Reporting materiality is concerned with whether a misstatement of a financial statement item, or an aggregation of such misstatements, is likely to affect the judgement of users of financial statements [fn].
In the client acceptance stage the auditor evaluates whether, if the client is accepted or retained, the audit risk (the risk of a material misstatement in the audited financial statements) can be reduced to an acceptable level. In this, the initial audit stage, the word "material" refers to the value of reporting materiality [fn]. Similarly in the final opinion formulation stage, the auditor evaluates the likelihood of the audited financial statements containing a material misstatement. Again, this evaluation is based on the value of reporting materiality.
Reporting materiality of, say, $500,000 implies that the auditor will accept (aggregated) misstatements in the financial statements of up to that amount yet still be able to state that in his/ her opinion the financial statements are materially complete, valid and accurate. In this example, a misstatement (or aggregated misstatements) greater than $500,000 is a material misstatement of the financial statements as a whole; a misstatement (or aggregated misstatements) equal to or less than $500,000 is a tolerable misstatement of the financial statements as a whole [fn]. Auditors qualify the audit opinion if the financial statements contain a material misstatement [fn].
The value of reporting materiality is based on such factors as the entity's earnings, total revenue, total assets and equity. This materiality value may remain constant throughout the course of the audit [fn].
For example, the following materiality guidelines are used by auditors to assess reporting materiality:
| Pre-tax income | 5-10% |
| Net (or after-tax) income | 5-10% |
| Gross revenue | 0.5-1% |
| Equity | 5-10% |
| Total assets | 0.5-1% |
(Note that when materiality is determined in the client acceptance/retention stage, pre-tax income and other figures above may only be capable of estimation. Accordingly, the phrase "estimated reporting materiality" may be the appropriate term to use.)
Where an entity's results are expected to be "normal", then reporting materiality is based on (estimated) after tax income amounts. For example, the starting point for materiality of a "normal" entity with net income of $5,000,000 is somewhere between $250,000 and $500,000. However, where the entity incurs losses, has potential going concern problems or the results are in other ways unusual, materiality may be based on one or more of the other factors referred to above. For example, if the entity is incurring losses, both before and after tax, the auditor may use total assets or total revenue, whichever is the greater. The final assessment of reporting materiality is subjective and depends on the auditor's perception of, for example, what information is relevant, who the users of the financial statements are, what decisions the users may make and what would influence those decisions.
Note that a financial statement item may be materially misstated as a result of either a quantitative misstatement (in relation to its monetary value) or a qualitative misstatement (in relation to its accuracy of presentation, disclosure, description) [fn].
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