Materiality is an amount which, if known, would likely change the decision of a decision maker. For example, if the financial statements show net income before taxes of $100, but the audit shows net income before taxes of $89, would a decision maker make a different decision about the information if they knew the statements were misstated by 11%? What if the amount of misstatement was 5%? 6%? The auditor must establish an amount or threshold by which to judge whether the financials are fairly stated. The level of materiality is set in the planning stage of the audit.
Materiality is referred to as tolerable error in statistical sampling.
Auditors must determine if financial statements are materially misstated. If material misstatement exists the client must change the amounts or the auditor must render a less than unqualified opinion.
The auditors perception of the "likely users" of the financial statements will influence the level of materiality set for the financials. If the user group is limited, materiality may be set higher than when the user group is assumed to be broad.
Steps in applying materiality
1. preliminary judgment of materiality set early in the planning stage of the audit (professional judgment of an amount that would make the statements misstated)
a. bases are used to establish a dollar amount of materiality. examples of bases include: net income before taxes, net sales, gross profit, total assets. Percentages are often used, such as 5% of net income before taxes.
2. allocate preliminary judgment of materiality to accounts (generally balance sheet accounts). This is often done proportionally, i.e., cash is $100, total assets is $1,000, therefore cash is allocated 10% of the materiality.
3. to determine if account balance is materially misstated, auditor compares a priori judgment of allocated materiality to actual amount of misstatement detected in account (considering both understatement and overstatement net).
Relationship of Risk and Materiality
Risk and materiality must be considered together. The more material an item the greater the audit risk. This means an account or transaction of large dollar size represents a significant threat to the audit if it is misstated. However, when audit materiality increases in amount, audit risk decreases. This means that as the judgment of materiality (tolerable error) increases in amount, the risk to the audit is lessened since the auditor perceives that less evidence is needed for protection in the audit.