ASA 320

This Auditing Standard deals with the auditor’s responsibility to apply the concept of materiality in planning and performing an audit of a financial report.  ASA 450 ^[1]  explains how materiality is applied in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial report.

Financial reporting frameworks often discuss the concept of materiality in the context of the preparation and presentation of a financial report. Although financial reporting frameworks may discuss materiality in different terms, they generally explain that:

• Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial report;
• Judgements about materiality are made in light of surrounding circumstances, and are affected by the size or nature of a misstatement, or a combination of both; and
• Judgements about matters that are material to users of the financial report are based on a consideration of the common financial information needs of users as a group.^[2] The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered.

Such a discussion, if present in the applicable financial reporting framework, provides a frame of reference to the auditor in determining materiality for the audit.  If the applicable financial reporting framework does not include a discussion of the concept of materiality, the characteristics referred to in paragraph 2 of this Auditing Standard provide the auditor with such a frame of reference.

The auditor’s determination of materiality is a matter of professional judgement, and is affected by the auditor’s perception of the financial information needs of users of the financial report. In this context, it is reasonable for the auditor to assume that users:

1. Have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information in the financial report with reasonable diligence;
2. Understand that the financial report is prepared, presented and audited to levels of materiality;
3. Recognise the uncertainties inherent in the measurement of amounts based on the use of estimates, judgement and the consideration of future events; and
4. Make reasonable economic decisions on the basis of the information in the financial report.

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial report and in forming the opinion in the auditor’s report. (Ref: Para. A1)

In planning the audit, the auditor makes judgements about misstatements that will be considered material. These judgements provide a basis for:

1. Determining the nature, timing and extent of risk assessment procedures;
2. Identifying and assessing the risks of material misstatement; ^[3] and
3. Determining the nature, timing and extent of further audit procedures.

The materiality determined when planning the audit does not necessarily establish an amount below which uncorrected misstatements, individually or in the aggregate, will always be evaluated as immaterial. The circumstances related to some misstatements may cause the auditor to evaluate them as material even if they are below materiality. It is not practicable to design audit procedures to detect all misstatements that could be material solely because of their nature. However, consideration of the nature of potential misstatements in disclosures is relevant to the design of audit procedures to address risks of material misstatement. In addition, when evaluating the effect on the financial report of all uncorrected misstatements, the auditor considers not only the size but also the nature of uncorrected misstatements, and the particular circumstances of their occurrence.^[4] (Ref: Para. A2)

[Deleted by the AUASB.  Refer Aus 0.3]

When establishing the overall audit strategy, the auditor shall determine materiality for the financial report as a whole.  If, in the specific circumstances of the entity, there is one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than materiality for the financial report as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial report, the auditor shall also determine the materiality level or levels to be applied to those particular classes of transactions, account balances or disclosures. (Ref: Para. A3-A12)

The auditor shall determine performance materiality for purposes of assessing the risks of material misstatement and determining the nature, timing and extent of further audit procedures. (Ref: Para. A13)

The auditor shall revise materiality for the financial report as a whole (and, if applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures) in the event of becoming aware of information during the audit that would have caused the auditor to have determined a different amount (or amounts) initially. (Ref: Para. A14)

If the auditor concludes that a lower materiality for the financial report as a whole (and, if applicable, materiality level or levels for particular classes of transactions, account balances or disclosures) than that initially determined is appropriate, the auditor shall determine whether it is necessary to revise performance materiality, and whether the nature, timing and extent of the further audit procedures remain appropriate.

The auditor shall include in the audit documentation the following amounts and the factors considered in their determination:^[5]

1. Materiality for the financial report as a whole (see paragraph 10 of this Auditing Standard);
2. If applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures (see paragraph 10 of this Auditing Standard);
3. Performance materiality (see paragraph 11 of this Auditing Standard); and
4. Any revision of (a)-(c) as the audit progressed (see paragraphs 12-13 of this Auditing Standard).

(Ref: Para. 5)

In conducting an audit of a financial report, the overall objectives of the auditor are to obtain reasonable assurance about whether the financial report as a whole is free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial report is prepared, in all material respects, in accordance with an applicable financial reporting framework; and to report on the financial report, and communicate as required by the Australian Auditing Standards, in accordance with the auditor’s findings.^[6] The auditor obtains reasonable assurance by obtaining sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.^[7] Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial report is materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.^[8] Materiality and audit risk are considered throughout the audit, in particular, when:

1. Identifying and assessing the risks of material misstatement;^[9]
2. Determining the nature, timing and extent of further audit procedures;^[10] and
3. Evaluating the effect of uncorrected misstatements, if any, on the financial report^[11] and in forming the opinion in the auditor’s report.^[12]

(Ref: Para. 6)

Identifying and assessing the risks of material misstatement involves the use of professional judgement to identify those classes of transactions, account balances and disclosures, including qualitative disclosures, the misstatement of which could be material (i.e., in general, misstatements are considered to be material if they could reasonably be expected to influence the economic decisions of users taken on the basis of the financial report as a whole). When considering whether misstatements in qualitative disclosures could be material, the auditor may identify relevant factors such as:

• The circumstances of the entity for the period (for example, the entity may have undertaken a significant business combination during the period).
• The applicable financial reporting framework, including changes therein (for example, a new financial reporting standard may require new qualitative disclosures that are significant to the entity).
• Qualitative disclosures that are important to users of the financial report because of the nature of an entity (for example, liquidity risk disclosures may be important to users of the financial report for a financial institution).^[13]

Considerations Specific to Public Sector Entities (Ref: Para. 10)

In the case of a public sector entity, legislators and regulators are often the primary users of its financial report.  Furthermore, the financial report may be used to make decisions other than economic decisions.  The determination of materiality for the financial report as a whole (and, if applicable, materiality level or levels for particular classes of transactions, account balances or disclosures) in an audit of the financial report of a public sector entity is therefore influenced by law, regulation or other authority, and by the financial information needs of legislators and the public in relation to public sector programs.

