2102 Overall Materiality

Sep-2022

OAG Guidance

Our assessment of materiality for the financial statements as a whole is termed overall materiality. We apply professional judgment to determine overall materiality when establishing the overall strategy for the audit which is based on the results of risk assessment analytical procedures, our understanding of the entity and its environment, and appropriate discussion. Overall materiality is also considered in evaluating the effect of identified uncorrected misstatements on the financial statements as a whole and the opinion in our audit report (OAG Audit 9015). When the determination of materiality is particularly complex, consider consulting Audit Services.

We determine a single quantitative level (i.e., one number) of overall materiality based on a selected benchmark (e.g., profit before tax) relevant to users of the financial statements. Overall materiality based on this benchmark is applied to the financial statements as a whole and forms the basis for performance materiality. Applying separate quantitative levels of overall materiality (e.g., a certain materiality level for profit and loss account items and a different materiality level for balance sheet items) will not enable us to plan our audit effectively to detect material misstatements. See OAG Audit 2104 for further guidance on materiality for particular classes of transactions, account balances or disclosures.

OAG Guidance

Benchmark is defined as an element or component of the financial statements to which a threshold is applied for purposes of calculating materiality. Such a threshold is frequently a percentage, i.e., rule of thumb, based on our experience.

For further guidance on selecting an appropriate benchmark, refer to the block on Guidance specific to Legislative Auditors.

OAG Guidance

Profit/loss before tax from continuing operations (i.e., profit/loss before tax before discontinued operations) is often used for profit-oriented entities. However, a primary focus on the current period’s profit/loss before tax may not always be appropriate. Depending on the entity’s nature and particular circumstances, other elements of the financial statements that may be useful in determining overall materiality include

• total revenues,
• total expenditures / expenses,
• gross profit,
• earnings before Interest, Tax, Depreciation and Amortization (EBITDA),
• current assets,
• net working capital,
• total assets,
• total equity,
• cash flow from operations,
• debt‑to‑equity ratio,
• return on equity ratio.

Consider the following:

While profit/loss before tax from continuing operations may be a suitable benchmark for profit-oriented entities and entities whose debt or equity securities are publicly traded, it may not be appropriate

• for not‑for‑profit organisations,
• when an entity’s earnings are volatile,
• when an entity’s earnings are consistently at or near breakeven,
• for start‑up entities,
• for entities whose products are in the development stage, and
• for asset-based entities.

Consider the following benchmarks:

• For not‑for‑profit organisations, total expenses, total revenues or total assets may be more suitable.

• When an entity’s earnings are volatile, i.e., profit/loss before tax fluctuates widely from year to year, or a loss for the current year having previously been profitable, there may be specific qualitative factors influencing this year’s results. If so, it may be appropriate to adjust for those unusual or infrequently occurring items. If there are not, it may be appropriate to use an average of profit/loss before tax over a preceding number of years (it would typically be three years and would not exceed five), or a different benchmark. When averaging is considered an appropriate approach to determining materiality, also consider whether there have been any fundamental changes in the business that may result in more recent periods providing a more relevant basis for determining materiality. For example, if the nature of the business has undergone significant change, the preceding number of years used would generally need to be shorter.

• When an entity’s earnings are consistently at or near breakeven, profit/loss before tax may be a less meaningful measure in the view of the users of the financial statements. It may then be more appropriate to consider other benchmarks, such as EBITDA, total revenues, total assets etc. that may be considered more relevant to the users of the financial statements.

• For start up entities or entities whose products are in the development stage, losses may not be representative of the operations or expected future operations in the view of the users of the financial statements. It may then be more appropriate to consider using benchmarks such as total revenues, total expenses, total assets or total equity, rather than profit/loss before tax.

• For asset-based entities, benchmarks such as total or net assets may be appropriate.

• For industry-specific situations other benchmarks may be appropriate.

