Choosing a materiality benchmark and percentage

• Select a benchmark using the factors in AU-C 320.A6.
• Normalize a volatile earnings benchmark under AU-C 320.A8.
• Choose benchmarks for owner-managed, nonprofit and governmental entities.

Factors that drive the benchmark

AU-C 320.A6 lists factors that affect the choice of benchmark:

• The elements of the financial statements: assets, liabilities, equity, revenue, expenses.
• Items on which users of this entity's statements tend to focus. For performance, users may focus on profit, revenue or net assets.
• The nature of the entity, where it is in its life cycle, and its industry and economic environment.
• Ownership structure and financing. An entity financed solely by debt may lead users to focus on assets and claims on them rather than earnings.
• The relative volatility of the benchmark.

AU-C 320.A7 gives examples: categories of reported income such as profit before tax, total revenue, gross profit and total expenses; total equity; or net asset value. Profit before tax from continuing operations is often used for profit-oriented entities. When it is volatile, gross profit or total revenue may be more appropriate.

The percentage

AU-C 320.A10 says determining the percentage is a matter of professional judgment, and that a percentage applied to profit before tax will normally be higher than one applied to total revenue. The standard does not give numbers. Firm methodologies set ranges by benchmark and adjust within them for qualitative factors: public debt, a pending sale, covenant pressure, first-year audit, known control problems. AU-C 320.A10 points to the AICPA audit guide on risk assessment for further benchmark guidance.

Normalizing

AU-C 320.A8 says relevant financial data ordinarily includes prior periods' results, current period-to-date results and budgets adjusted for significant changes. When profit before tax has an exceptional increase or decrease, you may conclude materiality is more appropriately based on normalized profit before tax drawn from past results. Typical adjustments: a one-time lawsuit settlement, a gain on a building sale, or an unusual impairment. Average several years if earnings swing.

Do not normalize to inflate materiality. If a loss year is the new normal, it is not an anomaly.

Benchmarks by entity type

• Owner-managed businesses. AU-C 320.A11 notes that when profit before tax is consistently nominal because the owner takes profit as compensation, profit before remuneration and tax may be more relevant.
• Nonprofits. Users focus on revenue, expenses and net assets. Total expenses or total revenue are common.
• Governments. AU-C 320.A12 says total cost or net cost may be appropriate for program activities, and assets may be appropriate when a governmental entity has custody of public assets. AU-C 320.A5 explains that materiality is established for each opinion unit in state and local government audits.
• Investment funds. Net asset value.
• Start-ups. Total expenses or total assets while there is no revenue.

AU-C 320.A9 says materiality relates to the statements being audited. A short or long period means the benchmark comes from that period, not an annualized amount.

Documentation

AU-C 320.14 requires documenting materiality and the factors considered in its determination. A complete memo records:

1. Who the users are and what they focus on.
2. The benchmark and why it fits.
3. Any normalization adjustments and the support for them.
4. The percentage and why it sits where it does in the firm's range.
5. The resulting amount.

The audit materiality worksheet follows this layout, and the materiality guide has more benchmark examples.

Common findings

• Same benchmark every year with no reassessment of user focus.
• Revenue used for a profitable company with no explanation, producing a higher amount.
• Normalization adjustments that remove only losses, never gains.
• No benchmark rationale at all.

Normalizing a volatile year