Materiality

How it works

On most files I've reviewed, the materiality calculation itself took about 15 minutes. The RN that followed it took longer to clear. The gap is almost never the arithmetic. It's the missing paragraph explaining why this benchmark and this percentage fit this particular client. At firms like ours, that paragraph is what separates a clean review from a finding.

ISA 320.10 requires the auditor to determine materiality for the financial statements as a whole using a benchmark appropriate to the entity. A listed company with analysts watching EPS needs a tighter number than a private company where the owner-manager is the only user. For a profit-oriented entity, the starting point is usually profit before tax (PBT). Not-for-profits typically use total revenue or total expenditure. Asset-heavy entities like investment property companies use total assets. You apply a percentage to the benchmark (commonly 5% of PBT, 1% of revenue) and that produces your overall materiality figure.

Materiality is not a single number. You also set performance materiality (PM) below overall materiality as a working threshold for individual tests, and occasionally specific materiality for classes of transactions or disclosures where users are especially sensitive (related party transactions, director remuneration, regulatory capital, and key covenant metrics).

ISA 320.12 requires you to revisit the calculation if you become aware during the audit of information that would have changed your initial determination. In our experience, the most common trigger is actual PBT differing from the planning estimate by more than 10–15%.

What actually happens on most engagements is SALY with a methodology shield. The team opens last year's mat working paper (WP), updates the benchmark figure, and carries forward the same percentage without documenting why. The number is there. The rationale is not. That's the single most common materiality finding at both the AFM and the FRC, and it's the easiest one to avoid. As our ISA 320 guide covers in detail, documenting the reasoning takes 10 minutes and turns a potential finding into a non-issue.

Setting PM at 75% without documenting why is the other persistent problem. 75% is the upper end of most firms' accepted range. If your prior-year file had adjusted misstatements exceeding 20% of materiality or controls weren't tested, 75% is hard to defend. It's genuinely frustrating to see teams lose marks on this year after year when the fix is one sentence connecting the percentage to prior-year experience and control effectiveness.

Worked example

Scenario: De Vries Logistics B.V., a Dutch transport company. EUR 42M revenue, EUR 1.8M PBT, 120 employees, two warehouses in Rotterdam and Eindhoven. Recurring engagement (fourth year). The bank is the primary FS user.

Step 1: Select the benchmark. PBT is stable (EUR 1.5–2.0M over four years). Revenue is consistent. PBT is appropriate for a profit-oriented entity whose users focus on profitability.

Documentation note: “PBT selected as benchmark per ISA 320 .A4. Stable profit-oriented entity. Revenue cross-check: 1% of EUR 42M = EUR 420K (significantly higher than PBT-based materiality, confirming PBT is the more conservative measure).”

Step 2: Apply the percentage. 5% of EUR 1.8M = EUR 90,000. PY mat was EUR 80,000 (5% of EUR 1.6M PBT). The increase is proportional to PBT growth. No unusual circumstances.

Documentation note: “5% applied. Justified by: stable entity, recurring engagement, low prior-year error rate, bank as primary user with covenant headroom of 2x materiality.”

Step 3: Set PM. PY audit identified two misstatements totalling EUR 12,000 (both corrected). Controls over revenue and payroll tested and effective. PM set at 70%: EUR 63,000.

Documentation note: “PM at 70%. Prior-year misstatements below 15% of materiality. Controls effective. 70% appropriate given low error history.”

Step 4: Clearly trivial threshold. 5% of EUR 90,000 = EUR 4,500.

The complication

At completion, actual PBT is EUR 0.9M (50% below planning estimate) because De Vries lost a major contract in Q3. Overall materiality should be reconsidered. 5% of EUR 0.9M = EUR 45,000. The team revises materiality downward to EUR 45,000 and PM to EUR 31,500. All testing was performed to the original PM of EUR 63,000, which is above the revised PM. The team needs to evaluate whether additional procedures are required for higher-risk accounts where the narrower PM could have produced larger samples. Expect an RN if you skip this step. After review, the team performs additional substantive testing on revenue cut-off and payroll accruals. If you've used our materiality calculator, it flags this kind of revision automatically.

Documentation note: “Materiality revised downward at completion per ISA 320.12 . Actual PBT EUR 0.9M vs. planning EUR 1.8M. Loss of major contract in Q3. Revised materiality EUR 45,000. Revised PM EUR 31,500. Additional procedures performed on revenue cut-off and payroll accruals where original testing at PM of EUR 63,000 exceeded revised threshold.”

What reviewers and practitioners get wrong

The mat memo is the part of planning most likely to generate an RN, and most teams just roll it forward. Set mat at 5% of PBT and PM at 75%. Done. Move on. That's what actually happens, and that's the problem.

• No documented rationale for the percentage (AFM thematic reviews, FRC 2017 materiality review). "5% of PBT" without explanation is the most common finding. The fix takes 10 minutes: one paragraph in the mat WP connecting the percentage to the entity's characteristics, the users of the financial statements, prior-year (PY) misstatement rates, and control reliance.
• Not revisiting materiality when actual results differ from planning estimates. Teams plan materiality in November based on draft accounts. By March, actual results are in. If PBT moved significantly, the file needs evidence the team reconsidered (not necessarily changed, but reconsidered). This finding keeps appearing because teams treat materiality as a planning-stage exercise. It isn't.
• Defaulting to 75% PM on every file. When the engagement team changes year to year, the new team SALYs the PY percentage without questioning whether the ratio is still appropriate given current-year misstatements and control effectiveness. At my firm, the partner flagged this on at least a third of the files they reviewed last year.
• Skipping the revenue cross-check. ISA 320 .A4 lists multiple benchmarks for a reason. A PBT-only calculation on a thin-margin entity can produce a mat figure that looks fine relative to profit but is implausibly large relative to total assets or revenue. Running a second benchmark takes two minutes and pre-empts a review note.

Materiality vs. performance materiality

Overall materiality is the threshold for the opinion. PM is the working threshold for your procedures during fieldwork. You test to PM throughout the audit so that the aggregate of uncorrected and undetected misstatements stays below overall materiality. If you only tested to overall materiality, you'd have no margin for the misstatements you didn't find.

The percentage between PM and overall materiality (50–75%) reflects your assessment of aggregation risk: how likely are uncorrected misstatements to pile up? More PY misstatements or weaker controls push the percentage down (more margin needed). Fewer misstatements and effective controls push it up.

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