When we use benchmarks other than the generally expected benchmarks due to the nature of the entity to determine overall materiality, such benchmarks would normally be considered in addition to the generally expected benchmarks (e.g., 5 percent of profit/loss before tax from continuing operations for profit-oriented entities). When alternative benchmarks are used (e.g., total revenues for a profit-oriented entity), it is normally expected that the alternative benchmarks, together with the generally accepted benchmark, will be evaluated and materiality would be set using professional judgment considering the benchmark considered most appropriate in the circumstances of the entity being audited. See further guidance on applying a percentage threshold and “rules of thumb” below.

Guidance on documenting materiality is included in OAG Audit 2107.

OAG Guidance

Examples of percentage rules of thumb applied to benchmarks include:

• For a profit-oriented entity, ordinarily up to 5% of profit/loss before tax from continuing operations.

• For a not‑for‑profit entity, ordinarily up to 3% of total expenses or total revenues, or up to 1% of total assets.

• For entities other than not‑for‑profit entities, where revenue or total expenses are used as the benchmark, ordinarily up to 3% of total revenues or total expenses.

• For entities other than not‑for‑profit entities where total assets are used as the benchmark, ordinarily up to 1% of total assets.

• For entities where Earnings before Interest, Tax, Depreciation and Amortization (EBITDA) is used as the benchmark, ordinarily between 2.5 and  3.5% of EBITDA.

• For entities (mutual funds), where net assets is used as a benchmark, ordinarily between 0.5 and 1.75% of net asset value.

The table below summarizes the rules of thumb examples referred to above.

*Alternatively, annualized average profit before tax or an adjusted profit-based benchmark, if appropriate in the circumstances.

As noted in the block Examples of Benchmarks above, for profit-oriented entities the generally expected benchmark is profit/loss before tax from continuing operations. When we use benchmarks other than the generally expected benchmarks to calculate materiality levels, such benchmarks would normally be considered in addition to the generally expected benchmarks (e.g., up to 5% of profit/loss before tax from continuing operations for profit-oriented entities). When alternative benchmarks are used (e.g., total revenues for a profit-oriented entity), it is normally expected that the alternative benchmarks, together with the generally accepted benchmark, will be evaluated and materiality would be set using professional judgment considering the benchmark considered most appropriate in the circumstances of the engagement.

The above rules of thumb are guidelines and we do not necessarily default to the rules of thumb. We use professional judgment in applying these guidelines to the individual circumstances. Note that industry specific guidance may specify other benchmarks and/or rules of thumb appropriate in the circumstances. If we consider it appropriate to use alternative benchmarks and/or exceed the upper ends of these ranges, the decision should be documented as a Significant Matter.

Document the factors considered when determining materiality levels and rationale for selecting the benchmark and the percentage used. See OAG Audit 2107 for further guidance.

National Laws and Regulations

Requirements of national laws and regulations may also impose restrictions in selecting a percentage. For example, engagement teams on SEC Foreign Private Issuers (FPI) engagements consider the SEC Staff Accounting Bulletin 99 (SAB 99) when determining materiality.

National laws and regulations may alternatively provide guidance on selecting a percentage which is more or less restrictive, and such guidance may be used in determining the overall materiality. When using such guidance, consider whether the resulting overall materiality differs significantly from that which would be determined applying OAG Audit guidance, and, if so, whether it is appropriate to increase or reduce that overall materiality.

Consultation Considerations

After consulting with the engagement leader consider consulting with Audit Services, if appropriate, in the following situations:

• If we consider it appropriate to exceed the upper ends of the rule of thumb ranges listed above or to use alternative benchmarks.

• When the determination of materiality levels is particularly complex or difficult.

See OAG Audit 3081 for guidance on performing and documenting consultations.

Relevant Factors

Factors which indicate that a percentage at the lower end of the ranges referred to above may be appropriate include, e.g.:

• The financial statement users are widely distributed or the entity is a public/listed entity.

