What is Materiality?
Materiality simply means: how important is something to the user of the financial information? A small error of €10 in a billion-dollar company will not affect anyone, but an error of €10 million could make a significant difference for a bank or investor. Auditors use materiality to determine which errors or discrepancies are relevant for their audit and which are not.
Why is Materiality Important?
In the end an audit is not about achieving perfection but about providing a reliable opinion on the financial statements. Without materiality, auditors would have to check every single detail, which would be impossible and inefficient. By applying materiality, auditors can focus on the amounts and issues that truly matter.
How is Materiality Determined?
Auditors usually calculate materiality as a percentage of a financial measure, such as:
- Profit before tax (for profitable companies)
- Revenue (for example, in non-profit organizations)
- Total assets (for banks and investment firms)
For example: suppose a company has a profit of €5 million, and the auditor applies a materiality threshold of 5%. In this case, the materiality threshold is €250,000. This means that an error or discrepancy below this amount is likely not considered material.
Examples of Materiality in Practice
1. A Small Accounting Error
A company mistakenly records €1,000 too much in office expenses. The company’s total expenses are €10 million. This amount is so small that it does not affect the auditor’s opinion. This is considered an immaterial error.
2. An Incorrect Revenue Entry
A company records €2 million in revenue too early, even though the contract only starts next year. If the total revenue is €50 million, this could be material because it significantly affects the profit. The auditor will report this and ask management to correct the error.
3. A Fraud Case of €500,000
An accountant discovers that an employee has embezzled money. Although €500,000 may be below the usual materiality threshold, fraud can always be considered material, regardless of the amount. This is because fraud impacts the reliability of financial statements.
Performance Materiality: The Safety Margin
Auditors use a lower threshold than the overall materiality level to ensure they do not overlook important errors. This is called performance materiality.
For example: if the overall materiality threshold is €250,000, the auditor may decide to set performance materiality at €200,000 or lower. This means that transactions or errors above €200,000 are assessed more critically. This prevents an accumulation of small errors from having a significant impact.
Reporting Tolerance: Which Errors Are Reported?
Not every error an auditor finds needs to be immediately reported to management. That’s why auditors set a reporting tolerance. This is the threshold above which errors are reported, even if they are not necessarily material.
For example: if the reporting tolerance is set at €25,000, all errors above this amount will be reported to management. This helps ensure transparency without discussing too many unnecessary details.
Conclusion
Materiality helps auditors focus on what truly matters. By also using performance materiality and reporting tolerance, they can work efficiently while still conducting a reliable audit.
