Audit Materiality

Updated on March 29, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Audit Materiality Definition

Audit Materiality is an important part of an audit wherein the company’s misstatements will be considered material in the case. Likely, such misstatement will reasonably influence the users’ economic decision of the company’s financial statement. While considering materiality, both the quantitative and qualitative aspects are considered. In the case of the qualitative aspects, the approach is generally quite difficult to measure compared with the quantitative approach.

Types of Audit Materiality

Types of Audit Materiality

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#1 – Overall Materiality

The level which represents the significant level in the company’s financial statements, which can influence the decision making of the users of the company’s financial statement as a whole, as judged by the auditor appointed by the company, is known as the “overall materiality.”

#2 – Overall Performance Materiality

“Overall Performance materiality” is the materiality level judged by the company’s auditor. It can be the amount that is less than the overall materiality level. This materiality level is reduced from the “overall materiality level” to consider the risk of several smaller errors or omissions that the auditor could not find. But they are material if aggregated in totality, thereby reducing the probability that the aggregate amount of small misstatements exceeds the overall materiality level.

#3 – Specific Materiality

Specific materiality refers to the materiality level set to identify potential misstatements. These may exist in different areas in the company, for certain classes of transactions, and for the account balances that may affect the economic decisions of the users of the company’s financial statement of the company.

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Example of Audit Materiality

Let’s consider an example of Company XYZ Ltd, which took a loan from the bank for $ 100,000. Bank gave the loan but on the condition that the company’s current ratio should not fall below the level of 1.0. The company agreed to this and signed an agreement with the bank in this aspect. While conducting the audit, the auditor of the company came to know about this agreement.

At present, the company’s current ratio is only slightly more than the level of 1.0. Now for the company’s auditor, a minute misstatement of $ 3,000 can be material. It could lead to a violation of the agreement between the company and the bank. With the $ 3,000 misstatement also, the company’s current ratio would fall below the level of 1.0. So this would be considered part of the audit materiality as it could lead to the violation of the agreement. It can reasonably influence the economic decision-making of the users of the company’s financial statement.

Audit-Materiality

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Why is Audit Materiality Important?

  • Audit materiality is an important concept that considers both the quantitative and qualitative aspects. Both aspects impact the economic decision-making of the users of the company’s financial statement. Qualitative aspects such as adequate disclosures concerning the related party transactions, changes in the accounting policy, etc., of the company also significantly influence the economic decision-making of the users of the company’s financial statement.
  • It is the basis on which the auditor’s opinion about the company forms, as the auditor requires to obtain a reasonable level of assurance about whether the company’s financial statements are free from material misstatements or not.

Limitations

  • The auditor may not be able to set the materiality at the proper level, which may hamper the purpose of the same.
  • The misstatement that affects the company’s compliance with the regulatory requirements might not get detected by the company’s auditor.
  • In the case of the qualitative aspects, the approach is generally quite difficult to measure compared with the quantitative approach.

Key Points

  • Both the quantitative and qualitative aspects are considered in the case of audit materiality. The quantitative considerations include setting up preliminary judgment for the materiality; Considering the performance materiality; Estimating the misstatement in a cycle, accounting and Estimating the total aggregate amount of misstatements, etc. The qualitative considerations include providing adequate disclosures concerning the company’s contingent liabilities, providing the proper disclosures concerning the transactions with the related parties of the company, disclosure regarding the change in any accounting policy in the company, etc.
  • While dealing with material misstatements, an auditor must consider all the types of misstatements, including Identified Misstatements, Likely Misstatements, Likely Aggregate Misstatements, Further Possible Misstatements, and Maximum Possible Misstatements.
  • Three types of audit materiality include overall materiality, overall performance materiality, and specific materiality. The auditor uses these as per the different situations prevailing in the company.

Conclusion

Audit materiality provides the opportunity to the user of the financial statement, auditor, and the company. The materiality level is set at the level that could reasonably influence the users’ economic decision-making of the company’s financial statement.

This article has been a guide to what is audit materiality and its definition. Here we discuss three types of audit materiality with the help of an example. We also discuss its advantages and limitations. You can learn more about accounting from the following articles –

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