Four numbers set in planning control the whole audit: materiality for the financial statements as a whole, performance materiality, tolerable misstatement for each test, and the clearly trivial threshold. Staff use them every day, often without knowing how they connect. This post builds the chain with one client and shows how each number is used. The concept is in materiality in auditing and AU-C 320, and the SEC staff's qualitative view is in SAB 99 materiality.
The chain
| Level | What it is | Used for |
|---|---|---|
| Materiality for the financial statements as a whole | A preliminary amount based on a benchmark and judgment | Planning, evaluating the effect of misstatements, forming the opinion |
| Materiality for particular items | Lower amounts for items where smaller misstatements would influence users | Specific accounts and disclosures |
| Performance materiality | A portion of materiality set to keep the aggregate of uncorrected and undetected misstatements low | Risk assessment and the nature, timing and extent of procedures |
| Tolerable misstatement | Performance materiality applied to a particular sample | Sample size and evaluation |
| Clearly trivial | The level below which misstatements need not be accumulated | The schedule of uncorrected misstatements |
The GAO Financial Audit Manual states the relationships: materiality drives performance materiality, which drives tolerable misstatement, and the clearly trivial amount sits well below performance materiality so that many small items cannot add up to more than it.
Step 1: Choose the benchmark
The benchmark is the element of the financial statements that matters most to users. The GAO manual points to total assets for capital-intensive entities and total expenses for expenditure-intensive ones. For a for-profit business the usual candidates are pretax income, revenue, total assets or equity. A nonprofit might use total expenses or net assets. The choice depends on what users look at. A volatile benchmark, such as a year with a loss, calls for normalizing.
Record why you chose it, and what you considered and rejected.
Step 2: Choose the percentage
The percentage is a matter of judgment, set by firm policy and the circumstances of the client. The GAO manual's guideline for federal audits is 3 percent of the benchmark, and it asks the auditor to use judgment in deciding whether the calculated level is appropriate. Private-company audits follow the firm's methodology, which sets ranges by benchmark and adjusts for risk, such as the presence of loan covenants, a pending sale or public accountability. Do not copy a percentage from another firm's policy: use yours and record any adjustment for risk.
Step 3: Set performance materiality
Performance materiality is a fraction of overall materiality. The GAO manual's guideline is one-third, to allow for the imprecision of audit procedures and for misstatements that occur across accounts. A firm's methodology may use a higher fraction when risk is low and the client has a clean history, and a lower one when misstatements have been found in prior years or controls are weak. Record the fraction, and why it fits the engagement. The prior-year experience matters: a client with a history of misstatements justifies a lower fraction.
Step 4: Set tolerable misstatement for each test
Tolerable misstatement equals performance materiality for a test of details unless there is a reason to go lower. The GAO manual allows a lower tolerable misstatement for sensitive areas or where the sample population approximates the balance being tested. A lower figure increases sample size. For monetary unit sampling, the interval is tolerable misstatement divided by a risk factor.
Step 5: Set clearly trivial
Pick an amount well below performance materiality. The GAO guideline is 5 percent or less of performance materiality, and it asks for a documented reason for a higher percentage. Misstatements below the threshold are not accumulated unless their nature makes them more than trivial: related party items, items that change a trend or a covenant result, or items that suggest intent.
Worked example
A distributor has revenue of $41.2 million, pretax income of $2.35 million, total assets of $18.6 million and loan covenants tested on EBITDA. The firm's policy allows pretax income or revenue as a benchmark.
| Step | Choice | Amount |
|---|---|---|
| Benchmark | Pretax income, normalized for a one-time $280,000 gain: $2.07 million. Revenue also considered as a cross-check | 2,070,000 |
| Percentage | Within the firm's policy range for pretax income (illustrative); the low end selected because of the covenant and lender reliance | 5% |
| Overall materiality | 5% × 2,070,000 | 103,500, rounded 100,000 |
| Cross-check | 100,000 is 0.24 percent of revenue and 0.54 percent of total assets, reasonable relative to those measures | |
| Performance materiality | 65 percent of materiality: prior-year audit found two misstatements totalling 60,000 and controls over cutoff are weak | 65,000 |
| Tolerable misstatement, receivables sample | Equal to performance materiality | 65,000 |
| Tolerable misstatement, inventory sample | Lower because inventory is the largest asset and prone to estimation error: 50,000 | 50,000 |
| Clearly trivial | 5 percent of performance materiality | 3,250, rounded 3,000 |
| Specific materiality: related party transactions | Any amount, because disclosure is sensitive | Zero threshold |
| Specific materiality: covenant-affecting items | Items that change EBITDA by more than 10,000 | 10,000 |
The covenant row matters. If a covenant has headroom of $150,000, then a $60,000 misstatement is below overall materiality of $100,000 and still might trigger a breach with other items. The auditor evaluates it for the effect on compliance. See loan covenant testing.
Using the numbers during the audit
- Sample sizes: tolerable misstatement drives them. With a $65,000 tolerable misstatement on $5.4 million of receivables, a monetary unit sample at factor 3 uses an interval of $65,000 ÷ 3 = about $21,700 and $5,400,000 ÷ $21,700 = about 250 items.
- Analytical procedures: the threshold for investigating differences is set from performance materiality. The GAO manual uses 20 percent or less for complete reliance and 30 percent or less for partial reliance: $13,000 or less at the $65,000 level here.
- Misstatement accumulation: items under $3,000 stay off the schedule.
- Evaluation: the schedule of uncorrected misstatements is compared with overall materiality and performance materiality. See the SUM schedule.
Revise during the audit
If actual results differ from the planning estimate, or if the auditor learns something that would have led to a different amount, revise materiality and then consider whether performance materiality and the procedures remain appropriate. Set final materiality when preparing the final evaluation, using the final numbers. If the pretax income ends at $1.1 million instead of $2.07 million, materiality drops and some completed work may need extension.
Communicate and document
Document the benchmark and why, the percentage and why, performance materiality and why, the clearly trivial level, any specific levels, and any revisions with the reason. Communicate the scope in the planning letter to governance only as needed. See planning communication. The auditor sets these figures for audit purposes. The client uses its own judgments for financial reporting.
Common mistakes
- Choosing the benchmark that gives the largest number.
- Using the prior year's materiality without updating.
- Setting performance materiality at 90 percent for a client with a misstatement history.
- Leaving clearly trivial at the same level as performance materiality.
- Forgetting qualitative items.
CORAA prepares ready-to-review audit files for US CPA firms; the firm keeps the client, the review and the signature. See /us.
Sources
- AICPA, AU-C Section 320, Materiality in Planning and Performing an Audit; AU-C Section 450, Evaluation of Misstatements Identified During the Audit
- U.S. Government Accountability Office, Financial Audit Manual, Volume 1 (GAO-26-108577), June 2026, FAM 230 (materiality, performance materiality, tolerable misstatement and clearly trivial guidelines): gao.gov
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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