Materiality in Auditing: Planning Materiality, Performance Materiality and the Clearly Trivial Threshold

Materiality decides how much work an audit needs and how the results are judged. Set it too high and the audit misses errors a user would care about. Set it too low and the team spends weeks testing items that could never change a decision. Every sample size, scoping decision and misstatement evaluation flows from it.

This guide explains how materiality works in a nonissuer audit under AU-C 320, Materiality in Planning and Performing an Audit and AU-C 450, Evaluation of Misstatements Identified During the Audit, with a worked example. The percentages shown are illustrative ranges of the kind used in firm methodologies, not requirements of the standards and not drawn from them; each firm sets its own. The guide paraphrases the standards.

What is materiality in auditing?

Misstatements, including omissions, are material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements. SAS No. 138, Amendments to the Description of the Concept of Materiality in Generally Accepted Auditing Standards, amended AU-C 320 to describe materiality consistently with the way the concept is described in US law.

Three points follow from the definition:

• Materiality is a judgment, made in light of the surrounding circumstances, and is affected by both the size and the nature of a misstatement.
• It is about users as a group. The auditor considers the common financial information needs of users as a group, not the needs of one particular user.
• It is not a single number for everything. The auditor sets an overall level, a lower working level for testing and, sometimes, lower levels for particular accounts or disclosures.

AU-C 320 summary: AU-C 320 explained.

The four amounts auditors set

"Planning materiality" is the informal name for overall materiality set at the start of the audit. "Tolerable misstatement" is the term AU-C 530 uses for the amount applied to a particular sample; it is often set at or below performance materiality.

Choosing a benchmark

Overall materiality usually starts with a percentage applied to a chosen benchmark. AU-C 320 lists factors that affect the choice of benchmark, including:

• the elements of the financial statements, such as assets, liabilities, equity, revenue and expenses
• whether there are items on which users tend to focus
• the nature of the entity, where it is in its life cycle, and its industry and economic environment
• the entity's ownership structure and the way it is financed, for example whether it is financed solely by debt
• the relative volatility of the benchmark

Illustrative benchmarks and percentage ranges of the kind some firm methodologies use (the standards set no percentages):

Avoid volatile benchmarks. If pretax income swings from a profit to a loss year to year, use normalized income (adjusted for unusual items) or a more stable benchmark, and explain the choice. Do not switch benchmarks each year to get a convenient number; document why the benchmark is the one users care about.

Lender-financed private companies are a common case where users focus on EBITDA or covenant metrics. Revenue or an adjusted earnings figure may be more relevant than reported pretax income, and covenant ratios are a reason to consider specific materiality.

Performance materiality

Performance materiality exists because the auditor does not test everything. If each account is tested to overall materiality, small undetected misstatements across many accounts can add up to more than overall materiality. Performance materiality builds in a cushion for undetected and uncorrected misstatements.

Firm methodologies vary; some set performance materiality at a percentage of overall materiality such as 50% to 75%, a range the standards do not prescribe. Factors that point to the lower end:

• a first-year audit, or an entity with a history of many or large misstatements
• higher assessed risks of material misstatement
• weak control environment or high staff turnover in accounting
• many accounts or locations, which increases aggregation risk
• significant estimates with high estimation uncertainty

Factors that point to the higher end are the reverse: a recurring audit with few prior-year misstatements, a stable business and effective controls.

Performance materiality is a judgment, not a mechanical calculation. AU-C 320 says it is affected by the auditor's understanding of the entity, updated during risk assessment, and by the nature and extent of misstatements identified in previous audits.

The clearly trivial threshold

AU-C 450 requires the auditor to accumulate all misstatements identified during the audit, other than those that are clearly trivial. Clearly trivial does not mean "not material." It means amounts of a wholly different, smaller order of magnitude than materiality, that would be clearly inconsequential individually or in aggregate, judged by any criteria of size, nature or circumstances. When there is any uncertainty about whether an item is clearly trivial, it is not.

Firm methodologies vary; some set the threshold at a small percentage of overall materiality, such as 3% to 5%, which the standards do not prescribe. Qualitative items, such as a misstatement involving a related party or a suspected fraud, are accumulated even when the amount is small.

Worked example (illustrative)

An illustrative privately held manufacturer, financed by a bank line with a debt-to-EBITDA covenant.

Step 1: choose the benchmark. Earnings are positive and reasonably stable, and the owners and the bank focus on profitability. Pretax income is the primary benchmark.

Step 2: apply a percentage. At 5% of $2,600,000, overall materiality is $130,000. A cross-check against revenue gives about 0.27% of revenue, below the typical revenue range, which confirms that pretax income is the tighter and more relevant measure here. The team rounds to $130,000.

