What is Planning Materiality?
For auditors and audit team leaders, the planning stage of an audit assignment is the most important. In this stage, team leaders plan out their strategy for handling the audit assignment. In the planning stage, some fixed activities need to be done.
Among these are determining planning materiality levels and threshold levels of tolerable misstatements. Doing this makes audit planning and execution easier for the audit team.
Planning materiality is a level that auditors set for acceptable misstatements (or mistakes) while planning their audit strategy for a specific client. This level of materiality determines the materiality status of the clients' audited financials.
By setting the level of planning materiality, auditors can decide if an error or misrepresentation reported in the financial statements will have a significant impact on the end users’ decision making.
If the impact is higher than the set level of tolerable misstatements, i.e, it is at an intolerable level, then the audit team needs to take corrective measures.
If it is at a tolerable level, which means that the impact of the error or omission is not significant or “material” to the financial statements, then the error can be ignored, and no corrective measures are needed.
There are several methods to determine this amount. Which will be discussed later.
Why Planning Materiality is Important
Planning materiality helps audit managers to determine parameters and acceptable margins of error that are acceptable during their audit assignment. Without knowing the level of materiality acceptable auditors will not know if a misstatement needs to be investigated or not.
The absence of planning materiality means that auditors can end up wasting their time and resources on tracing and rectifying errors that may not be significant enough to be worth the time and effort needed to correct them.
Knowing the planning materiality levels as well as the tolerable misstatement levels allows auditors to make their audit process more efficient and cost-effective.
It is however very important that the planning materiality is kept at a reasonable level to ensure an effective audit.
The Concepts Behind Planning Materiality
Planning materiality is based on the theory of materiality.
As per the International Standards on Auditing (ISA) which are issued by the International Auditing and Assurance Standards Board (IAASB), materiality determines the baseline for errors in accounting statements.
The baseline is set to determine if the errors singly or combined with other errors can impact the accounting statements to the extent that they may affect stakeholders’ decision making regarding the business or its allied investments.
Regulatory Requirements for Planning Materiality
The International Standards on Auditing (ISA) set out the procedure for assessing the planning materiality during the planning stage of an audit assignment.
Requirements for planning materiality are specified in the ISA # 320, which deals with “Materiality in Planning and Performing an Audit”.
As per this standard, during the audit planning, the audit managers need to set the materiality levels for the entire accounting statements on the whole.
This means that the planning materiality levels are preset before starting the audit. However, if there are findings that contradict their materiality levels during the audit process, the materiality level can be reset.
Auditors need to apply their professional judgment and experience to assess the extent of planning materiality. There are no fixed specifications in the ISA about how auditors need to get the materiality figures for their audit clients. there are some guidelines for aiding auditors in their calculations.
How To Calculate Planning Materiality?
The ISAs do not offer a clear specification for the procedure to calculate planning materiality. It just states that auditors need to use their professional judgment.
By implication, ISA 320 states that auditors can pick a certain financial benchmark and use a percentage of this benchmark to get their figure for planning materiality. In practice, the three main benchmarks that most auditors use are net income, total sales, or total assets.
A company, ABC Co., has total assets of $100 million. Its revenues for an accounting period were $25 million while its net profits were $5 million.
The company’s auditors want to determine planning materiality for the company based on these figures. Auditors calculate the materiality for ABC Co. based on the three prevalent benchmarks as follows.
- 0.5 % - 1 % of Income
- 1 % - 2 % of Net Assets
- 5 % to 10 % of Sales
In cases where these main parameters are not applicable or may be less relevant, auditors are free to use other benchmarks, like the shareholders’ equity or gross income.
The three benchmark items are the ones most used. In some cases, the materiality level calculated from them may not apply to every error or omission identified.
Some financial statement mistakes or omissions are material by default. This means that they will be treated as material irrespective of the figures associated.
Parameters for Determining Benchmarks
The ISAs have set down some specifications for auditors to evaluate some factors to pick a suitable benchmark for determining materiality.
These are broad-based parameters for assessing where stakeholders will be focusing while assessing or using the financial statements.
- The type of the business (proprietorship, Public or private limited)
- Its position in the life cycle, the segment in which it works
- the economic conditions at the time of the audit
- The ownership status and its funding sources
- The standard volatility of the selected financial parameter
Planning materiality is the level calculated by auditors while they are planning for an audit. While there are no set calculations for doing so, auditors are provided with guidelines on how to use their experience to decide on basis of some specified parameters.