatement (including omitted information) is material if it could reasonably be expected, individually or together with others, to influence the economic decisions of users of the financial statements. Materiality depends both on the amount and on the nature of the misstatement. If the auditor does not set it, the auditor knows neither how much work to do nor how to treat an error found.

How do the three thresholds differ?

Step 1: benchmark and overall materiality

ISA 320 gives no single mandatory formula for determining materiality: it is a matter of the auditor's professional judgment. The standard's application material only gives an example: for a profit-oriented entity in a manufacturing industry the auditor may consider 5 percent of profit before tax from continuing operations appropriate, and for a not-for-profit entity 1 percent of total revenue or total expenses.

"Moviy Ko'l Konserva" is a manufacturing company with stable profit. Kamola chose profit before tax as the benchmark:

To see how much the choice of benchmark changes the result: the company's revenue is 15 000 000. Had the auditor taken 1 percent of revenue, materiality would have been 150 000, that is, two and a half times larger. That is why the choice of benchmark and its reason are recorded in the documentation.

Step 2: performance materiality

The standard gives no percentage for performance materiality; the auditor sets it based on the level of risk, misstatements found in previous years and knowledge of the company. Since Kamola is auditing the company for the first year, she took 75 percent of overall materiality (a hypothetical choice):

60 000 × 75% = 45 000

This figure is used in practice: sample sizes and which balances are tested in detail are determined by it.

Step 3: the clearly trivial threshold

Under ISA 450 the auditor accumulates all misstatements identified other than those that are clearly trivial. "Clearly trivial" does not mean "not material": it is an amount of a wholly different, much smaller order than materiality. If there is any doubt whether an error is clearly trivial, it is not considered clearly trivial. Kamola set the threshold at 5 percent of overall materiality (a hypothetical choice):

60 000 × 5% = 3 000

Step 4: accumulating errors

Five errors were found during the audit. All of them overstated profit:

Accumulated errors: 18 000 + 9 500 + 14 000 + 12 000 = 53 500. This is 89.2 percent of overall materiality: almost at the threshold.

Step 5: communicating to management and requesting correction

Under ISA 450 the auditor communicates all accumulated misstatements on a timely basis to the appropriate level of management and requests that they be corrected. The director corrected errors 1 and 3. On errors 2 and 4 he said: "we will take them into account next year".

Step 6: evaluating uncorrected errors

Kamola answers the question whether the uncorrected errors are material individually and in aggregate. 21 500 is well below overall materiality of 60 000. Neither error is of particular significance by its nature: they are not a breach of law or an intentional act, and they do not change the ratio in the loan agreement. Therefore the uncorrected errors do not materially misstate the financial statements.

Had the director corrected none of the errors, the total would have been 53 500, very close to overall materiality. In such a situation the auditor would have to consider seriously the likelihood of exceeding the threshold together with errors not yet found: this is a matter of professional judgment.

Does materiality change during the audit?

Yes. Under ISA 320, if information comes to light that would have led to a different level had it been known at the start, the auditor revises materiality. For example, if at year end profit before tax turns out to be 900 000 rather than 1 200 000, with the same 5 percent materiality falls to 45 000: 900 000 × 5% = 45 000. Then the auditor reassesses whether the work performed is sufficient.

Practical takeaway for the accountant

Every error the auditor finds goes on the list, even a small one. Correcting them before the report is the safest route: the smaller the total of uncorrected errors, the less debate there is about the report.