Materiality in auditing gets treated as a single number, written once at planning and quoted for the rest of the engagement. Two US rulebooks ask for more than one number, and GAAS asks for the reasoning behind each amount to be written into the file. The percentage everyone argues about is the starting point for one of those amounts, not the answer to any of them.
What Materiality in Auditing Means Under GAAS
Materiality is a judgment about the reader of the financial statements, not about the account. Generally accepted auditing standards, GAAS, the rulebook behind an audit of an entity that is not an SEC registrant, reach it indirectly. At .02, AU-C 320, Materiality in Planning and Performing an Audit sets out how financial reporting frameworks generally explain the concept: misstatements, including omissions, are considered to be material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements. That wording arrived with SAS No. 138, effective for audits of financial statements for periods ending on or after December 15, 2021.
The framework's discussion is what the auditor works from. It provides the frame of reference for determining materiality for the audit, and where the applicable financial reporting framework carries no such discussion, the characteristics at .02 supply that frame of reference instead (AU-C 320, .03). Today the one term the section defines outright, in its own definitions paragraph, is performance materiality. SAS No. 149 adds a second definition to that same paragraph, aggregation risk, the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole, for audits of financial statements for periods ending on or after December 15, 2026 (AU-C 600, appendix C).
The standard also describes the reader it has in mind. For the purpose of determining materiality, the auditor may assume that reasonable users have a reasonable knowledge of business and economic activities and accounting, and a willingness to study the information in the financial statements with reasonable diligence. The same paragraph adds that they understand financial statements are prepared, presented and audited to levels of materiality, recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment and the consideration of future events, and make reasonable judgments based on the information in the statements (AU-C 320, .04).
Audits of issuers run on the other rulebook and reach the same idea through the courts. AS 2105 opens by noting that, in interpreting the federal securities laws, the Supreme Court has held that a fact is material if there is a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available (PCAOB, AS 2105, .02). A reasonable user under GAAS, a reasonable investor under PCAOB standards: one test, pointed at a different reader.
The Three Amounts AU-C 320 Makes You Document
Three amounts, the middle one only where the entity's circumstances call for it, and the audit file has to show each amount the engagement carries with the thinking behind it.
The first is the headline figure. When establishing the overall audit strategy, the auditor determines materiality for the financial statements as a whole. Where particular classes of transactions, account balances or disclosures exist for which there is a substantial likelihood that misstatements of lesser amounts than that figure would influence the judgment made by a reasonable user, the auditor also determines the materiality level or levels to be applied to those particular items, which is the second amount (AU-C 320, .10).
The third is performance materiality, and it carries the plan. The auditor determines it for the purpose of assessing the risks of material misstatement and determining the nature, timing and extent of further audit procedures, at .11, and the definition at .09 is the part worth reading twice: the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. The same definition adds that where a materiality level has been set for a particular class of transactions, account balance or disclosure, performance materiality also refers to an amount set below that level (AU-C 320).
The reason for a third number is stated plainly in the application material. Planning the audit solely to detect individual material misstatements overlooks the fact that the aggregate of individually immaterial misstatements may cause the financial statements to be materially misstated, and it leaves no margin for possible undetected misstatements. The same paragraph adds that the determination is not a simple mechanical calculation and involves the exercise of professional judgment (AU-C 320, .A15).
Then the file itself. Documentation under .14 covers materiality for the financial statements as a whole, the materiality level or levels for particular classes of transactions, account balances or disclosures where applicable, performance materiality, any revision of those amounts as the audit progressed, and the factors considered in determining them (AU-C 320). The factors, not only the amounts. A planning memo showing three numbers and no reasoning has answered half the paragraph.
Performance Materiality Is Not Tolerable Misstatement
The two terms get swapped in conversation, and the standards keep them apart deliberately.
Tolerable misstatement is the application of performance materiality to a particular sampling procedure, and the definition lives in the sampling section (AU-C 320, .A3). AU-C 530, Audit Sampling states it at .05 as a monetary amount set by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that the amount set is not exceeded by the actual misstatement in the population. Performance materiality shapes the whole plan. Tolerable misstatement is what that thinking becomes when it is carried into one sample.
PCAOB standards use a different vocabulary, which is one reason the two terms get mixed up in a firm that runs both kinds of engagement. The phrase performance materiality does not appear in AS 2105 at all. The account-level amount there is tolerable misstatement, determined for the purpose of assessing risks of material misstatement and planning and performing audit procedures at the account or disclosure level, at an amount that reduces to an appropriately low level the probability that the total of uncorrected and undetected misstatements would result in material misstatement of the financial statements, and it should be less than the materiality level for the financial statements as a whole and, if applicable, the materiality level or levels for particular accounts or disclosures (PCAOB, AS 2105, .08).
