ISA 320 (Revised) DEALS with the auditor’s responsibility to APPLY the Concept of Materiality in planning and performing an ‘Audit‘ of Financial Statements.
Table of Contents
Introduction to ISA 320
ISA 320, Materiality in Planning and Performing an Audit, provides auditors with the framework to make these critical judgments that shape the entire audit approach.
Why ISA 320 Matters
ISA 320 directly impacts audit quality, resource allocation, and risk assessment. It ensures that auditors don’t miss significant issues while avoiding unnecessary work on immaterial items. This standard bridges professional judgment with structured methodology, making it fundamental to modern audit practice.
What is ISA 320?
ISA 320 is an International Standard on Auditing issued by the International Auditing and Assurance Standards Board (IAASB). This standard establishes the auditor’s responsibilities regarding materiality when planning and performing an audit of financial statements.
Core Principle
The fundamental principle underlying ISA 320 is that misstatements, including omissions, are considered material if they could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.
Key Objectives of ISA 320
ISA 320 establishes three primary objectives for auditors:
Primary Objectives
- Determine Appropriate Materiality Levels when planning the audit to assess the risks of material misstatement and to determine the nature, timing, and extent of further audit procedures
- Apply Performance Materiality to particular classes of transactions, account balances, or disclosures where lower materiality levels are appropriate
- Revise Materiality Assessments as the audit progresses if the auditor becomes aware of information during the audit that would have caused different materiality levels to be determined initially
Types of Materiality Under ISA 320
ISA 320 introduces several distinct materiality concepts that work together to guide audit procedures:
Overall Materiality
Overall materiality is the materiality level for the financial statements as a whole. This is the maximum amount of misstatement that could exist in the financial statements without affecting the decisions of users. Auditors determine this amount during the planning phase of the audit.
Performance Materiality
Performance materiality is set at a level lower than overall materiality to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality. Think of it as a safety buffer.
Specific Materiality
For certain classes of transactions, account balances, or disclosures, auditors may determine that misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence users’ decisions. Examples include related party transactions, director remuneration, or key performance indicators.
Clearly Trivial Threshold
This is the amount below which misstatements need not be accumulated because the auditor expects that accumulation of such amounts would not have a material effect on the financial statements. Typically set at 3-5% of overall materiality.
| Materiality Type | Purpose | Typical Calculation |
|---|---|---|
| Overall Materiality | Maximum acceptable misstatement | 0.5-2% of selected benchmark |
| Performance Materiality | Safety buffer for testing | 50-75% of overall materiality |
| Specific Materiality | Sensitive areas requiring lower threshold | Varies based on area |
| Clearly Trivial | Accumulation threshold | 3-5% of overall materiality |
Determining Materiality: The Foundation
Determining materiality is one of the most critical professional judgments an auditor makes. ISA 320 provides a structured approach while acknowledging that judgment is essential.
Factors to Consider
When determining materiality, auditors must consider:
- The Size and Nature of Misstatements – both quantitative and qualitative factors matter
- The Information Needs of Users – who are the primary users and what drives their decisions?
- The Entity’s Circumstances – industry, size, complexity, and regulatory environment
- Financial Statement Elements – which benchmarks are most relevant?
- Previous Periods – trends and consistency considerations
Performance Materiality Explained
Performance materiality is perhaps the most misunderstood aspect of ISA 320. It serves as a crucial planning tool that helps auditors design procedures that will detect material misstatements.
Why Performance Materiality Exists
The reason for setting performance materiality below overall materiality is straightforward: Auditors Cannot Test Everything. Since sampling and professional judgment introduce uncertainty, performance materiality creates a buffer to ensure that the combination of detected and undetected misstatements doesn’t exceed overall materiality.
Typical Performance Materiality Formula:
The percentage applied depends on factors like:
- Prior period misstatements
- Assessment of control environment
- Expected changes in the entity
- Complexity of the business
Practical Application
Consider a company with overall materiality of $100,000. If the auditor sets performance materiality at 75% ($75,000), audit procedures will be designed to detect misstatements of $75,000 or more. This buffer helps ensure that even if some misstatements go undetected, the total unlikely exceeds $100,000.
Common Materiality Benchmarks
Selecting the appropriate benchmark is crucial for determining materiality. ISA 320 doesn’t mandate specific benchmarks but provides guidance on commonly used measures.
Selecting the Right Benchmark
The choice of benchmark depends on several factors:
| Scenario | Recommended Benchmark | Rationale |
|---|---|---|
| Stable, profitable company | Profit before tax (5%) | Earnings are primary focus of users |
| Loss-making or volatile profits | Revenue (0.5-1%) or Assets (1-2%) | Profit is not a stable benchmark |
| Early-stage growth company | Revenue or Gross assets | Focus on growth metrics, not yet profitable |
| Asset-heavy business | Total assets (1-2%) | Balance sheet strength is key metric |
| Not-for-profit organization | Total expenses (1-2%) | Focus on resource stewardship |
Step-by-Step Materiality Determination Process
ISA 320 implies a systematic approach to determining and applying materiality. Here’s a practical workflow:
Select the Benchmark
Choose the most appropriate financial statement element based on user needs and entity circumstances. Consider what drives economic decisions for the primary users of the financial statements.