• The entity has a significant level of external debt.

• There are specific factors, such as the existence of financial covenants, which increase the sensitivity of the selected benchmark.

• The selected benchmark is considered to be particularly sensitive based on our understanding of users’ interests in the financial statements (but note that general purpose financial statements are being considered—it is more likely that benchmarks are particularly sensitive in special purpose financial information designed to meet the specific needs of the users).

Factors which indicate that a percentage at the higher end of the ranges referred to above (e.g., at 5% of profit before tax, 1% of total assets or 3% of revenue) may be appropriate include, e.g.:

• Distribution of, or use of, the financial statements is limited to few users, e.g., the parent company or the entity has only a limited number of shareholders.

• The entity has no significant level of external debt and/or no close calls on financial covenants.

• There may be intra-group support in place where the subsidiary entity obtains financing from the group rather than via external debt, and a letter of support is in place, or the external debt may be guaranteed by the parent or a fellow subsidiary.

• The benchmark may be focused on particular relevant factors, for example, the entity operates under a manufacturing scheme where all its costs are recharged to the group with a percentage mark-up.

Note that consideration of audit risk is reflected in the determination of performance materiality (see OAG Audit 2103 rather than overall materiality. Therefore factors such as the effectiveness of the entity’s internal controls and the number of identified misstatements in prior years’ audits are reflected in the determination of performance materiality, affecting the positioning within the 10 to 50% range, rather than overall materiality.

Where overall materiality is determined based on a percentage at the upper end of the range, certain financial statement line items may therefore be out of scope for testing. Consider whether there are specific risks attributable to these line items which warrant a lower materiality being used for these particular classes of transactions, account balances or disclosures (e.g., the risk of understatement of liability accounts)—see OAG Audit 2104.

The selection of benchmarks and numerical thresholds may change from year-to-year depending on changes in the entity’s circumstances (e.g., business acquisitions or disposals) and/or conditions in the economy or the industry in which the entity operates. To take this into account, we consider prior periods’ results and financial position, the period-to-date financial results and financial position, and budgets or forecasts for the current period. For example, when we normally determine materiality based on profit, and circumstances give rise to an exceptional increase or decrease in profit, we may consider that it is more appropriate to determine materiality based on past results or an annualized profit figure.

For profit oriented entities with highly volatile profits or low margins, it may be appropriate to use an adjusted profit benchmark or average profit/loss. In cases where these two options are not considered appropriate, we may also consider using alternative benchmarks (e.g. EBITDA, total revenues or total assets).

When using an adjusted profit-based benchmark, consider using a different rule of thumb. Although we may determine that using an adjusted profit-based benchmark may be appropriate for setting materiality, it is hard to argue that users of financial statements would completely disregard profit/loss before tax. Therefore, when we base materiality on an adjusted profit-based benchmark, do not completely disregard profit/loss before tax. Consider the appropriateness of the determined materiality when overall materiality based on the adjusted benchmark varies widely from materiality determined based on profit/loss before tax.

Similarly, if we conclude that the absolute value of a loss is an appropriate benchmark, the usual rules of thumb mentioned in this topic may not apply. If an entity has a history of losses, consider what the users of financial statements may be focusing on and how the engagement risk is impacted, e.g., going concern risk, impact on loan covenants and other agreements with banks or other creditors. In such situations, a lower percentage than the rule of thumb may be appropriate.

Document the factors considered when determining materiality levels and rationale for selecting the benchmark and the percentage used. See OAG Audit 2107.

Qualitative Factors

When determining the appropriate benchmark or measure of materiality, also consider relevant qualitative factors, such as

• earnings or other trends,
• intended user or analyst consideration,
• industry / sector market statistics.

Refer to Guidance specific to Legislative Auditors for additional guidance on applying a rule of thumb and selecting an appropriate benchmark.

OAG Guidance

In circumstances where using the short period benchmark indicates a level of materiality the engagement leader believes is inappropriate, consider consulting with Audit Services.

