How to Determine Materiality in Audit

Auditors do not provide absolute assurance for audit assignments. It is because they cannot test every single transaction or balance. Usually, auditors work with limitations, such as time, which require them to complete their work before a specific time. However, they still need to test items that they may consider to be material.

What is Materiality in Audit?

Materiality refers to a threshold set by auditors relating to the importance of amounts in a subject matter. It expresses the importance of the underlying matter in terms of the impact on users’ decisions. Usually, auditors specify this amount during the planning process. Based on the audit materiality, auditors determine whether they should test a balance or transaction.

Auditors may consider several factors when determining the materiality in an audit engagement. These factors may relate to the size of the tested item or its nature. While there is some guidance for choosing the materiality for an audit, they still have to use their judgment. Therefore, materiality is a subjective matter and may differ based on specific circumstances.

How to determine Materiality in Audit?

As mentioned, auditors must consider various factors when determining the materiality in audit engagements. It relates to how misstatements in the subject matter affect the economic decisions made by users. Therefore, auditors must primarily focus on setting materiality based on the impact on users’ decisions.

On top of that, auditors must also consider the size and nature of any amounts or misstatements. Some items in the subject matter may not be of significant size. However, they will still be material, based on their nature. For example, amounts relating to compliance with regulatory requirements are inherently material.

Lastly, auditors must also consider the information needs of the users as a group. These factors also play a significant role in determining materiality in audit as different groups may have varying needs. Overall, auditors must use their professional judgment and determine the materiality level for an audit engagement. Usually, however, auditors set a benchmark based on the size of items in the subject matter.

How to determine Materiality level based on size?

In most cases, auditors use several benchmarks to determine the materiality based on size. These benchmarks include revenues or expenses, total assets, and net profit before tax. Usually, auditors use one of these to set a materiality level for an audit engagement. However, they may also use a combination of these.

Once auditors choose a benchmark, they must determine a level for it. There is no specific guidance related to what this level should be. However, there are generally accepted levels that auditors often use. These are as below.

  • 5%-1% of total revenues (or expenses).
  • 1%-2% of total assets.
  • 5%-10% of net profit before tax.

Auditors can also calculate the materiality level under all these categories. Once they do so, they can select a materiality level that they deem appropriate based on their judgment. Based on this level, auditors can also determine the performance materiality in an audit engagement.

Conclusion

Materiality is a crucial concept in audit engagements. It defines a benchmark that allows auditors to determine whether they should test a given subject matter item. Auditors must consider various factors when determining materiality in an audit engagement. Usually, auditors use a benchmark to set a materiality level. However, the process is subjective and requires auditors to exercise their professional judgment.

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