Materiality concepts under AU-C 320

In this lesson you will

Explain the concept of materiality as described in AU-C 320.02.
Describe the reasonable user assumed in AU-C 320.04.
Identify where materiality is used across the audit.
Explain why planning materiality is not a bright line for evaluation.

The concept

AU-C 320.02 summarizes how financial reporting frameworks discuss materiality:

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.
Judgments about materiality are made in light of surrounding circumstances and are affected by size, nature or both.
Materiality involves both qualitative and quantitative considerations.
Materiality is judged against the common information needs of users as a group, not the needs of any single user.

Materiality is about users, not about the auditor's comfort or the client's preference.

The reasonable user

AU-C 320.04 makes the determination a matter of professional judgment, affected by your perception of users' needs. You may assume reasonable users:

have reasonable knowledge of business, economics and accounting, and will study the statements with reasonable diligence;
understand that statements are prepared, presented and audited to levels of materiality;
recognize uncertainty in amounts based on estimates and future events; and
make reasonable judgments based on the statements.

Who the users are shapes the number. A bank lending against receivables, a nonprofit board watching program spending, and a government grantor all look at different things.

Three uses of materiality

AU-C 320.05 describes materiality being applied in planning and performing the audit, evaluating the effect of identified misstatements on the audit, evaluating uncorrected misstatements on the statements, and forming the opinion. In practice:

Planning. AU-C 320.06 says planning judgments about what is material provide a basis for the nature and extent of risk assessment procedures, identifying and assessing risks, and determining the nature, timing and extent of further procedures.
Performing. Performance materiality and tolerable misstatement set the precision of tests and the scope of work on individual accounts. See performance materiality.
Evaluating. AU-C 450 applies materiality to the misstatements you find.

AU-C 320.10 requires you to determine materiality for the financial statements as a whole when establishing the overall audit strategy. AU-C 320.11 requires you to determine performance materiality. AU-C 320.14 requires documenting both, any lower levels for particular items, any revisions, and the factors considered.

Not a bright line

AU-C 320.06 states that planning materiality does not establish an amount below which uncorrected misstatements will always be evaluated as immaterial. Circumstances can make a smaller misstatement material: a covenant breach, a reversal of a trend from profit to loss, a regulatory compliance matter or a misstatement that increases management compensation. AU-C 450.A28 lists these circumstances. The same paragraph of AU-C 320 notes you cannot design procedures to detect every misstatement that could be material solely because of its nature, so planning uses a quantitative amount while evaluation considers both.

What materiality is not

Not a percentage the standards prescribe. AU-C 320.A6 and .A10 describe applying a percentage to a benchmark as a starting point and leave the percentage to judgment; firm methodologies set ranges.
Not fixed at planning. AU-C 320.12 requires revision when new information would have led to a different amount.
Not the same as the threshold for posting adjustments. Management is asked to correct all accumulated misstatements (AU-C 450.07).

Common findings

Materiality computed with no explanation of why the benchmark fits users.
No documentation of factors considered (AU-C 320.14).
Misstatements passed because each one is below materiality, with no aggregation or qualitative evaluation.

The materiality guide and materiality calculator support the steps in the next lessons.

Worked example

Same company, different users

Two entities each report revenue of $30 million and a $1.5 million bottom line.

Copperline Tool & Die, Inc. reports pretax income of $1.5 million. It is owned by a private equity fund that values it on a multiple of earnings, and its bank tests a fixed-charge coverage covenant. Users focus on earnings. The engagement team uses pretax income as the benchmark. Under the firm's methodology, 5% of $1.5 million gives $75,000.

Copperline Community Clinic, a nonprofit with the same revenue figure, has an operating surplus of $1.5 million that swings widely with grant timing. Its board and grantors focus on total expenses and on how money is spent. The engagement team uses total expenses of $28.5 million. Under the firm's methodology, 1% gives $285,000, then the team considers qualitative factors and selects $250,000.

The two numbers differ by more than three times, and both can be appropriate, because the users and their focus differ. Each file documents the users, the benchmark rationale and the percentage under AU-C 320.14.

Self-check

Answer each question before you open the answer.

According to AU-C 320.02, when is a misstatement material?
Show answer
When there is a substantial likelihood that, individually or in the aggregate, it would influence the judgment made by a reasonable user based on the financial statements.
Does AU-C 320 prescribe a percentage for materiality?
Show answer
No. It describes applying a percentage to a chosen benchmark as a starting point and leaves the percentage to professional judgment (AU-C 320.A6 and .A10). Firm methodologies set ranges.
Can a misstatement below planning materiality be material?
Show answer
Yes. AU-C 320.06 says planning materiality is not an amount below which misstatements are always immaterial, and AU-C 450.A28 lists circumstances such as covenant compliance and trend reversals that can make a smaller misstatement material.

Sources

AICPA Statements on Auditing Standards, currently effective (AU-C sections)

Back to the syllabus

Standards are paraphrased from the primary sources listed above; read the source before relying on a requirement. This lesson is training material, not professional advice. Report an error