An audit is the process of examining the financial statements of a business by an independent person, called an auditor. The auditor gathers audit evidence regarding the truthfulness and fairness of the financial statements and gives an opinion regarding whether the financial statements are free from material misstatement, either due to fraud or error. Usually, an audit can be either external or internal. However, in both scenarios, the auditor must be independent of the management of the business. To gather audit evidence, auditors must first determine the efficiency of the internal control of the business based on which they can decide the audit procedures to use to gather audit evidence.
When auditors identify any misstatements, they must evaluate whether the misstatements will affect the decisions of the users of the financial statements, whether individually or in aggregate. This basis concept is called materiality and performance materiality. Usually, the materiality of an error depends on certain factors, such as the size and nature of the error concerning the total assets, profits or revenues of the business. It is the responsibility of the auditor to determine what the materiality threshold for an audit is. However, sometimes, auditors may also consider the performance materiality of errors rather than just materiality.
Performance materiality is an amount that auditors set, which is less than materiality. They set performance materiality at a lower amount to reduce the chances of the aggregate value of the uncorrected and undetected errors in the financial statements exceeding materiality. Performance materiality reduces the risk that auditors cannot identify misstatements that are material when aggregated. The International Standard on Auditing that deals with materiality and performance materiality is ISA 320 – Materiality in Planning and Performing an Audit.
Performance materiality and materiality are topics that are very similar to each other. This is mainly because performance materiality is calculated based on materiality. Auditors must first determine the materiality for a particular business, before calculating performance materiality. When setting materiality and performance materiality, auditors must consider several factors, such as the risks of material misstatement in the financial statements and the efficiency of internal controls of the business.
Materiality vs Performance Materiality
While materiality and performance materiality are closely related to each other, there are still some differences between them. First of all, materiality refers to the idea that a single misstatement in the financial statements of a business can affect the ability of users to make economic decisions based on those financial statements. On the other hand, performance materiality does not consider the effect of a single misstatement but an aggregate of misstatements.
Furthermore, auditors set materiality based on the needs and expectations of the users of the financial statements. This may require auditors to determine the overall risk of misstatement in the financial statements. In contrast, auditors set performance materiality based on the assessment of audit risk. There are three types of audit risk namely inherent risk, control risk and detection risk.
Importance of Performance Materiality
Performance materiality is a crucial concept in an audit. This is because it is closely related to materiality, and can help auditors avoid audit risks. Therefore, auditors can easily reduce the risk of providing an incorrect opinion by using performance materiality. Similarly, auditors cannot only rely on materiality because there is still a chance that some misstatement may occur in immaterial items. Performance materiality aggregates all those items that are immaterial to check if the aggregate of those items is material.
How to calculate Performance Materiality
To calculate it, auditors must first calculate materiality. ISA 320 allows auditors to calculate materiality based on benchmarks. Auditors can base materiality on either pre-tax profit, revenue or total assets of a business based on which aspect of the business they deem is more crucial. Auditors use pre-tax profits as a benchmark when the business is primarily profit-making and focuses on profitability. The value of materiality for those businesses is set at 5%-10% of pre-tax profits.
Similarly, auditors can use revenues as a benchmark for materiality as well. For performance materiality based on revenue, the value is much lower at about 0.5%-1% of the revenues of a business. Usually, auditors also use this benchmark for profit-making businesses. Finally, the value of materiality based on total assets is 1%-2% of total assets. Auditors use this benchmark for businesses that don’t focus on profits or are capital intensive.
Apart from whether a business is profit-making or not, there are several other factors that auditors must consider when deciding on which benchmark to use. These factors may include the elements of financial statements, the nature of the business, its ownership and capital structure, whether users focus on particular items, etc.
Once auditors determine the materiality for an assignment, they can also calculate performance materiality based on it. Performance materiality is usually taken as a percentage of materiality. For most audit assignments, it is taken as 75% of materiality as it needs to be lower than materiality. However, for some assignments where the auditor thinks the audit risks are higher, they can use even lower performance materiality than 75%.
Auditors at ABC Co. want to audit the financial statements of XYZ Co. as a part of their annual external audit. To audit the financial statements of XYZ Co., ABC Co. must first decide what an appropriate materiality and performance materiality level is for them. ABC Co. can base materiality for the audit on three benchmarks, revenues, profits or total assets. XYZ Co. provided ABC Co. with their financial statements with the following figures:
Similarly, ABC Co. must determine the total risks associated with the audit of XYZ Co. To do so, ABC Co. has already performed a test of controls to determine the efficiency of internal controls of XYZ Co. ABC Co. believes the risk of material misstatement in the financial statements is low. Therefore, it will use the higher end of the materiality percentage for the benchmarks. Based on the above figures, the materiality of the assignment determined by ABC Co. will be:
|Particulars||Amount ($)||Materiality %||Materiality|
Based on the above calculation, ABC Co. will have to choose which benchmark would be appropriate for the audit. Since XYZ Co. is a profit-making business, ABC Co. can use either pre-tax profit or revenue as a benchmark. As mentioned above, ABC Co. will also consider several other factors before making a decision. For this example, suppose ABC Co. determine pre-tax profit will be the best benchmark. Now that ABC Co. has determined the value of materiality, they can also base the calculation of performance materiality on it.
To calculate performance materiality, ABC Co. must use a lower value as compared to materiality. As the risk for the audit is low, ABC Co. determines the performance materiality would be appropriate at 75% of materiality. Since ABC Co. set materiality at $450,000 based on pre-tax profit, the performance materiality will be equal to $337,500 ($450,000 x 75%).
Suppose ABC Co. wants to apply materiality and performance materiality in its audit assignment. They must compare balances and transactions with materiality, and determine whether the value of those balances or transactions exceeds the materiality. If their values exceed $450,000, ABC Co. will consider them material and apply audit procedure to the balance or transactions. However, if they do not exceed the materiality threshold, ABC Co. will aggregate them and compare them to performance materiality.
Assume ABC Co. wants to evaluate 3 transactions valued at $500,000, $220,000 and $150,000. While the first transaction valued at $500,000 exceeds the materiality of $450,000 the other two transactions don’t. Therefore, ABC Co. will perform audit procedures on the transactions valued at $500,000. However, even though the two other balances are below materiality, ABC Co. will still need to check if they exceed performance materiality.
Therefore, ABC Co. will aggregate the two transactions, which will come to $370,000 ($220,000 + $150,000). Since the combined value of the transactions is above $337,500, which is the performance materiality, ABC Co. will also perform procedures on one or even both of the transactions. Practically, auditors may come across thousands of transactions, the aggregate of which exceeds performance materiality. In these cases, auditors perform audit procedures based on sampling.
Performance materiality is a concept used in auditing that is closely related to materiality. Materiality is a limit set by auditors above which any misstatements are deemed to affect the decisions of the users of financial statements. It is an amount lower than materiality calculated to reduce the chances of the aggregate of items exceeding the materiality of financial statements. To calculate performance materiality, auditors must first calculate materiality based on three benchmarks. Once materiality is determined, auditors can base performance materiality on it. Usually, auditors consider certain factors before calculating materiality and performance materiality.