Separate materiality levels for particular accounts or disclosures sit one paragraph earlier on that side too, where there is a substantial likelihood that misstatements of lesser amounts than the financial statement level would influence the judgment of a reasonable investor (PCAOB, AS 2105, .07).
Where the Benchmark and the Percentage Come From
The standards name no percentage and no benchmark. What they say is that a percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial statements as a whole (AU-C 320, .A6). The same paragraph lists the factors that may affect which benchmark is the right one.
- The elements of the financial statements. Assets, liabilities, equity, revenue and expenses do not carry equal weight for every entity, and the benchmark follows the element those statements are built around.
- Whether items exist on which the attention of that entity's users tends to be focused. Users judging financial performance may focus on profit, revenue or net assets, and a benchmark nobody reads produces a threshold nobody trusts.
- The nature of the entity, where it sits in its life cycle, and its industry and economic environment. A business in its first trading years and one in a mature market do not present the same statements to the same readers.
- The ownership structure and the way the entity is financed. An entity financed solely by debt rather than equity may push its users toward assets and the claims on them rather than toward earnings.
- The relative volatility of the benchmark. A base that swings year to year moves the threshold with it, which is an argument for a steadier base.
Which Benchmark the Standard Points To
Examples the standard offers, depending on the circumstances of the entity, include categories of reported income such as profit before tax, total revenue, gross profit and total expenses, along with total equity and net asset value. Profit before tax from continuing operations is often used for profit-oriented entities, and when that figure is volatile, gross profit or total revenues may be more appropriate (AU-C 320, .A7).
A year that does not look like the others has an answer written into the standard. Where materiality has been determined as a percentage of profit before tax from continuing operations, circumstances that give rise to an exceptional decrease or increase in that profit may lead the auditor to conclude that materiality is more appropriately determined using a normalized profit before tax figure based on past results (AU-C 320, .A8). The relevant data for that judgment ordinarily includes prior periods' results and financial positions, period-to-date results, and budgets or forecasts for the current period adjusted for significant changes such as a business acquisition.
Owner-managed clients get their own note. Where profit before tax from continuing operations is consistently nominal, which might be the case for an owner-managed business in which the owner takes much of the profit before tax in the form of remuneration, a benchmark such as profit before remuneration and tax may be more relevant (AU-C 320, .A11).
Then the Percentage
A relationship exists between the percentage and the chosen benchmark, so the two choices are not made independently. A percentage applied to profit before tax from continuing operations will normally be higher than a percentage applied to total revenue, and settling on the percentage is itself an exercise of professional judgment (AU-C 320, .A10).
The 5% Rule of Thumb and What the SEC Staff Said About It
The rule of thumb is real, and the staff position on it is more specific than its reputation. Staff Accounting Bulletin No. 99 states that exclusive reliance on any percentage or numerical threshold has no basis in the accounting literature or the law, and that the use of a percentage such as 5% may provide the basis for a preliminary assumption that, without considering all relevant circumstances, a deviation of less than that percentage with respect to a particular item is unlikely to be material. The staff has no objection to such a rule of thumb as an initial step in assessing materiality. Quantifying the magnitude of a misstatement in percentage terms begins the analysis and cannot be substituted for it.
What follows in the bulletin is the more useful half. The staff sets out the considerations that may well render material a quantitatively small misstatement, and says plainly that the list is not exhaustive. Each one is a question worth putting to a real engagement.
- Whether the misstatement arises from an item capable of precise measurement or from an estimate. Where it arises from an estimate, the degree of imprecision inherent in that estimate is part of the question, so an error of a given size can sit inside a reasonable range for an estimate while being plainly wrong for an amount that can be measured exactly.
- Whether the misstatement masks a change in earnings or other trends. A correction that reverses the direction of a trend is not small to the person reading the trend.
- Whether it hides a failure to meet analysts' consensus expectations for the enterprise. The threshold that matters there was set outside the financial statements.
- Whether it changes a loss into income, or income into a loss. The sign of the number carries information that its size does not.
- Whether it concerns a segment or other portion of the business identified as playing a significant role in operations or profitability. An error inside the part of the business that has been singled out as important reads differently from the same error in a part nobody has been told to watch.
- Whether it affects compliance with regulatory requirements. A requirement tested at a fixed threshold makes any misstatement near that threshold consequential.
- Whether it affects compliance with loan covenants or other contractual requirements. A covenant works the same way, with a counterparty rather than a regulator holding the trigger.
- Whether it has the effect of increasing management's compensation, for example by satisfying the requirements for the award of bonuses or other forms of incentive compensation. A figure that sets a bonus has an audience inside the company as well as outside it.