Considerations specific to determining materiality for periods shorter or longer than 12 months

Determining materiality for stub periods is a matter of professional judgement. When determining the appropriate benchmark and rule of thumb for the stub period, engagement teams should generally apply the same considerations as they would apply if the reporting period was for an entire 12-months period. Once the benchmark and rule of thumb have been selected, engagement teams should normally calculate materiality for both the period being audited and an estimated 12 month period based on the same information. The materiality to be applied in the audit is normally selected from between the two calculations.

Auditing stub periods often creates scenarios where the materiality in either the preceding or subsequent period will be significantly different than the period being audited. If the preceding period materiality is significantly higher, engagement teams should refer to the guidance in Materiality—Frequently asked questions (FAQ) question #7 which addresses the considerations for the current year audit of a declining materiality. If the engagement team expects that the materiality in the subsequent period is expected to be lower, the engagement team should consider if it would be appropriate to apply a specific materiality to the closing balance sheet to avoid potential issues in the subsequent audit.

OAG Guidance

In addition, we consider adding certain other items back before applying the rule of thumb. Other common items considered as “add backs” include but are not limited to

• management fees allocated to an entity resulting from its ownership structure,
• dividends that have been taken out of the business by owners,
• interest charged on parent-company indebtedness,
• other owner-driven allocations, and
• special non-recurring charges.

Our rationale for adding back these items is not because we will be testing these items separately, although we may test them separately based on their own significance. We document the determined rationale for adding such items back in our audit workpapers.

OAG Guidance

The Office generally considers a quantitative estimate of materiality of 0.5% to 3% of total expenditures as appropriate. For more commercially oriented organizations, such as enterprise Crown corporations, materiality might be determined using a base of revenues, operating income, or some other appropriate measure. The base selected and the threshold percentage applied should reflect, in the auditor’s judgment, the measures that financial statement users are most likely to consider important.

OAG Guidance

This FAQ is to be used in conjunction with the policies and guidance of this section.

The topics discussed include:

1. Can I pick any Benchmark I want for calculating materiality?

2. The guidance for applying a rule of thumb to a chosen benchmark in section Applying a percentage (rule of thumb) to a chosen benchmark says “up to x%”. Do I need to select a rule of thumb that is below the upper end of the range?

3. Is it OK to change benchmarks from year-to-year?

4. Is changing materiality or using a benchmark other than profit before tax a required consultation with Audit Services?

5. Am I going to end up with a significant increase in materiality? Won’t I be questioned in a review or inspection?

6. How do I communicate the change to my audit committee or management team?

7. How does declining materiality impact considerations on procedures to be performed in the current year?

8. What is the difference between averaging and normalizing and when should each be used?

9. How do debt covenants impact the rule of thumb?

1. Can I pick any benchmark I want for calculating materiality?

No. Materiality is a user based concept. When selecting a relevant benchmark you need to consider the users of the financial statements. Often, there will be multiple users who may measure the success of an entity in different ways. That said, there is no requirement to go to the lowest calculated materiality amongst the users. Generally we would expect teams to consider all of the relevant users in determining materiality. This can be done by calculating materiality for all of the identified users and judgmentally selecting a materiality within the range based on the team’s assessment what the most appropriate materiality level would be.

There are several good sources to consider to help in determining which benchmarks are relevant. These include but are not limited to:

• Analysts reports
• Client MD&A
• Debt agreements
• Compensation arrangements

2. The guidance for applying a rule of thumb to a chosen benchmark in section Applying a percentage (rule of thumb) to a chosen benchmark says “up to x%”. Do I need to select a rule of thumb that is below the upper end of the range?

The different rule of thumbs already take into consideration some of the factors discussed in the guidance as it relates to the question of whether it is appropriate to select a rule of thumb at the top or bottom of the range. Accordingly, in many cases it is likely appropriate to use the upper end of the range of a particular rule of thumb.

However, selecting an appropriate rule of thumb is a matter of professional judgment and engagement teams need to consider client specific circumstances. For example, those charged with governance might require a lower percentage to be used to be able to fulfil their fiduciary duties.

Documentation of the rationale for selecting the rule of thumb is important to demonstrate appropriate application of professional judgment.

3. Is it OK to change benchmarks from year-to-year?

Generally you should not change benchmarks each year. However, some teams have not implemented recent changes to materiality guidance. In these cases we do expect that teams will reconsider their benchmarks and rules of thumb - and this is completely acceptable. As long as you are following the guidance and properly considered the needs of the users of the financial statements, you should be confident in your decision to change materiality benchmarks or rules of thumb.

4. Is changing materiality or using a benchmark other than profit before tax a required consultation with Audit Services?

No—there are no required consultations that result from the determination of materiality. If you are considering deviating from a published benchmark or are using a percentage higher than the published rule of thumb you should consider consulting with Audit Services. Of course, if you are ever unsure of the materiality level selected, or the nature or extent of your documentation, Audit Services are available to discuss your concerns. If an engagement team determines that changing benchmarks for materiality (e.g. pre-tax income to revenue or assets) they should clearly document why the change is being made.

5. Am I going to end up with a significant increase in materiality? Won’t I be questioned in a quality review or inspection?

Materiality judgments will always be reviewed as a part of a quality review or inspection—irrespective of the size of the increase or the amount of the change. As long as you have followed the guidance and supported your decision with documentation, the Office will support your materiality judgment.

6. How do I communicate the change to my audit committee or management team?

We believe that transparency is important in this process and that the audit committee should be informed of the change—moreover, they may have views on the appropriate level of materiality and these should be included in our overall assessment. Senior members of the team should be involved in discussions around scope of our work.

7. How does declining materiality impact considerations on procedures to be performed in the current year?

When there is a reduction in materiality year-over-year the evidence supporting the absence of misstatements in balances representing opening equity is gathered by

• examine prior year’s summary of uncorrected misstatements (SUM);

• examining transaction streams in the current period relating to the realization of opening assets and the discharge of opening liabilities;

• examining items included in the balance sheet at the end of the reporting period that are carried forward from the preceding balance sheet; and, in the event that any of these procedures indicate there may be issues with the opening balances;

• in some circumstances, performing further auditing procedures on the opening asset and liability balances themselves.

Generally, we would only expect additional procedures to be performed by teams if the results of the first and second bullet point indicated that the opening balances may be misstated.

8. What is the difference between averaging and normalizing and when should each be used?

Both normalizing and averaging are methods used to address unusual circumstances in client results in calculating materiality.

Normalization is most commonly used when clients have a large one time item such as an impairment or an unusual gain. In these cases the engagement team would remove the item from the benchmark before applying the rule of thumb. When normalizing, we should be avoiding items that have become part of the normal course of business or cherry picking only items that only increase materiality.

Averaging is used when there is volatility in the client’s benchmarks from year-to-year. Averaging is most appropriately used when a business has a predictable cycle over several years. Averaging is not appropriate when we are reaching back to include a year that will raise materiality in the current year. Teams should generally try to identify the most stable benchmark at the client for calculating materiality if it properly reflects the considerations of the users of the financial statements.

Consultation

Materiality is highly subjective and consultation is encouraged if the engagement team is not clear.

9. How do debt covenants impact the rule of thumb?

The existence of debt covenants often gives a good perspective of what benchmarks are relevant to the users of the financial statements. However, it would be rare for materiality to be calculated based on the amount of headroom an entity has before they will breach a financial covenant. In situations where an entity is very close to breaching a financial covenant we should specifically consider the impact on our SUM posting level and we would generally expect clients to adjust for all known errors on the SUM sheet. Consultation with Audit Services is highly recommended when posting unadjusted items may result in a debt covenant violation.