## SA 320 — Materiality in Planning & Performing an Audit

### Concept of Materiality

An item is material if its knowledge would influence the economic decisions of users of financial statements.

Financial statements are materially misstated when items are erroneously stated or omitted, and such misstatements or omissions influence users' economic decisions.

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### Materiality and Audit Risk — Inverse Relationship

$$\text{Audit Risk} \propto \frac{1}{\text{Materiality}}$$

Materiality Level	Audit Risk	Audit Procedures Required
Higher	Lower	Fewer / less extensive
Lower	Higher	More / more extensive

> Example: The risk that an account balance is misstated by a large amount may be very low, but the risk of misstatement by a small amount may be very high.

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### Factors to Consider in Determining Materiality

1. Materiality may be determined individually or in aggregate

2. Materiality has both quantitative (amount) and qualitative (nature) dimensions

3. Even quantitatively small items may be material in special circumstances (e.g., a small bribe)

4. Materiality is sometimes prescribed by law — Schedule III requires disclosure of expenditure items exceeding 1% of revenue from operations or ₹1,00,000, whichever is higher

5. An item insignificant today but potentially significant in the future may be considered material

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### Process of Determining Materiality

1. Involves professional judgment

2. Starting point: a percentage applied to a chosen benchmark (e.g., % of revenue, total assets, profit before tax)

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### Performance Materiality

Definition: Amount(s) set by the auditor at less than materiality for the financial statements as a whole.

Purpose: To reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality.

> Performance materiality acts as a safety buffer — individual items each below overall materiality can accumulate and collectively become material.

Key: Performance Materiality < Overall Materiality

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### Revision of Materiality as the Audit Progresses

Materiality must be revised when:

1. A change in circumstances occurs (e.g., decision to dispose of a major part of the business)

2. New information comes to light

3. The auditor's understanding of the entity changes as a result of further audit procedures

Worked example

### Example 1

An auditor sets overall materiality at ₹10 lakhs (5% of PBT) and performance materiality at ₹7 lakhs. During the audit, three uncorrected misstatements of ₹3L, ₹2.5L, and ₹2L are identified. Individually each is below ₹10L, but in aggregate they total ₹7.5L — exceeding performance materiality of ₹7L. The auditor must now evaluate whether additional procedures are required.

### Example 2

A company's accounts show entertainment expenses of ₹80,000. Revenue from operations is ₹50 lakhs. The Schedule III threshold is: 1% of ₹50L = ₹50,000 OR ₹1,00,000 — whichever is higher, so ₹1,00,000 applies. Since ₹80,000 < ₹1,00,000, mandatory Schedule III disclosure is NOT required.

### Example 3

Mid-audit, the auditor learns the entity plans to sell its manufacturing division (which represents 40% of total assets). This 'change in circumstances' requires revision of materiality — the relevant benchmark (total assets or revenue) is materially altered by this planned disposal.

⚠️ Common exam mistakes

Equating performance materiality with overall materiality — performance materiality is always lower than overall materiality; it provides a buffer.
Applying only quantitative judgment — a ₹5,000 facilitation payment may be quantitatively trivial but qualitatively material due to legal and reputational risk.
Setting materiality once at the planning stage and never revisiting it — materiality must be reassessed when new information or changed circumstances arise.
Misreading the inverse relationship: lower materiality does NOT mean fewer procedures — lower materiality means higher audit risk, requiring more extensive procedures.
Forgetting the Schedule III threshold is 'whichever is higher' between 1% of revenue and ₹1,00,000 — students often apply just the 1% figure.

Bare-Act text Schedule III — General Instructions for Preparation of Statement of Profit and Loss · Companies Act, 2013 — Schedule III · click to expand

Schedule III requires disclosure of items of expenditures which are in excess of 1% of the revenue from operations or ₹1,00,000, whichever is higher.

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