‘Materiality’ – If you are an audit or accounting professional, this term should sound very much familiar to you. Right from the planning stage up to the issue of Audit report and even while considering the impact of subsequent events, materiality plays a pivotal role at almost every stage in Audit. Considering its importance, lets dive a bit deep into the meaning and importance of materiality.
What is materiality?
As per SA 320 “Materiality in Planning and Performing an Audit”, 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 on the basis of the financial statements.
Confused? Well in simple terms, a financial statement line item or its misstatement would be considered material if it could influence the decisions of the users of the financial statements.
Why is it important to determine materiality?
The process of audit involves making professional judgments in terms of deciding nature, timing and extent of audit procedures to test a particular line item as well as to test the financial statements as a whole. It is not practically possible for the audit team to test each and every item in detail because of deadlines and limited resources.
This is where materiality comes in play. An auditor can determine a materiality level based on which one will plan & perform one’s audit procedures. This would not only save the audit team’s time, but will also make the audit procedure more efficient as the audit team can focus more on material areas of the financial.
How to determine materiality?
Determination of materiality involves professional judgment on the auditor’s part as this process would vary for entity to entity based on its size, nature of business, legal structure, industry, economic conditions etc. To start with, an Auditor needs to select a ‘benchmark’ based on which materiality would be calculated.
Some of the commonly used benchmarks are ‘Revenue, profit before tax, total assets, total equity or total expenses of an entity’. ‘Which benchmark to be used’ is again a matter of professional judgment of the auditor and it is mainly decided based on the users of financial statements and their objectives (for e.g.: Investors or lenders of a business are more interested in knowing its profitability)
Once the appropriate benchmark is selected by the audit team, a certain percentage is applied to the same to derive an amount which is known as ‘overall materiality’.
Revision of Materiality
The materiality level may be revised in case auditor comes across some information during course of the audit, which would have caused the auditor to determine a different amount at the very beginning. Based on such relevant information, the auditor shall assess whether any change in materially amounts, is called for or not.
Auditors need to document the materiality, the evaluation of misstatements and the rational for both as a part of their working papers.
Materiality plays a very crucial role in the tax planning & performance of an audit. While determining appropriate materiality is a bit challenging task and a matter of professional judgment, the benefits derived from it (in terms of increased audit efficiency and improved decision making) outweigh the efforts involved in setting it.
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FSLI – Financial statement line item
EBITDA – Earnings before interest, tax, depreciation and amortization