What is Performance materiality?

PERFORMANCE MATERIALITY

1. Is the calculation of materiality for the financial statement as a whole.
2. Additionally, calculating a lesser amount when designing audit procedures to reduce the risk that misstatement in aggregate exceed the financial statements materiality.

Well, let’s say you had determined that 10,000 was the materiality level for assets. If a receivable balance were wrong by more than that then the possibility of a material misstatement has to be considered, and the error has to be noted by the audit team for consideration by the partner.

However, what if receivables were overstated by 8,000 and non-current assets overstated by 8,000 and liabilities understated by 8,000? These errors add up to $24,000 ALL IN THE SAME DIRECTION. Therefore, materiality is set at a lower level just in case such a scenario occurs.

Since the the concept of materiality at application level has been defined in the standards, it has been posing problems for students. Many think that this is a new concept, but it is fairly old and was there but it was certainly not defined before. Main reason to my mind why students find it hard to digest is that some concepts are bound to be understood through application and cannot be simply put in sentences.

Lets go through one example before we discuss this concept formally.

Example

A personal computer (PC) is made up of different components which are connected with each other and the user can use the PC only if all of these small pieces of hardware are working properly. In other words, if one of the component fails then whole PC might be useless.

Now consider yourself that you are using a particular PC which has different components in it. And we can understand that every electronic component can fail at any time if proper care is not taken.

Let’s assume that our PC in this example consists of monitor, mouse, keyboard, power supply and hard disk. All of these items can get faulty and some create more trouble then others and thus level of patience you have towards the fault in a particular component is different i.e. if some components are not working at their best you can manage to ignore them but for some components you have ZERO patience and correct them asap!

Now suppose that you want to use this PC to draft an analysis report using Microsoft Excel. In such situation if one key in a keyboard is not working you might still manage to complete your task easily. Same goes for mouse of which scroll wheel was not working and you were facing problem in scrolling the sheet downwards, but still you can complete your report. Yet in another instance if monitor is not giving true colors and screen is a bit reddish in tone, you can still use it and complete your work. You might get irritated on these problems, but these problems are not keeping you from using PC.But if all these problems start happening at one time (collectively causing problems) then user might get so angry that he find PC useless.

But lets assume that suddenly, you heard some metallic tapping and you found out that it is coming out of hard disk drive. Now, definitely your patience level will not be of same level like you shown towards keyboard, mouse and monitor and on hearing such sound you will act promptly and more seriously to fix hard disk problem so that you can save your crucial data. So here we observed that even single device was capable of rendering PC useless.

In above situation we understood that user of PC will take different level of care for different components in order to ensure that PC as a whole never fails.

Same goes in auditing for auditor.

Financial statements are made up of different accounts which are connected with each other just like components of a PC. Every account is interdependent and fault in one can pose problems in other areas of accounting just like if one component fails it has its bearing on other components.

As we discussed above that user shows different level of cautiousness different components as some are more crucial then others and thus slightest problem in then cannot be ignored as whole PC will fail because of this. Same goes for financial statements where some accounts are more crucial then others and slightest misstatements in them can be material in nature which can cause whole financial statements to be useless.

In our example user responded much more seriously to fix the problems in hard disk and ignored the problems in keyboard. Same is true for auditor who ignores some misstatements in certain accounts and for certain accounts he asks management to correct the misstatements promptly.

Just like user who showed different level of care for different components and because of this he ensured that no big problem of such nature arise either in a single component (hard disk) or in different components together (keyboard + mouse + monitor) that PC as a whole works suitable enough to draft a report.

Same goes for auditor who will have different level of materiality for different accounts so that no material misstatement either individually or collectively render financial statements useless for users of financial statements.

These varying materiality level he had for different accounts is basically examples of performance materiality at account balance level which is often more strict then the materiality level settled for a financial statements as a whole.

Lets take another example to understand how performance materiality helps auditor in reducing audit risk to an appropriate level.

Example

A student took an admission in an auditing course. Course contains 60 lectures in total. In order to qualify for exam entrance, students have to fulfill attendance criteria i.e. student can be absent from 10 lectures as a whole but not more than 1 lecture in a week.

Now the above attendance policy has two levels of restrictions. First that students cannot leave more than 10 lectures unattended during the whole course. Whereas, the second level is that maximum of one lecture can be left unattended in a particular week. This second restriction is probably there to ensure that no student fall short of 50 lectures in total and must attend at least 50 lectures. In simple words this second layer, which is more stringent then the first, is ensuring that first level of restriction is not breached.

Same goes in auditing. Performance materiality (materiality established for a particular component inside financial statement for example an assertion level) i.e. materiality established while performing audit procedures on certain account balances and/or transactions etc is deliberately settled lower than the materiality level for the financial statements as a whole so that overall misstatements are kept under the materiality level for the financial statement as a whole (materiality level established for the whole financial statement for example financial statement level).

Usf,
You have explained everything really clear!
It seems that you understand the topic in deep.
I would like to thank you for the time that
you spent to share this knowledge with us!

Take care!

Thanks so much, USF ?