AU-C 320 Materiality: Performance Materiality, Benchmarks and Documentation

AU-C section 320, Materiality in Planning and Performing an Audit, tells the auditor how to set and use materiality in a GAAS audit of a nonissuer. Materiality drives the scope of procedures, the size of samples and the evaluation of misstatements at the end.

This page paraphrases the standard. The authoritative text is AU-C 320 in AICPA Professional Standards. To run the numbers, use the materiality calculator.

What is materiality in an audit?

Since SAS 138 (effective for periods ending on or after December 15, 2020), AU-C 320 uses the same materiality concept as FASB, the SEC and the courts: misstatements, including omissions, are material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment of a reasonable user relying on the financial statements. The auditor judges this from the common financial information needs of users as a group, not the possible effect on specific individual users, whose needs can vary widely.

Materiality has a quantitative side and a qualitative side. An item can be small in amount and still material because of its nature, such as a misstatement that changes a loss into a profit or hides a covenant violation.

Three different amounts

AU-C 320 and the related sections use three numbers, and they are not interchangeable.

A related term, tolerable misstatement, is used in sampling under AU-C 530. It is performance materiality applied to a specific sampling procedure, and it is not set above performance materiality.

Step 1: Choose a benchmark

Materiality for the financial statements as a whole is a matter of professional judgment, and it is often found by applying a percentage to a benchmark. AU-C 320 does not prescribe the benchmark or the percentage. The application guidance lists factors for choosing a benchmark, including:

• the elements of the financial statements (assets, liabilities, equity, revenue, expenses)
• items users tend to focus on for this type of entity
• the entity's ownership structure and how it is financed
• how stable and volatile the benchmark is

Common benchmarks in practice, depending on the entity:

• profit before tax from continuing operations, for a stable profit-oriented entity
• total revenue or total expenses, where profit is volatile, near zero or not the focus of users
• total assets or net assets, for investment-type entities
• total expenses or revenue, for not-for-profit entities

When profit is unusually high or low in the current year, the application guidance points the auditor to adjusted or normalized results, for example an average of recent years, rather than the volatile figure.

Step 2: Apply a percentage

The standard does not specify the percentage either. Firms usually have a policy or a tool with ranges. The ranges below are illustrative practice conventions. They are not part of the standard and not drawn from an authoritative source:

• about 5% of profit before tax
• about 0.5% to 1% of revenue
• about 0.5% to 1% of total assets
• about 0.5% to 2% of total expenses (common for not-for-profit entities)

Treat these as starting points. A higher-risk entity, one with debt covenants, a pending sale or a going concern question, usually gets a lower percentage. The file should record why the percentage fits this entity.

Step 3: Set performance materiality

Performance materiality is set below overall materiality. The standard does not give a percentage, and it says the amount is a matter of judgment, informed by the auditor's understanding of the entity, the results of risk assessment and the nature and extent of misstatements found in prior audits, which is the basis for expecting misstatements in the current period.

Some firms set performance materiality at roughly 50% to 75% of overall materiality. That range is illustrative practice, not a standard. A possible pattern:

• toward the lower end for a first-year audit, a weak control environment or a history of corrected misstatements
• toward the higher end for a repeat audit with strong controls and few past adjustments

Materiality for particular classes of transactions, balances or disclosures

If there are specific classes of transactions, account balances or disclosures where misstatements of a lesser amount than overall materiality could reasonably be expected to influence the judgment of a reasonable user, the auditor sets a lower materiality level for them. Typical examples:

• related-party transactions and balances
• officer or director compensation
• amounts that affect compliance with a debt covenant
• items tied to a grant or regulatory requirement

Where such a level is set, the auditor also sets a performance materiality for it.

A worked example

A privately held distributor has pretax profit of $1,800,000 and revenue of $42,000,000. Profit is stable, so the auditor selects profit before tax as the benchmark.

Every percentage here is illustrative. The file would explain the benchmark, the percentages and the reasons for the lower level on related parties.

Revising materiality during the audit

Materiality set at the planning stage is not fixed. The auditor revises it if information becomes available during the audit that would have led to a different amount initially. One trigger is actual results that come in well above or below the figure used at planning. The auditor then reconsiders performance materiality, and whether the nature, timing and extent of further audit procedures are still appropriate.

Using materiality at the end of the audit

Materiality for the financial statements as a whole is also the reference for the evaluation under AU-C 450. The auditor accumulates misstatements above the clearly trivial threshold, considers them individually and in aggregate against materiality, and takes qualitative factors into account. Misstatements below the overall number can still matter. See AU-C 450 evaluation of misstatements.

What must be documented?

AU-C 320 asks the auditor to include in the audit documentation the following amounts and the factors considered in setting them:

• materiality for the financial statements as a whole
• if applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures
• performance materiality
• any revision of these amounts as the audit progressed

Because the factors behind each amount must be documented, record the benchmark, the percentage and why they fit this entity. A figure with no recorded reasoning does not meet that requirement. See AU-C 230 audit documentation for the general rules.

File checks on materiality

These are practice checks, not requirements of the standard. Weaknesses to look for:

• Materiality is calculated but the benchmark is not explained
• A single percentage is used for every client with no link to risk
• Performance materiality is the same as overall materiality, or is not documented at all
• Materiality is never revisited after the final numbers differ from the planning numbers
• Tolerable misstatement in samples exceeds performance materiality
• Qualitative factors are ignored when evaluating small uncorrected misstatements

Related

• AU-C 315 risk assessment and SAS 145
• AU-C 530 audit sampling
• AU-C 450 evaluation of misstatements
• AU-C 230 audit documentation
• Materiality calculator (AU-C 320)

Sources

• AICPA, AU-C Section 320, Materiality in Planning and Performing an Audit (AICPA Professional Standards)
• AICPA, SAS No. 138, Amendments to the Description of the Concept of Materiality (audits of periods ending on or after December 15, 2020)
• AICPA, AU-C Sections 230, 315, 450 and 530 (cross-referenced sections)

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