1. Definition
Materiality refers to the significance that an error or omission, individually or collectively (fraud or unintentional error), may have on the economic decisions of the users of the annual financial statements.
Simply put: if the error can change the opinion or choices of an investor, a creditor, or another user, it is significant.
2. Application in Audit
In auditing, materiality is set at two levels:
- OM – Overall Materiality (ISA 320.10): overall threshold for the entire financial statements.
- PM – Performance Materiality (= performance materiality): a lower threshold used to reduce the risk that undetected errors exceed OM (at the level of each individual account or individual balance).
Also established:
- Specific Materiality: reduced threshold for certain sensitive items (even if the error is small, it can influence decisions).
- SAD – Clearly Trivial Threshold: an amount below which an error is considered clearly insignificant and not accumulated.
3. What Makes an Error “Material”
Materiality depends on the size and/or nature of the error. It has no universal value: it varies depending on the company, its context, and its users.
Factors to consider:
- Impact on financial trends (e.g., turning a loss into a profit).
- Effects on key indicators (earnings per share, revenue of a strategic sector, etc.).
- Compliance or non-compliance with contracts, laws, or regulations.
- Influence on management compensation (premiums, bonuses).
- Particular sensitivity (fraud, illegalities, conflicts of interest).
- Classification errors (e.g., confusing current and exceptional expenses).
- Cost of correction vs. benefit of information provided.
4. Role of Materiality in Audit
It is used throughout the audit:
- To plan tests and procedures.
- To identify risk areas.
- To determine the quantity and type of evidence to collect.
- To assess whether detected errors are significant.
- To formulate our final opinion (qualified opinion if significant uncorrected misstatements).
5. Setting the Materiality for Annual Financial Statements (OM)
It is a professional judgment: we start from a calculation basis (benchmark) then apply a percentage.
Possible benchmarks [and suggested ranges]:
- Profit before tax (often the most used, but can be “normalized” in case of significant variations) [3% – 10%].
- Revenue (useful if profit is too unstable or low) [0.5% – 3%].
- Total assets (relevant for investment companies or funds) [1% – 2%].
- Net assets (useful for start-ups or developing companies) [2% – 5%].
Once the benchmark is chosen, a percentage is applied.
In summary:
Materiality is the threshold at which an error becomes significant for the decisions of financial statement users. In auditing, it is set globally. For certain specific items, a threshold for trivial errors is also determined. It is a central tool that influences the entire audit strategy, from planning to the final opinion.
6. Overall Materiality (OM) – Details
OM = materiality threshold for the financial statements as a whole.
If the period covered by the financial statements is not 12 months (new company, change of fiscal year, etc.), OM is calculated for this specific period.
The chosen benchmark (e.g., profit before tax, revenue) should in principle remain the same from one year to the next, unless there is a major change in context.
Example:
- Entity A: stable activity, few stakeholders → materiality based on revenue (€375,000).
- Entity B: preparing for an IPO, more stakeholders → materiality based on profit (€75,000, or 5% of profits, conservative side).
7. When to Set OM?
Sometimes before the preparation of financial statements (based on forecasts or interim statements).
Sometimes after, but taking into account expected significant events (mergers, economic changes, etc.).
- OM is re-evaluated once the actual figures are known.
8. Specific Materiality for a Financial Statement Item
Used for certain sensitive items or information where an error, even if below OM, can influence users’ decisions.
A specific threshold lower than OM is then set.
Typical situations:
- Compliance with a sensitive contractual commitment (e.g., liquidity ratio).
- Specific legal or regulatory requirements (e.g., management compensation, related party transactions).
- Client’s explicit request to examine a balance.
- Strategic items for the sector (e.g., R&D in pharma).
- Separate information in financial statements (segments, acquisitions).
- Cases where the income statement is not very significant but assets are substantial (real estate).
Rules:
- If an error exceeds the specific threshold → adjustment or impact on the audit opinion.
- If it is below → it is noted and accumulated with other errors of the same item for final evaluation.
9. Performance Materiality (PM)
- PM = a threshold lower than OM, set to reduce the risk that uncorrected or undetected errors exceed OM. Reflects the risk of non-detection => safety margin.
- Used to:
- Identify risks of material misstatements.
- Determine sample sizes.
- Set investigation thresholds.
Key points:
- PM generally set between 50% (client with high risk) and 75% of OM.
- The higher the risk → the lower the percentage (ISA 320.11).
- In initial audits, PM is often more conservative (lower), due to limited client knowledge.
- PM may be revised during the engagement if new risks emerge.
In summary:
- OM = main threshold for the entire financial statements.
- Specific Materiality = reduced threshold for sensitive items.
- PM = lower operational threshold to guide tests and limit the risk of overall errors exceeding OM.
10. Clearly Trivial Threshold (Summary of Audit Differences) (SAD) (ISA 450.5)
- Definition:
An amount so small that it is unnecessary to accumulate these errors in the final evaluation.
-> This is not the same as “immaterial”: it is well below, an order of magnitude much lower than OM or PM. - Criteria:
- Amount without consequence even when accumulated with others.
- Amount that could not influence users’ decisions.
- If uncertainty → it is considered by default not trivial.
- Common range:
Generally 5% of OM.
Exceeding 5% = rare and requires justification. - Difference from management expectations:
SAD may be different from the threshold above which the client wants errors to be reported to them. - SAD is only used to set the threshold from which we accumulate misstatements (no effect on work scope).
11. Revision of Materiality During the Audit
- Why revise?
Events or changes in context may render the initial materiality inappropriate. - Examples of triggers:
- Changes in laws or accounting standards affecting investor expectations.
- Signing of major contracts drawing attention to a particular item.
- Steps:
- Revise OM and/or specific materiality.
- Adjust PM if necessary.
- Re-evaluate the nature, timing, and extent of procedures.
