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Principles
Concept of materiality
Materiality is a fundamental concept in financial and compliance audit. It sets the level of deviation that the auditor considers is likely to influence the decisions of the intended users. In theory, deviations, or errors, are material if they, individually or aggregated with other errors, would reasonably affect the underlying audit conclusions or the decisions of the addressees of the audit report.
Users of information in the EU context, who must be considered when determining materiality, are primarily the European Parliament and Council (in particular due to the discharge procedure) but also the Commission and other EU institutions, member state authorities, media and the general public. Given the variety of users, determining materiality is a matter of professional judgement.
An item or group of items may be material due to their amount (quantitative materiality), nature or the context in which the deviation occurs (qualitative materiality).
There is a relationship between materiality and the level of audit risk. Furthermore, this threshold serves as a determining factor both in the calculation of sample sizes for substantive testing and in the interpretation of the audit results achieved.
Setting materiality limits helps the auditor to plan the audit so as to ensure that material deviations are detected by audit tests and resources are employed economically, efficiently and effectively. Auditing to a stricter (lower) materiality threshold requires more audit testing; however, the auditor must avoid “over-auditing" in areas that do not merit extensive work.
Materiality in different phases of audit
Materiality should be considered by the auditor during:
- planning, to help assess material risks and determine the nature, timing and extent of audit procedures;
- examination, when considering new information that may require planned procedures to be revised, and evaluating the effect of deviations;
- reporting, when reaching final conclusions and, where required, forming an audit opinion.
The auditor should document the materiality levels and changes made thereto during the audit.
Quantitative materiality
Quantitative materiality is determined by setting a numerical value. The numerical value is achieved by taking a percentage of an appropriate base, which both reflect, in the auditor's judgement, the measures that users of the information are most likely to consider important.
- When establishing the overall audit strategy, the auditor shall determine materiality for the financial statements or the audited population as a whole (overall materiality).
- Performance materiality is established while performing audit procedures on certain account balances and/or transactions and is deliberately settled lower than the overall materiality so that overall misstatements are kept under the overall materiality level.
Because ECA’s audits are generally planned before the final accounts are available, a tentative materiality threshold is set using budget rather than actual data. As actual data on expenditure or revenue becomes available, the auditor should review the materiality threshold to determine whether it remains suitable.
Qualitative materiality
Certain types of misstatements or non-compliance, while not quantitatively material, may - because of their nature or because of the context in which they arise - be qualitatively material and thus have an impact on the audit conclusion reached. Qualitative materiality includes items that may be either:
- material by nature: this is related to inherent characteristics and concerns issues where there may be specific disclosure requirements or high political or public interest. It includes any suspicion of serious mismanagement, fraud, illegality or irregularity or intentional misstatement or misrepresentation of results or information;
- material by context: this concerns items that are material by their circumstance, so that they change the impression given to users. It includes instances where a minor error may have a significant effect, e.g. misclassification of expenditure as income, so that an actual deficit is reported as a surplus in financial statements.
Issues that are material by nature or context are to be disclosed; however, only in exceptional cases - to be decided by ECA - are they to be taken into consideration in the audit opinion.
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- In financial audit: inadequate or improper description of an accounting policy such that it is likely that a user of the accounts would be misled, or, where relevant, the omission of an entity in a list of consolidated entities.
- In legality and regularity audit: a situation where, while the total value of irregularity errors is below the materiality threshold, the auditor is aware that the Budgetary Control Committee has expressed a special interest in irregularities, and thus considers that those found merit mention in ECA’s report.
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Instructions
ECA materiality threshold
For ECA, the threshold percentage is between 0,5% and 2%. While the choice is a matter of judgement, a threshold of 2% is generally used. Based on users’ expectations a different threshold may be applied. In addition to the threshold percentage, a ceiling may also be set in terms of the absolute amount.
Reliability audits
In case of consolidated annual accounts of the EU, the materiality for the financial statements as a whole is fixed at 2 % of the total amount of the liabilities.
We determine a performance materiality level for each item of the balance sheet. We take into account the nature and extent of misstatements identified in previous years and expectations in relation to misstatements in the current period.
We consider that misstatements of balance sheet items less than 50 million euro are not expected to have a material effect on the financial statements. We consider the cumulative impact of uncorrected misstatements on the accounts.
Legality and regularity audits
In legality and regularity audits the base is typically total expenditure or total revenue. For example:
- for the general budget, the materiality threshold is fixed at 2% of total expenditure per MFF heading or total revenue of the EU budget;
- for the audit of commitments the materiality threshold is fixed at 2% of total utilisation of commitment appropriations;
- for the EDFs, the materiality threshold is set at 2% of the total expenditure or total revenue of the EDFs budget;
- for the Agencies, the materiality threshold is set at 2% of the budgeted appropriations available for payment.
It should be noted that the actual audited underlying transaction, having passed through various levels of implementation in the member state concerned, may be a payment of a rather low amount (e.g. 1000 euros). Although this may not be considered to be material by the authorising officer, it will, if it affects the conditions for payment and exceeds 2% of the audited expenditure, be material when projected.
Materiality and systems failures regarding non-compliance
It would not be appropriate to use the materiality threshold of 2% as the only benchmark in the context of systems failures regarding non-compliance. In fact, systems weaknesses may be a management risk without in themselves resulting in actual errors of non-compliance, or may be a risk to compliance without materialising.
The quality or effectiveness of the internal control systems can be determined solely on the basis of the materiality threshold of 2% if the audit provided a reasonable assurance (for instance, based on sufficient tests of controls and/or substantive tests):
- that a systems weakness did not lead to material errors. In this case the internal control system would be rated as “effective";
- or, on the contrary, that due to the system weakness errors have not been prevented or detected and corrected that exceeded the materiality threshold that had been set. In this case, the internal control system would be rated as either “partially effective" or “not effective".
Without sufficient tests of controls and/or substantive tests, consideration should be given both to qualitative aspect (specifically, the seriousness of the shortcoming found) and the quantitative aspect (i.e. its potential financial impact) of the weakness. If the impact of these two elements together is of an order judged to exceed defined limits, the systems weakness must be considered material. As an indication, this is the case when a fundamental part of the internal control system has not been implemented (absence of an obligatory external auditor's certificate, absence of independence in a certifying body, etc.) and if the total sum of the transactions concerned exceeds a magnitude of around 10% of the total financial volume of the activities in question. This materiality threshold is based on the following logic: Based on experience, if the volume of transactions exceeds 10% and the expected maximum error rate exceeds 20% the materiality threshold will be exceeded (0,2 * >10% = >2%).
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