Annual Audit Manual
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2103 Performance Materiality
Sep-2022
In This Section
Determining performance materiality
Performance materiality (the ‘haircut’) and factors to consider
CAS Requirement
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 (CAS 320.11).
CAS Guidance
Planning the audit solely to detect individually material misstatements overlooks the fact that the aggregate of individually immaterial misstatements may cause the financial statements to be materially misstated, and leaves no margin for possible undetected misstatements. Performance materiality (which, as defined, is one or more amounts) is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in the financial statements exceeds materiality for the financial statements as a whole. Similarly, performance materiality relating to a materiality level determined for a particular class of transactions, account balance or disclosure is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in that particular class of transactions, account balance or disclosure exceeds the materiality level for that particular class of transactions, account balance or disclosure. The determination of performance materiality is not a simple mechanical calculation and involves the exercise of professional judgment. It is affected by the auditor’s understanding of the entity, updated during the performance of the risk assessment procedures; and the nature and extent of misstatements identified in previous audits and thereby the auditor’s expectations in relation to misstatements in the current period (CAS 320.A13).
OAG Guidance
We use performance materiality in the planning and execution parts of fieldwork to plan which account balances, classes of transactions and disclosures to select for examination. It enables us to define the extent of work necessary to reduce audit risk to an acceptably low level. For example, performance materiality is used in determining the tolerable misstatement level for audit sampling (OAG Audit 7044) or threshold for analytical procedures (OAG Audit 7030).
When we develop our audit plan, we typically consider which accounts (whether initially determined to be significant FSLIs or not) are material by reference to the financial statement line items (FSLIs) and also consider if further disaggregation of a line item would result in a more effective response to the assessed risks of material misstatement. When considering the risks of material misstatement due to fraud or error relating to those disaggregated line items, we also consider the risk relating to completeness of those balances.
Refer to OAG Audit 5042 for guidance on identifying significant and material FSLIs.
Performance materiality (the ‘haircut’) and factors to consider
OAG Policy
If the haircut chosen is greater than 50% of overall materiality, the engagement leader is required to consult with Audit Services before proceeding with the proposed audit approach. [Jun-2020]
OAG Guidance
We set performance materiality at an amount less than overall materiality and would normally use the performance materiality of 50%, 75% or 90% of overall materiality. This means that a percentage reduction of 10%, 25% or 50% would normally be applied to the overall materiality (this is referred to as the haircut).
For example, if the level of overall materiality has been determined to be $1,000,000, using a haircut of 25% would result in the performance materiality of $750,000.
We select an appropriate haircut percentage, applying professional judgment and considering engagement circumstances. Factors supporting various haircut percentages are explained below.
| Factors Supporting the Haircut | |||
|---|---|---|---|
| 10% | 25% | 50% | |
| History of misstatements | History of limited or no booked or proposed audit adjustments. | History of limited or no booked or proposed audit adjustments. | History of frequent audit adjustments. Significant management turnover that suggests a potential increase in the frequency of audit adjustments. |
| Risk assessment and aggregation risk | The characteristics of the entity being audited result in low aggregation risk related to potential misstatements arising from environmental factors (such as sufficient qualified management resources are present, there is low pressure to achieve targeted results, the entity does not operate in a high risk industry, there is a limited number of FSLIs subject to high estimation uncertainty, with significant risks and/or elevated risks.) | The characteristics of the entity being audited result in low to moderate aggregation risk related to potential misstatements arising from environmental factors (such as sufficient qualified management resources are present, there is low pressure to achieve targeted results and/or the entity does not operate in a high risk industry, etc.) | The characteristics of the entity being audited result in high aggregation risk related to potential misstatements arising from environmental factors (such as insufficient qualified management resources are present, the initial audit of an entity having never been audited before, there is high pressure to achieve targeted results and/or the entity operates in a high risk industry, etc.) |
| Effectiveness of controls | Where testing of operational effectiveness of controls is part of the overall audit strategy, the controls have historically been determined to be operating effectively. | Where testing of operational effectiveness of controls is part of the overall audit strategy, the controls have historically been determined to be operating effectively. | Expected or known significant deficiencies in controls. |
Using one of the haircut percentages above will generally be appropriate and facilitate standardization and effective execution of our audit engagements and increase efficiency of our audit documentation. We would determine an appropriate haircut based on the evaluation of the factors above and considering whether all or some of the factors are present on the engagement. In situations when a combination of various factors is present (e.g., the engagement is considered high risk, but there is no history of adjustments and controls are operating effectively), we would normally select an appropriate haircut using professional judgment and considering which factors are most important to the engagement. However, in some circumstances we may consider using percentages other than those above. For example, a percentage in-between 25% and 50% may be appropriate in some circumstances, e.g., the entity has a predominant factor at both the higher and lower end of the range and we consider these factors to be equally important. When in doubt, consider consulting with Audit Services.
Use of the 50% Haircut
When we consider using a 50% haircut, determine if all the factors above have been appropriately evaluated. Consider using a 50% haircut only when the risk factors described above are pervasive across the entity versus related to specific risks. For those engagements where there are specific risks, consider using a 25% haircut and varying the nature, timing, and extent of testing to address the specific risk items (documenting this as materiality for particular classes of transactions, account balances or disclosures). For example, if there is a history of misstatements and significant risk in a particular account, we may apply a higher haircut to that account and apply a 25% haircut for performance materiality to be used for all other accounts.
An initial audit also does not require a 50% haircut just because of the fact that it is an initial audit. Engagement teams should distinguish between scenarios where a company has been audited in the past by a predecessor auditor and scenarios where an entity has never been subject to a review or audit. In the first scenario, engagement team should use the knowledge obtained from the review of the predecessor auditor’s working papers when determining the appropriate haircut. In the second scenario, the engagement team would generally be expected to use a 50% haircut.
Use of the 10% Haircut
This section outlines when a 10% haircut can be used. With regards to the criterion of the history of limited adjustments, if your entity has adjustments in specific areas year after year, and the engagement team has developed procedures to identify these known adjustments, then these would not be considered unexpected from an aggregation risk point of view. In this case, it is appropriate to still use the 10% haircut. On the other hand, if the entity has numerous adjustments that come up unexpectedly from year to year, then this haircut would likely not be appropriate.
Use of Haircuts other than 10%, 25% or 50%
Teams should evaluate the guidance and select the haircut percentage that best reflects their client facts and circumstances. The use of a haircut that is different from the percentages discussed in the guidance above is not recommended.