Define and explain the concepts of materiality and performancemateriality

The materiality concept, also called the materiality constraint, states that financial information is material to the financial statements if it would change the opinion or view of a reasonable person. In other words, all important financial information that would sway the opinion of a financial statement user should be included in the financial statements.

The concept of materiality is relative in size and importance. Some financial information might be material to one company but might be immaterial to another. This is somewhat obvious when you think about a small company verses a large company. A large and material expense to a small company might be small an immaterial to a large company because of their size and revenue. The main question that the materiality concept addresses is does the financial information make a difference to financial statement users. If not, the company doesn't have to worry about including it in their financial statements because it is immaterial.

Most of the time financial information materiality is judged on qualitative and quantitative characteristics. Professionals are often left up to their experience and good judgment to understand what is material and what isn't.

Materiality for the financial statements as a whole and performance materiality must be calculated at the planning stages of all audits. The calculation or estimation of materiality should be based on experience and judgement. Materiality for the financial statements as a whole must be reviewed throughout the audit and revised if necessary. ISA 320 Materiality in planning and performing an audit provides guidance for auditors in this area and states that the objective of the auditor is to apply the concept of materiality appropriately in planning and performing the audit. ISA 320 does not define materiality (in relation to the financial statements as a whole) but notes that while it may be discussed in different terms by different financial reporting frameworks the following are generally the case:

(a) Misstatements are considered to be material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users.

(b) Judgements about materiality are made in the light of surrounding circumstances, and are affected by the size and nature of a misstatement or a combination of both.

(c) Judgements about matters that are material to users of financial statements are based on a consideration of the common financial information needs of users as a group.

The practical implication of this is that the auditor must be concerned with identifying 'material' errors, omissions and misstatements. Both the amount (quantity) and nature (quality) of misstatements need to be considered, eg lack of disclosure regarding ongoing litigation is likely to be considered material. To implement this, the auditor therefore has to set their own materiality levels – this will always be a matter of judgement and will depend on the level of audit risk. The higher the anticipated risk, the lower the value of materiality will be.

The materiality level will impact on the auditor's decisions relating to: • How many items to examine • Which items to examine • Whether to use sampling techniques • What level of misstatement is likely to result in a modified audit opinion

Conforming amendments to ISA 320 published in 2015 make it clear that auditors must consider the risks of material misstatement in qualitative disclosures. In doing so, the auditor should consider: • The circumstances of the entity (eg any business acquisitions or disposals during the period) • The applicable financial reporting framework (eg new qualitative disclosures may be required by a new financial reporting standard) • Qualitative disclosures that are important to the users of the financial statements because of the nature of the entity (e.g. liquidity risk disclosures for a financial institution)