Microlesson · 5-min read

SA 320 - Materiality in Planning and Performing an Audit

# SA 320 — Materiality in Planning and Performing an Audit

## Concept of Materiality

Misstatements are considered material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the FS.

### Two Important Principles

1. Statutory disclosures are always material — irrespective of amount.

Example: As per Division I of Schedule III of the Companies Act, 2013:
Any item of income or expenditure exceeding 1% of revenue from operations or ₹1,00,000, whichever is higher, shall be disclosed separately.
Shares held by each shareholder holding >5% shares shall be separately disclosed.

2. Judgments about materiality are matters of professional judgment affected by size, nature, or both.

## Auditor's Perception of Users' Information Needs

When determining materiality, the auditor assumes users:

Have reasonable knowledge of business, economic and accounting activities and are willing to study FS with diligence
Understand FS are prepared and audited with reference to materiality
Recognise uncertainties in measurement of estimate-based amounts
Make reasonable economic decisions based on FS

## Use of Materiality in Planning & Performing the Audit

Materiality judgments provide a basis for:

Determining NTE of Risk Assessment Procedures (RAP)
Identifying and assessing ROMM
Determining NTE of Further Audit Procedures (FAP)

> Materiality determined at planning stage does NOT automatically become the threshold for evaluating uncorrected misstatements at the end. The auditor considers size, nature and circumstances of misstatements when evaluating their effect.

## Performance Materiality (PM)

PM = An amount set by the auditor at less than materiality for FS as a whole to reduce — to an appropriately low level — the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for FS as a whole.

PM can also be set for Particular Classes of Transactions, Account Balances or Disclosures (CAD).
Concept: provides a cushion/buffer below the overall materiality.

## Determining Materiality — Use of Benchmarks

A percentage is applied to a chosen benchmark as a starting point.

### Factors Affecting Identification of Appropriate Benchmark

Nature of entity, life cycle, industry, economic environment
Entity's ownership structure and financing
Elements of FS (assets, liabilities, equity, revenue, expenses)
Items on which users' attention tends to focus
Relative volatility of the benchmark

### Examples of Benchmarks

Profit Before Tax (PBT) from continuing operations — for profit-oriented entities
If PBT is volatile → use gross profit or total revenues

### Chosen Benchmark — Relevant Financial Data Includes

Prior periods' financial results and positions
Period-to-date financial results and position
Budgets/forecasts for current period
Adjusted for significant changes in entity's circumstances

## Materiality Level for Particular CAD

Lower than overall materiality. Factors indicating its need:

Law/AFRF affecting user expectations about disclosure of certain items
Key disclosures in the industry concerned
Attention focused on an aspect that is separately disclosed in FS

## Revision as Audit Progresses

Materiality may need revision due to:

New information
Change in circumstances during the audit
Change in auditor's understanding of the entity as a result of FAP

> If the auditor concludes that a lower materiality than initially determined is appropriate, he shall determine if it is necessary to revise PM and whether NTE of FAP remain appropriate.

## Documentation

The auditor shall document:

Materiality for FS as a whole
Materiality level for particular CAD (if applicable)
Performance Materiality (PM)
Any revision of the above as the audit progressed

## Materiality and Audit Risk — Considered Throughout

Both concepts are considered:

When identifying and assessing ROMM
When determining NTE of FAP
When evaluating effect of uncorrected misstatements on FS and forming the opinion

Worked example

### Example 1

Example 1 — Statutory materiality: ABC Ltd has revenue from operations of ₹500 cr. A miscellaneous expense of ₹6,00,000 has been clubbed under 'other expenses'. Threshold = higher of (1% × ₹500 cr = ₹5 cr) or ₹1,00,000 = ₹5 cr. Since ₹6,00,000 < ₹5 cr, separate disclosure is NOT required by Schedule III. But: an item of ₹1,50,000 in a company with revenue of ₹50 lakhs (1% = ₹50,000; ₹1,00,000 higher) crosses ₹1,00,000 → MUST be disclosed separately, however small in absolute terms.

### Example 2

Example 2 — Choice of benchmark: XYZ Ltd is a profit-making entity with stable PBT of ₹100 cr. Auditor selects PBT as benchmark and applies 5% → materiality = ₹5 cr. In contrast, DEF Ltd has fluctuating PBT (loss ₹2 cr in Y1, profit ₹10 cr in Y2, profit ₹1 cr in Y3) — PBT is volatile, so the auditor uses total revenue as benchmark instead.

### Example 3

Example 3 — Performance Materiality cushion: Auditor sets overall materiality at ₹50 lakhs and Performance Materiality at ₹35 lakhs (70% of overall). This cushion ensures that even if undetected misstatements across multiple areas aggregate up, they are unlikely to exceed the ₹50 lakh overall threshold.

### Example 4

Example 4 — Revision during audit: During FAP at PQR Ltd, the auditor discovers a covenant in a bank loan requiring PBT > ₹20 cr. Earlier materiality was set at ₹2 cr (5% of PBT of ₹40 cr). Now, even smaller misstatements could push PBT below the covenant threshold and affect users' decisions → auditor revises materiality DOWNWARD, recalculates PM, and considers if additional FAP are needed.

⚠️ Common exam mistakes

Treating ALL statutory disclosures as material only if they exceed the quantitative threshold — Schedule III requirements (like >5% shareholder disclosure) are material IRRESPECTIVE OF amount.
Confusing materiality for FS as a whole with Performance Materiality (PM) — PM is always set LOWER than overall materiality to provide a buffer for undetected misstatements.
Applying a fixed % (e.g. always 5% of PBT) without considering volatility — when PBT is volatile, gross profit or total revenue is more appropriate.
Believing materiality determined at planning stage is the FINAL cut-off for evaluating uncorrected misstatements — auditor must also consider NATURE and CIRCUMSTANCES, not just size.
Forgetting to REVISE materiality and PM as the audit progresses — failing to do so when new information emerges (e.g. covenant breach, change in financial performance) is non-compliance with SA 320.
Documenting only the final materiality figure — auditor must document materiality for FS as a whole, for particular CAD (if any), PM, AND any revisions during the audit.
Setting materiality only at FS level when the engagement clearly involves particular CADs (like specific disclosures of director remuneration) where users expect a lower threshold.

Bare-Act text SA 320 — Materiality in Planning and Performing an Audit; Schedule III, Division I, Companies Act 2013 · Standards on Auditing (SA) issued by ICAI; Division I of Schedule III to the Companies Act, 2013 for statutory disclosure thresholds · click to expand

SA 320 — Materiality in Planning and Performing an Audit: The objective of the auditor is to apply the concept of materiality appropriately in planning and performing the audit. When establishing the overall audit strategy, the auditor shall determine materiality for the financial statements as a whole. If, in the specific circumstances of the entity, there is one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements, the auditor shall also determine the materiality level or levels to be applied to those particular classes of transactions, account balances or disclosures. The auditor shall determine performance materiality for purposes of assessing the risks of material misstatement and determining the nature, timing and extent of further audit procedures. The auditor shall revise materiality for the financial statements as a whole in the event of becoming aware of information during the audit that would have caused the auditor to have determined a different amount initially.

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