The following requirements are excerpted from AU-C Section 320 (the complete section should be read for a thorough understanding of materiality concepts):

• 10 When establishing the overall audit strategy, the auditor should determine materiality for the financial statements as a whole. If, in the specific circumstances of the entity, one or more particular classes of transactions, account balances, or disclosures exist for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users, then, taken on the basis of the financial statements, the auditor also should determine the materiality level or levels to be applied to those particular classes of transactions, account balances, or disclosures. (Ref: par. .A3–.A13)
• 11 The auditor should determine performance materiality for purposes of assessing the risks of material misstatement and determining the nature, timing, and extent of further audit procedures. (Ref: par. .A14)

Some practical issues: definitions

 Previously used terms, such as planning materiality and tolerable misstatement, have been changed by AU-C Section 320 to materiality and performance materiality, respectively. Performance materiality applied to sampling applications is now termed tolerable misstatement. While Section 320 requires a distinction between performance materiality and tolerable misstatement, practically it will be rare when there is an identifiable difference. Following is a definition paraphrased from Section 320:

Materiality: materiality concepts generally are that misstatements are considered to be material if they may be expected to influence the economic decisions of users of the financial statements.

Judgments about materiality are made in light of risk evaluations and the needs of financial statement users.

Materiality, similar in concept to the previously used term “planning materiality,” may be practically defined as the maximum amount of known and unknown error an auditor can accept in the financial statements taken as a whole without adjustment. As you can see below, this is also the definition of performance materiality.

Performance materiality: the amount or amounts determined by the auditor, based on the assessed level of risk at the financial statement level, which is less than materiality for the financial statements as a whole. The amount of performance materiality is considered necessary to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements is greater than materiality. Performance materiality may also refer to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances, or disclosures.

Tolerable misstatement: tolerable misstatement is essentially the maximum amount of known and likely error an auditor can accept in a financial statement classification without adjustment. As one can see, it will be difficult to find circumstances when performance materiality at the account class or transaction level is different from tolerable misstatement.

Materiality levels and error definitions

 Quantifying material levels based on assessed levels of material misstatement, including calculating the lower limit for individually significant items, enables the auditor to identify material unusual matters (risks of material misstatement). As indicated in the excerpts from AU-C Section 320 above, these risks of material misstatement will precipitate changes in the nature, extent, and timing of further auditing procedures.

 Substantive evidence from these procedures may identify errors. The amount of known and likely error in financial statement classifications is compared with the amount of performance materiality to determine if an acceptable level of error remains in the financial statements during the completion phase of an audit.

Known and likely error (uncorrected error) includes:

1. Known but unadjusted error (passed adjustments) less than the lower limit for individually significant items and greater than any “paper pass”
2. Projected error from sampling applications.
3. Estimated error from tests of accounting estimates and other procedures, such as predictive analytical procedures that are designed to provide most of the substantive evidence for certain financial statement classifications.

The reversing effects of the prior year’s errors must also be reflected in the current year’s aggregation of error, at least by material financial statement classifications, to support the in-charge accountant and engagement leader’s conclusions about an acceptable level of error in the financial statements.

Source: accountingweb.com – By Larry Perry CPA