What drives materiality in the audit of financial statements?

The following three factors make any amount material.

1-Material by amount

Any amount is material if large enough to distort the decision of financial statement users. So, any trivial amount that does not impact their decision is immaterial.

Generally, this type of materiality is performance materiality & overall materiality.

Performance materiality – This materiality level is for the specific account balance in the financial statement. For instance, accounts payable, receivable, PPE, and any other balance/amount/transaction in the business financial statement. 

So, suppose the misstatement at the account balance level is more than performance materiality. The corrected action is needed in that case, or an audit report can be qualified based on material misstatements reported in the financial statement.

Overall materiality is the materiality level for the whole financial statement. Overall materiality is generally higher than performance materiality.

Cumulative misstatements at performance/account balance level are compared with overall materiality. So, if the cumulative material misstatement amount exceeds overall materiality, the report can be qualified if the misstatement remains uncorrected.

2-Material by impact

Sometimes, the amount can be trivial but comes with a higher impact. For instance, if a trivial amount comes with the ability to change loss to profit or profit to loss, it’s considered material by default, and the intensity of the amount is not considered in this case.

3-Materiality by nature

An amount can be material by default, regardless of impact and size. For instance, the director’s remuneration and related party transactions are considered material by default. Hence, any misstatement concerning related party disclosures is considered material irrespective of the amount.  

Wrap up

The materiality in the financial statement can be derived via the following three ways.

• The amount is material if it comes with the ability to distort the decision of financial statement users.
• A trivial amount can be material if its impact is significant (adjustment leads to profit or loss and vice versa).
• Some amounts/facts/transactions in the financial statement are, by default, material. For instance, related party transactions in the business’s financial statement.