- Whether it involves concealment of an unlawful transaction. Size is beside the point once that is the question being asked.
The bulletin takes up intent separately. A registrant and the auditors of its financial statements should not assume that even small intentional misstatements, for example those pursuant to actions to manage earnings, are immaterial. While the intent of management does not render a misstatement material, it may provide significant evidence of materiality (Staff Accounting Bulletin No. 99).
That bulletin speaks to SEC registrants and the auditors of their financial statements, so it is reasoning a private company auditor borrows rather than a requirement they inherit. GAAS reaches the same place in its own words. The materiality determined when planning the audit does not necessarily establish an amount below which uncorrected misstatements, individually or in the aggregate, will always be evaluated as immaterial, and the circumstances related to some misstatements may cause the auditor to evaluate them as material even when they sit below materiality (AU-C 320, .06).
How identified misstatements are then accumulated, communicated and documented is a separate standard with rules of its own, walked through in the year-end audit preparation guide.
Revising Materiality While the Audit Is Running
The amount set at planning is a judgment, not a commitment.
The auditor revises materiality for the financial statements as a whole, and the levels for particular classes of transactions, account balances or disclosures where they exist, on becoming aware of information during the audit that would have caused a different amount to be determined initially (AU-C 320, .12). The triggers named in the application material are a change in circumstances during the audit, such as a decision to dispose of a major part of the business, new information, or a change in the auditor's understanding of the entity as a result of performing further audit procedures.
The follow-up question is the one that gets skipped. Where a lower materiality turns out to be appropriate, the auditor determines whether performance materiality also needs revising and whether the nature, timing and extent of the further audit procedures remain appropriate (AU-C 320, .13). A revision that changes the number without changing the plan is not finished.
Issuer audits carry the same duty, written toward the investor. The auditor reevaluates the established materiality level or levels and tolerable misstatement when changed circumstances or additional information mean there is a substantial likelihood that misstatements of amounts differing significantly from those established initially would influence the judgment of a reasonable investor, and where the reevaluation produces lower amounts, the auditor evaluates the effect on the risk assessments and modifies the nature, timing and extent of procedures as necessary to obtain sufficient appropriate audit evidence (PCAOB, AS 2105, .11 and .12).
Group Audits and Component Performance Materiality
Clients that consolidate get an extra materiality amount, and the standard behind it has been rewritten.
AU-C 600, Special Considerations, Audits of Group Financial Statements, issued as SAS No. 149 in March 2023, supersedes the earlier section 600 and is effective for audits of group financial statements for periods ending on or after December 15, 2026. A component, in its vocabulary, is an entity, business unit, function or business activity, or some combination of those, determined by the group auditor for the purpose of planning and performing audit procedures.
The new amount is component performance materiality. Where classes of transactions, account balances or disclosures in the group financial statements are disaggregated across components, the group auditor determines component performance materiality for the components at which audit procedures will be performed, and that amount should be lower than group performance materiality, the performance materiality determined for the group financial statements under section 320 (AU-C 600, .37).
The definition says what the lower amount is for. Component performance materiality is an amount set by the group auditor to reduce aggregation risk to an appropriately low level for the purpose of planning and performing audit procedures in relation to a component (AU-C 600, .16).
The arithmetic people expect is explicitly not required. The amount may be different for each component, it need not be an arithmetical portion of group performance materiality, and the aggregate of the component amounts may therefore exceed group performance materiality (AU-C 600, .A128). A group file that allocates a single number across components in neat slices is doing something the standard does not ask for.
One more amount travels with it. The group auditor also determines the threshold above which misstatements identified in the component financial information are communicated to the group auditor, and that threshold should not exceed the amount regarded as clearly trivial to the group financial statements. Clearly trivial is the level below which misstatements are not accumulated at all (AU-C 450, Evaluation of Misstatements Identified During the Audit, .05), and .A2 of that section is careful to say it is not another expression for not material. Both amounts are then communicated to the component auditor (AU-C 600, .37 and .38).
What to Write Down Before Fieldwork Opens
Materiality in auditing is not one number, and it is not a percentage. It is a small set of amounts, each with its reasoning recorded, revisited when the facts move, and, on a group audit for periods ending on or after December 15, 2026, pushed down to the components under a name of its own.
Before fieldwork opens, put the amounts and the reasoning in the planning memo: materiality for the financial statements as a whole with the benchmark chosen and the percentage applied to it, any lower level set for a particular class of transactions, account balance or disclosure, and performance materiality with the judgment behind it. The documentation paragraph asks for the factors as well as the amounts, and for any revision of them as the audit progressed to be recorded the same way (AU-C 320, .14). That memo is also the fastest way for a reviewer to pick up a file they did not plan.
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