Use of Benchmarks in Determining Materiality for the Financial Report as a Whole (Ref: Para. 10)

Determining materiality involves the exercise of professional judgement. A percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial report as a whole. Factors that may affect the identification of an appropriate benchmark include the following:

• The elements of the financial report (for example, assets, liabilities, equity, revenue, expenses);
• Whether there are items on which the attention of the users of the particular entity’s financial report tends to be focused (for example, for the purpose of evaluating financial performance users may tend to focus on profit, revenue or net assets);
• The nature of the entity, where the entity is in its life cycle, and the industry and economic environment in which the entity operates;
• The entity’s ownership structure and the way it is financed (for example, if an entity is financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity’s earnings); and
• The relative volatility of the benchmark.

Examples of benchmarks that may be appropriate, depending on the circumstances of the entity, include categories of reported income such as profit before tax, total revenue, gross profit and total expenses, total equity or net asset value.  Profit before tax from continuing operations is often used for profit-oriented entities.  When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues.

In relation to the chosen benchmark, relevant financial data ordinarily includes prior periods’ financial results and financial positions, the period-to-date financial results and financial position, and budgets or forecasts for the current period, adjusted for significant changes in the circumstances of the entity (for example, a significant business acquisition) and relevant changes of conditions in the industry or economic environment in which the entity operates.  For example, when, as a starting point, materiality for the financial report as a whole is determined for a particular entity based on a percentage of profit before tax from continuing operations, circumstances that give rise to an exceptional decrease or increase in such profit may lead the auditor to conclude that materiality for the financial report as a whole is more appropriately determined using a normalised profit before tax from continuing operations figure based on past results.

Materiality relates to the financial report on which the auditor is reporting.  Where the financial report is prepared for a financial reporting period of more or less than twelve months, such as may be the case for a new entity or a change in the financial reporting period, materiality relates to the financial report prepared for that financial reporting period.

Determining a percentage to be applied to a chosen benchmark involves the exercise of professional judgement.  There is a relationship between the percentage and the chosen benchmark, such that a percentage applied to profit before tax from continuing operations will normally be higher than a percentage applied to total revenue.  For example, the auditor may consider five percent of profit before tax from continuing operations to be appropriate for a profit-oriented entity in a manufacturing industry, while the auditor may consider one percent of total revenues or total expenses to be appropriate for a not-for-profit entity.  Higher or lower percentages, however, may be deemed appropriate in the circumstances.

Considerations Specific to Small Entities

When an entity’s profit before tax from continuing operations is consistently nominal, as might be the case for an owner-managed business where the owner takes much of the profit before tax in the form of remuneration, a benchmark such as profit before remuneration and tax may be more relevant.

Considerations Specific to Public Sector Entities

In an audit of a public sector entity, total cost or net cost (expenses less revenues or expenditure less receipts) may be appropriate benchmarks for program activities.  Where a public sector entity has custody of public assets, assets may be an appropriate benchmark.

Materiality Level or Levels for Particular Classes of Transactions, Account Balances or Disclosures (Ref: Para. 10)

Factors that may indicate the existence of one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than materiality for the financial report as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial report include the following:

• Whether law, regulation or the applicable financial reporting framework affect users’ expectations regarding the measurement or disclosure of certain items (for example, related party transactions the remuneration of management and those charged with governance, and sensitivity analysis for fair value accounting estimates with high estimation uncertainty).
• The key disclosures in relation to the industry in which the entity operates (for example, research and development costs for a pharmaceutical company).
• Whether attention is focused on a particular aspect of the entity’s business that is separately disclosed in the financial report (for example disclosures about segments or a significant business combination).

In considering whether, in the specific circumstances of the entity, such classes of transactions, account balances or disclosures exist, the auditor may find it useful to obtain an understanding of the views and expectations of those charged with governance and management.

Performance Materiality (Ref: Para. 11)

Planning the audit solely to detect individually material misstatements overlooks the fact that the aggregate of individually immaterial misstatements may cause the financial report to be materially misstated, and leaves no margin for possible undetected misstatements.  Performance materiality (which, as defined, is one or more amounts) is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in the financial report exceeds materiality for the financial report as a whole.  Similarly, performance materiality relating to a materiality level determined for a particular class of transactions, account balance or disclosure is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in that particular class of transactions, account balance or disclosure exceeds the materiality level for that particular class of transactions, account balance or disclosure.  The determination of performance materiality is not a simple mechanical calculation and involves the exercise of professional judgement.  It is affected by the auditor’s understanding of the entity, updated during the performance of the risk assessment procedures; and the nature and extent of misstatements identified in previous audits and thereby the auditor’s expectations in relation to misstatements in the current period.

(Ref: Para 12)

Materiality for the financial report as a whole (and, if applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures) may need to be revised as a result of a change in circumstances that occurred during the audit (for example, a decision to dispose of a major part of the entity’s business), new information, or a change in the auditor’s understanding of the entity and its operations as a result of performing further audit procedures.  For example, if during the audit it appears as though actual financial results are likely to be substantially different from the anticipated period end financial results that were used initially to determine materiality for the financial report as a whole, the auditor revises that materiality.