Materiality and Pervasiveness

Two Important Concepts in Auditing: Materiality and Pervasiveness

This blog post discusses the concepts of materiality and pervasiveness in auditing, as per the Audit and Assurance (AA) and Advanced Audit and Assurance (AAA) syllabus guidelines.

The ACCA examiner reports suggest that applying materiality and pervasiveness concepts often needs to be clarified for candidates. Hence, it is strongly recommended to watch the video by Owais Mirchawala where he offers a comprehensive explanation of these concepts, and then read the blog. 

The Concept of Materiality

Materiality is a core auditing concept and refers to the importance of a particular transaction, piece of information, or item within the financial statements.

Key Characteristics of Materiality 

• When an auditor declares that a misstatement is material to financial statements, it implies that the misstatement is significant enough to affect the decision of users, who are typically the shareholders.
• In other words, material misstatements in financial statements are most likely to influence the decisions of financial statement users.
• An auditor concludes his judgments about materiality by considering several factors, such as the nature and size of the misstatement and the surrounding circumstances.
• If there is a material misstatement that is material enough to affect the decision of shareholders, the auditors consider these misstatements as material, and they take that impact on his audit opinion (discussed later in the blog).

The Importance of Materiality in Auditing

The International Standards of Auditing (ISAs) instruct auditors to gain ‘reasonable assurance’ regarding whether there are no material misstatements in the financial statements, as a whole. Hence, materiality is an integral concept for auditing. It is usually applied by auditors in three stages:

• the planning stage,
• while conducting the audit, and
• while evaluating the impact of the misstatements on the overall audit and financial statements.

Read our recent blog post on assurance engagements to learn more about reasonable assurance.

How does a misstatement become material to the financial statements?

According to the auditing standards, misstatements can be classified into two types.

1. These can be quantitatively material (material due to its quantity/amount).
2. These can be qualitatively material (material due to its nature).

Quantitative Materiality

Quantitative materiality focuses on setting a numerical value and determining the mathematical impact of an item on the financial statement. 

We can find the numerical value by finding the percentage of a suitable base, or benchmark. 

Benchmarks for Quantitative Materiality

As per the auditing standards, the threshold/benchmark for quantitative materiality is:

• 5% – 10% of profit before tax (PBT),
• 0.5% – 1% of revenue, and
• 1% – 2% of assets.

For example, less than 5% of PBT is an immaterial quantity of misstatements, more than 10% is a material quantity and between 5% – 10% requires judgment.

Qualitative Materiality

Qualitative materiality takes into account the circumstances and nature surrounding the transaction within the financial statements.

A transaction is material to the financial statements due to its nature. For example: if it is a related party transaction, if it is an issue in earnings per share, or if it is an issue with the going concern assumption. It will be material to the financial statements irrespective of its amount because the nature of the transaction is material to the financial statements.

How does the auditor determine the materiality level?

As per the auditing standards, it is up to the auditor’s judgment and discretion about how he intends to select the materiality level from the above-mentioned ranges of thresholds. In other words, the process of calculating materiality is judgmental and depends largely on the practitioner’s professional expertise. However, several factors may be taken into account:

*The size, nature, and pervasiveness of the item

*the intended use of financial statements

*the level of risk involved

For example: If the auditor considers the client high-risk, he may choose a lower materiality level, such as 5% of the PBT. If the auditor’s risk assessment reveals that the client is low risk, the materiality level could also be 8% or % of the PBT.

The purpose of these ranges is to provide the auditor with an area of judgment to determine the materiality benchmark, based on his discretion.

Once the auditor determines materiality, he considers whether the misstatements are material to the financial statements if they exceed the quantitative benchmark that he has selected.

The Concept of Pervasiveness

The word ‘pervasive’ means spread or found everywhere.

A pervasive misstatement is a serious one, where the financial statements are deemed unfit for use for all purposes and intents. In other words, a pervasive misstatement is sufficient enough to make the financial statements meaningless, as a whole.

Unlike the case of materiality, there are no benchmarks or thresholds available to determine the degree of pervasiveness in financial statements. 

According to the auditing standards, it largely depends upon the auditor’s judgment and professional expertise to determine if the financial statements are pervasive. The auditor is expected to make a fair judgment about whether the matter pervades several elements in the financial statement or specific components.

If you are currently studying AA or AAA, you must have come across a few examination questions where the examiner considers the issue as ‘pervasive’ at a variety of percentages.

This is because the case of pervasiveness has nothing to do with the benchmarks of materiality.

The Impact of Materiality and Pervasiveness on Audit Opinion

The concepts of materiality and pervasiveness lead to the qualification in audit opinion.

Audit opinion is a highly examinable topic for AA and AAA. Contact Mirchawala’s Hub of Accountancy today, and connect with Sir Owais Mirchawala to strengthen your concepts.

If a misstatement becomes material to the financial statement, the auditor has an impact on his audit opinion, which may lead to a qualified audit opinion.

A Qualified Audit Opinion

When an auditor provides a qualified opinion, it means that he is declaring an area of uncertainty in the financial statement of the company. 

‘Except for’ that uncertainty, the financial statements provide a true-and-fair overview of the company’s financial performance.

Key Point: An auditor will typically use the words ‘except for’ when putting out a qualified opinion.

An Adverse Audit Opinion

An auditor or practitioner offers an adverse audit opinion when the misstatements in the financial statements are both material and pervasive. An adverse opinion indicates that the financial statements do not offer an accurate depiction of the company’s financial health and performance, and the figures have been misstated and misrepresented.

Key Point: An auditor will typically use words such as ‘… do not represent fairly …’ to exhibit an adverse opinion (material and pervasive both) on the financial statements.

Frequently Asked Questions (FAQ’s)

Q1. What are the benchmarks for materiality?
To determine the quantitative materiality, the following benchmarks are used.

• 5% – 10% of profit before tax (PBT),
• 0.5% – 1% of revenue, and
• 1% – 2% of assets.

Q2. What is the definition of materiality?
Materiality refers to the significance of misstatements or omissions in financial statements, judged in the context of their potential to impact the decisions of financial statement users (e.g. shareholders).

Q3. How do materiality and pervasiveness impact audit opinion?

When a misstatement is a material but not pervasive, the auditor gives a qualified opinion, and uses the words ‘except for’.

When a misstatement is material and pervasive both, the auditor gives an adverse opinion, and uses the words ‘do not present fairly’.

If you wish to find helpful resources for revision, Sir Owais’ YouTube channel offers a wealth of informative videos.

Written by Inbisaat Ahmed bright student of Mirchawala’s Hub OF Accountancy