Determine the Percentage
Apply an appropriate percentage to the selected benchmark. This percentage should reflect the auditor’s professional judgment about user expectations and industry norms.
Calculate Overall Materiality
Multiply the benchmark by the percentage to arrive at overall materiality. Round to a convenient number if appropriate (e.g., round $487,500 to $475,000 or $500,000).
Set Performance Materiality
Determine performance materiality by applying a percentage (typically 50-75%) to overall materiality, considering risk factors, control environment, and prior period experience.
Identify Specific Materiality Needs
Evaluate whether certain classes of transactions, balances, or disclosures require a lower materiality level due to their nature or user focus (e.g., related party transactions, executive compensation).
Establish Clearly Trivial Threshold
Set the clearly trivial threshold (typically 3-5% of overall materiality) below which errors need not be accumulated unless they could be material in aggregate.
Document the Rationale
Document all materiality levels determined, the benchmarks used, percentages applied, and the reasoning behind these professional judgments.
Revision of Materiality During the Audit
ISA 320 recognizes that materiality is not set in stone. Auditors must be prepared to revise materiality as circumstances change during the audit engagement.
When Revision is Required
Auditors must revise materiality if they become aware of information that would have led them to determine a different materiality amount initially. Common triggers include:
- Significant Changes In Entity Circumstances – major acquisitions, disposals, or restructuring
- Discovery of Material Errors – indicating the original assessment was inappropriate
- Change In Benchmark Values – significant variance from planning assumptions
- New Information About Users’ Needs – understanding of who relies on the statements changes
- Changes In Financial Performance – actual results differ materially from expectations
Impact of Revision
When materiality is revised, auditors must consider the impact on:
- The nature, timing, and extent of risk assessment procedures
- Further audit procedures already performed
- Performance materiality and specific materiality levels
- The evaluation of the effect of misstatements on the financial statements
Documentation Requirements
ISA 320 requires auditors to document specific materiality-related matters in the audit working papers to provide evidence of compliance with the standard.
Required Documentation
Mandatory Documentation Elements
- Overall Materiality Amount for the financial statements as a whole
- Benchmark Selected and reasons for its selection
- Percentage Applied to the benchmark and justification
- Performance Materiality amount and how it was determined
- Specific Materiality Levels for particular classes of transactions, balances, or disclosures (if applicable)
- Clearly Trivial Threshold and how it was calculated
- Any Revisions made during the audit and reasons for those revisions
Best Practices for Applying ISA 320
Based on regulatory observations and audit quality reviews, here are proven practices for applying ISA 320 effectively:
Start with Understanding Users
Before selecting benchmarks or calculating percentages, deeply understand who uses the financial statements and for what purposes. This understanding should drive all materiality decisions.
Consider Both Quantitative and Qualitative Factors
Never rely solely on mechanical calculations. Always consider qualitative factors that could make smaller amounts material, such as fraud indicators, regulatory violations, or covenant breaches.
Document Your Thinking Process
Document not just the conclusions but the reasoning process. This helps with consistency, review, and demonstrating compliance with professional standards.
Link Materiality to Risk Assessment
Ensure clear linkage between materiality levels (particularly performance materiality) and the assessment of risks of material misstatement. Lower performance materiality should correspond with higher risk areas.
Be Prepared to Revise
Don’t view materiality as fixed. Build in checkpoints during the audit to reassess whether materiality levels remain appropriate given current knowledge.
Maintain Professional Skepticism
When management pressure exists to increase materiality or when immaterial items accumulate, maintain skepticism and consider whether qualitative factors make these items material.
Common Pitfalls to Avoid
- Using profit benchmarks when profit is volatile or near breakeven
- Setting performance materiality too high (above 75% of overall materiality)
- Failing to consider specific materiality for sensitive areas
- Not documenting the rationale for benchmark selection
- Ignoring qualitative factors that could make small amounts material
- Not reassessing materiality when circumstances change significantly
- Setting clearly trivial threshold too high (above 5% of overall materiality)
Conclusion
ISA 320 provides the essential framework for one of auditing’s most critical professional judgments: determining what matters. By establishing clear guidance on materiality determination, application, and revision, this standard helps auditors focus their efforts where they matter most while maintaining audit efficiency.
(Qualified) Chartered Accountant – ICAP
Master of Commerce – HEC, Pakistan
Bachelor of Accounting (Honours) – AeU, Malaysia