The Committee of European Auditing Oversight Bodies (CEAOB) has issued its report aggregating the results of its thematic review on “Materiality in th

Published on 21 September 2022 Email this Share this on LinkedIn Share this on Facebook Communiqué The Committee of European Auditing Oversight Bodies (CEAOB) has issued its report aggregating the results of its thematic review on “Materiality in the context of an audit” The CEAOB, which is the framework for co-operation between national audit oversight bodies at an EU level, has recently issued its report on “Materiality in the context of an audit” which aggregates the results of the thematic review carried out by its members in 2020 and 2021. The report provides an overview of how Big 4 Firms determine materiality levels and how Audit Committee Chairs perceive this assessment and interact with auditors on materiality matters. This report serves also the CEAOB as a support to address certain recommendations to auditors, audit committees and standard setters with the objective to enhance the appropriateness of the assessed materiality levels applied by auditors and to prevent judgemental biases. The « Commission de Surveillance du Secteur Financier », as authority responsible for the public oversight of the audit profession in Luxembourg, has played an active role in this survey by leading the Task Force in charge of the project at EU level. A full version of the report is available here below. 21 September 2022 Report on the CEAOB survey – Materiality in the context of an audit Studies and reports PDF (516.55Kb) Main topic: Enforcement of Issuer Disclosure Relevant for Credit institutions Public Oversight of the Audit Profession REPORT ON THE CEAOB SURVEY MATERIALITY IN THE CONTEXT OF AN AUDIT JULY 2022 1|P a g e Preamble: objective of the survey One of the key objectives of an auditor in conducting an audit of financial statements (“FS”), is to obtain reasonable assurance about whether the FS as a whole are free from material misstatement, whether due to fraud or error. The concept of materiality is thus fundamental in the context of an audit. There are however several questions which remain open for clarification. For instance, what does a material misstatement mean? How does the auditor exercise professional judgment to assess the audit materiality? Or how does this assessment impact the scope of the audit work? Considering the above, the Committee of European Auditing Oversight Bodies (“CEAOB”) carried out a survey in 2020 and 2021, which pursued the following objectives: 1 4 Explaining the concept of audit materiality and how it impacts an audit 2 Analyzing how the Big 4 audit firms and their audit methodologies help in exercising professional judgment in a consistent manner 3 Investigating how the concept of materiality is applied in practice by the BIG 4 firms on a sample of audits of Public Interest Entities ("PIE"), and Collecting the views on materiality for a sample of Audit Committee Chairs ("ACCs") to see the potential convergences or divergences with those of auditors. Methodology of the survey The first objective is targeted towards non-practitioners and aims to explain in simple words with the recourse of concrete examples the notion of materiality and its application on an audit. The elements used are based on ISA literature and especially ISA 320 “Materiality in planning and performing an audit”. To achieve objectives #2 to #4 listed above, the CEAOB developed three questionnaires:    Questionnaire 1: distributed to Big 4 networks and dedicated to collect information on their methodologies on materiality, applicable at the time of this survey (refer to Section 3); Questionnaire 2: capturing the application by Big 4 auditors of the methodologies, guidance and concepts on a sample of PIE audits (refer to Section 4); Questionnaire 3: addressed and filed in on a voluntary basis by a sample of ACCs (comprising PIE sample of Q2). It captured their views on audit materiality and the way materiality is discussed with the auditor (refer to Section 5). Q1 BIG 4 guidance Q2 Q3 Materiality in practice Audit Committees This publication is based on the input received from participants to this survey. As further disclosed in the Report, the coverage reached, in terms of PIE audits and audit committees enables a fair analysis of how auditors of Big 4 firms assess materiality in practice on their PIE audit engagements and how audit materiality is perceived by audit committees. However, as our sample is not statistical, our results and observations cannot be extrapolated. 2|P a g e Table of Contents Preamble: objective of the survey 2 1. Executive summary 4 2. Materiality and its impact on an audit 6 2.1. What is Materiality? 6 2.2. How materiality impacts the audit? 7 2.2.1. Impact of the Overall Materiality 7 2.2.2. Impact of the Performance Materiality 8 2.2.3. Impact of the Clearly Trivial Threshold 9 3. Determining materiality (in theory) 3.1. Determining Overall Materiality 10 10 3.1.1. Identifying the common financial information needs of FS users 10 3.1.2. Identifying the benchmark of most importance to FS users 10 3.1.3. Determining a value for the selected benchmark 11 3.1.4. Determining the appropriate percentage of the selected benchmark 12 3.1.5. Specific materiality of a lesser amount 13 3.2. Determining Performance Materiality 14 3.3. Determining Clearly Trivial Threshold 15 4. Determining materiality (in practice) 16 4.1. Most common benchmarks used by industry sector 16 4.2. Percentages applied when determining overall materiality 18 4.3. Percentages used to set Performance Materiality 20 4.4. Correlation between performance materiality and engagement risk 20 4.5. Other observations 22 5. Audit committees and materiality 23 5.1. Main key performance indicators scrutinized by audit committees 23 5.2. Comparison with the benchmarks selected by auditors 24 5.3. Comparison between the percentages applied by auditors and the expectations of ACCs 26 5.4. Interaction between the audit committees and the auditors on materiality 27 Appendices 28 Glossary of terms 31 3|P a g e 1. Executive summary Assessing the appropriate materiality levels is a fundamental decision for an audit engagement as it drives the scope, nature and extent of the procedures performed by the auditors. It cannot be reduced to a simple mechanical task and requires professional judgment in considering all relevant facts and circumstances, including qualitative aspects, with due care. The CEAOB survey on materiality, the scope of which is summarized below, provides a good overview of how Big 4 Firms determine materiality levels and how Audit Committee Chairs perceive this assessment and interact with auditors on materiality matters. 