Step 3: set performance materiality. It is a recurring audit with two small prior-year misstatements, but the inventory reserve involves high estimation uncertainty. The team picks 65%: $84,500, rounded to $85,000.

Step 4: consider specific materiality. The debt covenant is close to its limit. Misstatements of EBITDA smaller than $130,000 could tip it, so the team considers a lower materiality for misstatements affecting EBITDA, documented with the covenant calculation. It also sets a lower amount for related party disclosures, where users care about the existence of the transactions more than their size.

Step 5: set the clearly trivial threshold. At 5% of overall materiality: $6,500.

Step 6: document the reasoning. The workpaper records the benchmark, why it was chosen, the percentages, the qualitative factors and who approved it.

Run your own numbers with the materiality calculator, which shows overall materiality, performance materiality and the clearly trivial threshold side by side.

Revising materiality as the audit progresses

AU-C 320 requires the auditor to revise materiality if the auditor becomes aware of information during the audit that would have caused a different amount to be set initially. Common triggers:

• actual year-end results differ significantly from the interim or budget figures used at planning
• a significant event, such as a disposal or a large impairment, changes the entity's profile
• the benchmark turns out to be misstated by audit adjustments

If materiality is revised downward, the auditor determines whether performance materiality and the nature, timing and extent of further audit procedures remain appropriate. In practice, that may mean larger samples or more accounts in scope.

At completion, AU-C 450 requires the auditor to reassess materiality, based on actual financial results, before evaluating the effect of uncorrected misstatements.

Using materiality to evaluate misstatements

Under AU-C 450, the auditor compares uncorrected misstatements, individually and in aggregate, with materiality, considering both size and nature. Some misstatements are material even though they are below materiality, for example one that:

• changes a covenant ratio from compliance to violation
• turns a loss into income or masks a change in earnings trend
• involves a related party or noncompliance with laws or regulations
• affects a disclosure users rely on, such as a segment or a commitment

The aggregate also matters. If uncorrected misstatements approach materiality, the risk that undetected misstatements push the total over is too high, and the auditor considers whether further procedures are needed. The summary of uncorrected misstatements evaluator tests the aggregate under both the income statement (rollover) and balance sheet (iron curtain) approaches.

How materiality drives sample sizes

Lower performance materiality or tolerable misstatement means larger samples. In monetary unit sampling with no expected misstatement, the sampling interval is tolerable misstatement divided by a reliability factor, so halving tolerable misstatement roughly doubles the sample. In practice, materiality also drives scoping: accounts below performance materiality with low risk may need only analytical procedures, while accounts above it generally get tests of details. AU-C 330 still requires substantive procedures for each relevant assertion of each material class of transactions, account balance and disclosure. See AU-C 530 and the audit risk model.

What to document

AU-C 320 requires documentation of:

• overall materiality
• specific materiality levels, if any
• performance materiality
• any revision of these amounts as the audit progressed

The documentation should also include the factors considered in setting each amount. The clearly trivial threshold is documented under AU-C 450. A number with no explanation of the benchmark or percentage, or materiality that was never reassessed after significant audit adjustments, is a weak file.

Frequently asked questions

What is the difference between planning materiality and performance materiality?

Planning (overall) materiality is the amount for the financial statements as a whole. Performance materiality is a lower amount used to design and perform procedures so that the total of uncorrected and undetected misstatements is unlikely to exceed overall materiality.

What percentage should performance materiality be?

AU-C 320 does not set a percentage. Firm methodologies set their own, for example a range of 50% to 75% of overall materiality, with the lower end where risk or prior misstatements are higher.

What is the clearly trivial threshold in an audit?

It is the amount below which misstatements are not accumulated because they are clearly inconsequential. AU-C 450 sets no percentage; firm methodologies set their own, and qualitative items are accumulated even when the amount is small.

Which benchmark should I use for materiality?

Use the benchmark users focus on and that is reasonably stable, often pretax income for profitable companies, revenue or assets where earnings are volatile, and total expenses for many not-for-profits.

Do I have to disclose materiality in the auditor's report?

No. Materiality amounts are not included in the auditor's report on a nonissuer's financial statements; they are documented in the audit file.

CORAA prepares ready-to-review audit files for US CPA firms; see /us.

Sources

• AICPA, AU-C Section 320, Materiality in Planning and Performing an Audit; SAS No. 138, Amendments to the Description of the Concept of Materiality
• AICPA, AU-C Section 450, Evaluation of Misstatements Identified During the Audit (clearly trivial, reassessing materiality, documentation)
• AICPA, AU-C Section 530, Audit Sampling (tolerable misstatement); AU-C Section 330, Performing Audit Procedures in Response to Assessed Risks

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error