Annual Audit Manual
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2104 Materiality for Particular Classes of Transactions, Account Balances or Disclosures
Jun-2021
In This Section
Determining materiality for particular classes of transactions, account balances, or disclosures
Overview
This topic explains:
- Determining materiality for particular classes of transactions, account balances or disclosures
- Factors that may indicate the need to determine materiality for particular classes of transactions, account balances or disclosures
- Materiality for particular classes of transactions, account balances or disclosures
CAS Requirement
If, in the specific circumstances of the entity, there is one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements, the auditor shall also determine the materiality level or levels to be applied to those particular classes of transactions, account balances or disclosures (CAS 320.10).
CAS Guidance
Factors that may indicate the existence of one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements include the following (CAS 320.A11):
- Whether law, regulation or the applicable financial reporting framework affect users’ expectations regarding the measurement or disclosure of certain items (for example, related party transactions, the remuneration of management and those charged with governance, and sensitivity analysis for fair value accounting estimates with high estimation uncertainty).
- The key disclosures in relation to the industry in which the entity operates (for example, research and development costs for a pharmaceutical company).
- Whether attention is focused on a particular aspect of the entity’s business that is separately disclosed in the financial statements (for example, disclosures about segments or a significant business combination).
In considering whether, in the specific circumstances of the entity, such classes of transactions, account balances or disclosures exist, the auditor may find it useful to obtain an understanding of the views and expectations of those charged with governance and management (CAS 320.A12).
OAG Guidance
When determining materiality for particular classes of transactions, account balances or disclosures also consider whether a risk of fraud has been identified (for example, transactions between related parties).
Where there is an aggregation risk in relation to the particular items, consider what lower level of performance materiality to establish in order to design the related audit procedures.
See OAG Audit 2210 for guidance on communicating materiality to clients.
Performance materiality for auditing pension assets in the financial statements of the sponsor
Materiality and Scoping Considerations for Testing Plan Assets when auditing the Sponsor
Pension and other postretirement plan assets (“plan assets”) are investments held by the pension or other postretirement plans to fund the benefit obligation for employees that participate in the plan. Plan assets are not directly owned by the sponsor entity and, therefore, are not recorded as an asset/investment in the sponsor entity’s balance sheet. Rather, the fair value of plan assets is a significant factor in calculating the funded status of the plan (which is recorded in the sponsor’s financial statements) and disclosures related to the plan. An error in the fair value of plan assets will often only have an indirect, rather than a dollar for dollar impact, on the sponsor entity’s income statement, due to the fact that the periodic plan cost reflected in the income statement is typically impacted only to the extent of the change in the expected return on plan assets assumption.
When auditing defined benefit plans in the financial statements of the sponsor it might be appropriate for engagement teams under certain circumstances to use a performance materiality level for testing plan assets that is higher than the performance materiality determined for the financial statements as a whole.
However, engagement teams should NOT use a higher performance materiality for testing plan assets in cases where the client recognizes the change in the fair value of plan assets immediately or on an accelerated basis within the income statement and your overall materiality is determined based on profit before tax.
Careful consideration of materiality needs to be made in advance of substantive testing of plan assets to ensure the development of an effective and efficient testing strategy for purposes of auditing the sponsor entity’s pension or other postretirement plan funded status and related disclosure.
Under IFRS the starting point for determining the performance materiality for testing plan assets is to determine the amount of error in plan assets that would result in a material error in the income statement (i.e. performance materiality for the financial statements as a whole divided by the expected return on plan assets).
Auditing Standards require that we plan and perform audit procedures to detect misstatements that, individually or in combination with other misstatements, would result in material misstatement of the financial statements, which include all of the relevant accounts and disclosures related to an entity’s pension plan. Such accounts and disclosures include:
- Comprehensive income (loss)
- Total plan assets
- Shareholders’ equity, including accumulated other comprehensive income (loss)
While an error in the fair value of plan assets would only have an indirect, rather than a dollar for dollar impact, on the sponsor entity’s income statement, it is important that engagement teams do not limit the consideration of materiality for plan assets solely to the income statement impact, even if it may be the most significant factor noted. Before accepting the “starting point” amount as the performance materiality for auditing plan assets, engagement teams should evaluate this amount (quantitative and qualitative assessment) in light of the other accounts and disclosures that would be affected by errors in the plan assets. Based on this judgmental analysis we may conclude that the alternative performance materiality amount needs to be less than the “starting point” but may still exceed that used for the financial statement as a whole.
| Qualitative Consideration | Rule of Thumb Considerations |
|---|---|
| Plan funding requirements - Does the funded status of benefit plans affect the determination of timing or amount of company funding of the plans? If so, how big would an error in plan assets have to be to affect that funding? How important are future benefit funding requirements to the company’s liquidity? | If an error in plan assets smaller than our “starting point” or amounts set using our rules-of-thumb would create a high risk of triggering material additional funding of the plan, we would consider a lower alternative performance materiality to address this risk. Generally because funding status is a net amount in a sponsor’s financial statements, a quantitative impact evaluation is not meaningful. |
| Regulatory capital - Is the company an institution subject to regulatory capital requirements? If so, how big would an error in plan assets have to be to risk noncompliance with those requirements? | If an error in plan assets smaller than our “starting point” or amounts set using our rules-of-thumb would create a high risk of violating regulatory capital requirements, we would consider a lower alternative performance materiality to address this risk. |
| Use of performance measures - What significance has the company placed in its communications with investors about comprehensive income? What significance have analysts attached to the company’s comprehensive income? | If significant weight is given by the company or analysts to comprehensive income, we would consider a lower alternative performance materiality relative to our rule-of-thumb for comprehensive income. |
| Very small benchmarks - Is either comprehensive income or total equity very small, or near break even levels? Both of these quantitative benchmarks for setting materiality for plan assets can be the net of positive and negative balances. | We might give greater weight to plan assets as a materiality benchmark when either comprehensive income or total equity is near break even. |
| Nature and Composition of AOCI - AOCI includes the effects of a variety of activities, which may be volatile from period to period and which may be offsetting in any given period. For example, cumulative gains on plan assets could be offset by cumulative losses on foreign exchange and reduce the amount of AOCI. Additionally, plan asset gains or losses included in AOCI do not necessarily bear a relationship to the recorded amount of plan assets. These factors make it inherently difficult to set meaningful rules of thumb using AOCI as benchmark in setting materiality for planning our tests of plan assets. |
AOCI would be evaluated qualitatively because it is a net amount in a sponsor’s financial statements such that a quantitative impact evaluation is not meaningful. |
| Materiality exceeds rules of thumb - This guidance presents rules of thumb relative to plan assets, equity, and comprehensive income to help engagement teams apply their judgment with greater confidence that the resulting audit strategy is appropriate. | Facts and circumstances beyond those discussed in this guidance may lead teams to conclude that a materiality level in excess of one or more of these rules of thumb is appropriate. |
After considering the qualitative factors noted above, engagement teams should assess the performance materiality level selected for testing plan assets based on the following rule of thumbs:
- 15% of total plan assets
- 15% of comprehensive income (loss)
- 5% of total equity
Although we would generally expect the alternative performance materiality amount as a percentage of the relevant benchmark above to be at or below the relevant rule of thumb percentage, facts and circumstances specific to individual audits may lead engagement teams to select an alternative performance materiality amount for testing plan assets in excess of one or more of the relevant rule of thumb percentages. If the alternative performance materiality amount exceeds any one of the relevant rule of thumb percentages, consultation with Audit Services should be considered.
Considerations for determining performance materiality for testing plan assets are complex. Consult with Audit Services if you have any questions about calculating this materiality for your client.