4 objectives covered 4 audit methodologies and guidance from Big 4 Firms scrutinized 495 PIE audits across 21 EEA countries observed 247 Audit Committee Chairs surveyed from 15 EEA countries If similarities between audit firms and audit committees were observed, some discrepancies and inconsistencies which are worth further consideration were noted. Therefore, in order to enhance the appropriateness of assessed materiality levels made by auditors, to prevent judgmental biases and to limit the source of discrepancies that may arise, recommendations made include the following: While recognizing the fundamental role of judgment in assessing audit materiality, standard setters may enhance the requirements on audit materiality by: • Providing application materials and/or illustrative examples regarding the ranges of percentages that could be applied by the auditors to the most frequently used benchmarks for PIE audit engagements; • Supporting auditors with an application guidance for the determination of the overall materiality percentage within a range, including for instance relevant indicators when using a percentage higher or lower in such range; • Establishing minimal rules for assessing performance materiality (for example the introduction of specific requirements for the "haircut" to be applied and the development of specific considerations for first year audits); • Considering for PIE audits the disclosure of overall materiality and its assessment basis not only in the additional report to the audit committee but also in the audit report. 4|P a g e Auditors need to stand back and may reconsider certain aspects of their practice when assessing audit materiality by: • Paying greater attention to the needs of financial statements' users when identifying the most relevant benchmark applicable to the audited entity, being sensitive to the key metrics and drivers they are following (e.g. EBITDA, Return on Equity...); • Challenging current methodology and guidance for assessing materiality for PIE audits, considering best-practices observed at peers; • Reconsidering the appropriateness of "Total assets" as the relevant benchmark when auditing a credit institution or an insurance company; • Favouring the use of higher "haircuts" for assessing performance materiality when working on a first-year engagement; • Having a closer look at the consistency of assessments made between engagement risks and materiality; • Carefully assessing the circumstances when specific materiality of a lesser amount for particular classes of transactions, accounts or disclosures needs to be determined. Audit committees need to enhance dialogue with auditors on materiality matters, taking even further steps when appropriate by: • Sharing their views on the main key performance indicators relevant to the situation and discussing contradictions, if any, with the benchmark selected by auditors for determining the overall materiality; • Challenging with due care the appropriate overall materiality percentages assessed by auditors. To this end, audit committees may consider enhancing their expectations, carefully assessing the amount of an omission or misstatement that could influence the economic decisions of the financial statements' users; • Paying attention to particular classes of transactions, account balances and disclosures, for which a specific lower materiality would be expected; • Putting more emphasis on the materiality level in the auditors' selection process and assessing the impact of the materiality determined on the audit scope and insofar on the audit quality. 5|P a g e 2. Materiality and its impact on an audit 2.1. What is Materiality? The concept of materiality recognizes that some matters are more important for the fair presentation of the FS than others are. In performing the audit, the auditor is concerned with matters that, individually or in aggregate, could be material to the FS. The auditor’s responsibility is to conduct an audit of the entity’s FS in accordance with ISAs. To this end the auditor has to “obtain reasonable assurance about whether the FS as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the FS are prepared, in all material respects, in accordance with an applicable financial reporting framework”1. Materiality is not only relevant for an audit but also for financial reporting. This is why ISA 320 notes that the frame of reference in determining the materiality for an audit is provided above all in the applicable financial reporting framework. Although financial reporting frameworks may discuss materiality in different terms2, they generally explain that: Frame of reference in determining materiality Misstatements and omissions are considered material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the FS. [ISA 320.2] Judgment about materiality are made in light of surrounding circumstances and are affected by the size or nature of a misstatement, or a combination of both; and Judgment about matters that are material to users of the FS are based on a consideration of the common financial information needs of users as a group. The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered. Whereas audit materiality is always represented by a figure, qualitative aspects surrounding its determination remain essential. In addition, it applies also to all types of disclosures, including non-quantified information. Therefore, while this survey focusses on many instances on figures and percentages, it is important that the reader keeps in mind that these amounts are always closely related to specific qualitative features suitable to the facts and circumstances of the audit engagement. 1 [ISA 200.11] See for instance the definition of the materiality given in §7 of IAS 1 “Presentation of Financial Statements” and in §5 of IAS 8 “Accounting policies, Changes in Accounting Estimates and Errors”. If the applicable financial reporting framework does not include a discussion of the concept of materiality, the characteristics referred to above (as per ISA 320.2) provide the auditor with such a frame of reference [ISA 320.3]. 