What is the difference between performance materiality and overall materiality?

Performance materiality is a haircut (decrease) from overall materiality. Since overall materiality is the max amount that the financials can be misstated and still be free from material misstatement, the audit team will typically haircut overall materiality to calculate performance materiality.

Performance materiality is considered the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.

For example, if overall materiality was \$10,000, and the firm applied a 40% haircut, then performance materiality would be \$6,000.

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• How to set component materiality for a group audit?

If a parent company has multiple subsidiaries that are material to the overall business, then the group audit team will have component audit teams to performs audit of those subsidiaries. Now, overall materiality is set at the parent company / group level, however, the audit team needs to assign materiality to each component audit (i.e. component materiality). Now, the question is, how do you allocate the group materiality to each component. There is no set method, but the AICPA/PCAOB have provided several guidelines to be followed: 1) To reduce the risk that the aggregate of detected and undetected misstatements in the group financial statements exceeds the materiality level for the group financial statements as a whole, the component materiality level is set lower than the group materiality level. 2) Different materiality levels may be established for different components. 3) The component materiality level need not be an arithmetical portion of the group materiality level and, consequently, the aggregate of the component materiality levels may exceed the group materiality level. So as an example, if “group materiality” is \$9,000, and there are 3 components, then we should think about how to set materiality for each of the components. It would be way too risky to set component materiality at \$9,000 for each of the components since that is equal to the group materiality. If component materiality was set at \$9,000, then there is a chance that misstatements at the component level could go undetected, and when aggregated with other components, the total undetected misstatement could exceed group materiality of \$9,000. Ultimately, the audit team should use their judgement and set materiality at various levels below \$9,000 based on the size, complexity, and other factors of the specific component. Despite your component materiality levels, the “clearly trivial threshold” is determined at the group level and is the same for all components regardless of component materiality.

• What is the relationship between audit risk and materiality?

Audit risk has an inverse relationship with materiality. The lower the materiality, the higher the audit risk as a lower materiality means there is less room for error.

• What is the clearly trivial threshold?

Audit teams should establish a “clearly trivial threshold”, which is usually calculated as a percentage of overall materiality (e.g. 5% of overall materiality). Audit teams need to define this threshold because there may be errors that are below overall materiality, that when aggregated with other misstatements, may result in a material misstatement. How to calculate the clearly trivial threshold? If overall materiality is \$10,000, and the audit firm establishes the “clearly trivial threshold” by applying 5% (each firm will have their own methodology), then the clearly trivial threshold would be \$500. How to interpret the clearly trivial threshold? Now that we know the clearly trivial threshold is \$500, each member of the audit team should understand that if there is an error that is less than \$10,000 but greater than \$500, it needs to be recorded to a list (typically tracked in the audit software). While the difference or error won’t result in a material misstatement on an individual basis, when combined or aggregated with other errors, there could be a material misstatement. How to aggregate differences to assess if a material misstatement exists? At the end of the audit, the audit team should combine all of the errors or differences that are less than \$10,000 but greater than \$500 by the financial statement line item they impact. For example, if the audit team identified the 3 errors that all related to revenue (see below), then the aggregated impact is \$10,750, which is above overall materiality of \$10,000. Now there is a material misstatement to revenue! How can I keep track of all these small differences? Make life easier by having everyone on the team keep track of these differences as they go. Have a centralized workpaper in the audit file where the team tracks them. Otherwise, you’ll have to go through all of the workpapers at the end of the audit to make sure items below materiality don’t aggregate to a material misstatement! If you’re studying for the CPA exam, the Universal CPA Review course is the #1 course for visual and video learners. You can find 12 critical study tips that other candidates used to successfully pass the CPA exam here. Start a free trial by clicking the button below: