Performance materiality and how to set it

In this lesson you will

Explain the purpose of performance materiality using AU-C 320.09 and .A15.
Set performance materiality based on risk and expected misstatement.
Distinguish performance materiality from tolerable misstatement.

Why a lower amount

AU-C 320.A15 explains the problem: planning only to detect individually material misstatements overlooks that individually immaterial misstatements can add up to a material amount, and leaves no margin for misstatements you do not detect.

AU-C 320.09 defines performance materiality as the amount or amounts set at less than materiality for the statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality. AU-C 320.11 requires you to determine it for assessing risks and determining the nature, timing and extent of further procedures.

What drives the amount

AU-C 320.A15 says determining performance materiality is not a simple mechanical calculation. It is affected by:

your understanding of the entity, updated during risk assessment; and
the nature and extent of misstatements found in previous audits, and therefore your expectations about misstatements this period.

Firm methodologies express this as a percentage of overall materiality, commonly a range, and move within the range on factors like:

Factor	Pushes performance materiality
First-year audit, no history	Lower
Many or large misstatements in prior years	Lower
Significant deficiencies, weak control environment	Lower
High turnover in accounting staff	Lower
Stable entity, few prior adjustments, effective controls	Higher

Pick a point and write the reason. "75%, standard" is not a reason.

Performance materiality "amounts" can be plural. AU-C 320.09 also covers amounts set below the materiality level for particular items; see materiality for particular items. You can also set a lower performance materiality for a specific higher-risk account.

Tolerable misstatement

AU-C 320.09 states performance materiality is distinguished from tolerable misstatement. AU-C 530.A6 explains that tolerable misstatement is the application of performance materiality to a particular sampling procedure. It may equal performance materiality or be smaller, for example when the population sampled is smaller than the account balance.

If accounts receivable is $4 million and you sample from the $2.5 million of balances under your key-item threshold, the tolerable misstatement for that sample considers that the key items were tested separately. It cannot be larger than performance materiality.

How it is used

Scoping. Accounts below performance materiality with no qualitative risk often need limited work, and the stand-back checks the decision.
Substantive analytics. The threshold for investigating differences is usually set with reference to performance materiality.
Sample sizes. Tolerable misstatement is a direct input to statistical sample sizes. Halving it doubles a monetary unit sample when no misstatement is expected, and more than doubles it when some is.
Key items. Many methodologies select all items above performance materiality for testing.

Common findings

Performance materiality set at the top of the range with no rationale in a year with significant prior adjustments.
Tolerable misstatement larger than performance materiality.
Particular-item levels set but no matching performance materiality.
No reconsideration after many misstatements were found in fieldwork (AU-C 320.13 and AU-C 450.06).
The same percentage used every year with no link to the prior year's misstatement history.

Write the rationale in the materiality memo next to the number, so the reviewer sees the factors and the result together. When fieldwork changes the picture, update both.

The performance materiality worked example carries one entity through all the levels.

Worked example

Setting performance materiality after a messy year

Tidewater Seafood Processors, Inc. has overall materiality of $200,000. The firm's methodology range for performance materiality is 50% to 75% of materiality.

Facts: last year the audit found 11 misstatements totaling $165,000, including a $90,000 inventory cutoff error. The controller left in August and a new one started in October. The auditor communicated a significant deficiency in the close process.

The team selects 50%: performance materiality = $200,000 x 50% = $100,000. Rationale: prior-year misstatements of $165,000 equal 82.5% of materiality, so expected misstatement is high; the accounting turnover and the deficiency increase the risk of undetected errors.

For inventory, where last year's largest error occurred, the team sets a lower performance materiality of $70,000.

Sampling: the inventory price test population is $3.1 million after removing 12 key items over $70,000 totaling $1.4 million. Tolerable misstatement for the sample is set at $70,000, equal to the inventory performance materiality, and the key items are tested 100%.

Self-check

Answer each question before you open the answer.

Why is performance materiality set below overall materiality?
Show answer
To reduce to an appropriately low level the probability that uncorrected and undetected misstatements together exceed materiality (AU-C 320.09 and .A15).
Is performance materiality the same as tolerable misstatement?
Show answer
No. Tolerable misstatement applies performance materiality to a particular sampling procedure and may be equal to or smaller than it (AU-C 530.A6).
Prior audits found many misstatements. Which way should performance materiality move?
Show answer
Lower. AU-C 320.A15 makes prior misstatements and expectations of current misstatements a factor; more expected misstatement leaves less margin for undetected misstatement.

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