2 6|P a g e 2.2. How materiality impacts the audit? Applying the concept of materiality in audit requires the auditor to determine various amounts including the materiality for the FS as a whole (referred as the overall materiality or “OM”), the performance materiality (“PM”) and to set a “clearly trivial” threshold (“CTT”). OM PM CTT Overall materiality is the maximum amount of an omission or misstatement that, individually or in the aggregate, could reasonably be expected to influence the economic decisions of the FS users. Performance materiality is used to assess risks of material misstatements (“RoMM”) and to determine the nature, timing and extent of the audit procedures. “Clearly trivial” threshold is intended to help the auditor to identify and accumulate misstatements identified during the audit, other than those that are clearly trivial. 2.2.1. Impact of the Overall Materiality OM fulfills two primary objectives3: 1. OM is set at planning stage by the auditor and serves in the determination of the overall audit strategy. Making judgments about the size of misstatements that will be considered material provides a basis for:  determining the nature, timing and extent of risk assessment procedures; and  concentrating the engagement team's efforts on significant matters. 2. OM is considered by the auditor in evaluating the effect of uncorrected misstatements, if any, on the FS and in forming its audit opinion. In assessing whether misstatements are material, the auditor needs to consider both the size and the nature of those misstatements. Illustrative example: a non-pervasive judgmental misstatement amounting to M€ 25.0 was identified during the audit. This misstatement is the only one identified by the auditor. Management disagrees with this audit misstatement and does not want to adjust the FS. Depending on the amount of overall materiality assessed by the auditor, the incidence on the audit opinion would be as follows: OM assessed at M€ 30.0 The misstatement is below OM. The auditor issues an unmodified opinion (i.e. the FS present fairly, in all material respects, the financial position of the Company as at YE (N) and its financial performance and its cash flows for the year then ended in accordance with the applicable financial reporting framework) and reports uncorrected misstatements to Management and TCWG. OM assessed at M€ 20.0 The misstatement is above OM but not pervasive. The auditor issues a qualified opinion (i.e. except for the identified misstatement described in the audit report, the FS present fairly, in all material respects, the financial position of the Company as at YE (N) and its financial performance and its cash flows for the year then ended in accordance with the applicable financial reporting framework) The OM is also used by the auditor to set PM as well as the CTT for accumulating misstatements. Both are in effect expressed as a percentage of the OM. 3 [ISA 320.5] 7|P a g e 2.2.2. Impact of the Performance Materiality Irrespective of the influence the use of data analytics4 may have in the audit work, PM remains key for identifying and assessing the RoMM and for determining the nature, timing and extent of further audit procedures. This amount is set below OM to reduce to an appropriately low level, the probability that the aggregate of uncorrected or undetected misstatements in the FS exceeds OM. In other words, it provides a buffer to the auditor for any possible undetected misstatements and helps him or her in reducing to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in the FS exceeds OM5. Depending on the facts and circumstances of the audit engagement, this buffer will need to be more or less significant. An inadequate assessment may therefore trigger insufficient audit procedures, as evidenced in the below illustrative examples:

1. a)Examination of accounts, classes of transactions (“CoTs”) and disclosures: PM primarily affects the identification of the account balances, CoTs and disclosures, the auditor plans to select for examination: Illustrative example: based on the understanding of the entity and its environment as well as on the experience gained from prior audits, the auditor determined PM to be M€ 16.9 which is 75% of OM (M€ 22.5). The audit response from the auditor to an account balance such as "Other debtors" may vary as follow: Account balance: M€ 15.0 Account balance: M€ 25.0 In the absence of any other identified risk factors, the auditor might not design and perform any audit procedures to cover the other debtors balance if there is no RoMM. Other debtors represent a material account balance. Irrespective of the assessed RoMM, ISA 330.18 requires the auditor to perform substantive procedures as it exceeds OM.
2. b)Determination of audit samples: PM serves often also for determining the tolerable misstatement6 level for audit sampling applicable to substantive audit procedures and accordingly affects the size of certain audit samples. A reduced level of PM requires a larger sample size to reduce the sampling risk as illustrated below: Illustrative example: let’s consider the following formulas for determining the sample size in a homogeneous population:  Sampling Interval = (Tolerable Misstatement – Expected deviation)  Confidence Factor  Sample Size = Population to be tested  Sampling Interval Considering the above formula with a population to be tested of M€ 200, an expected deviation of M€ Nil, a confidence factor of 2 and a tolerable misstatement set as PM, the sample size is: Tolerable Misstatement M€ 5.0 Tolerable Misstatement M€ 10 Tolerable Misstatement M€ 15 Calculated sample size = 80 items to be tested Calculated sample size = 40 items to be tested Calculated sample size = 27 items to be tested 4 In certain situations, data analytics techniques may enable, when adequately performed, the substantive testing of the entire population of CoTs, eliminating any sampling risk or aggregation risk. The incidence of PM on the audit and on the nature, timing and extent of further audit procedures, may therefore be significantly impacted in these instances. 5 “[ISA 320.A13]: 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. 6 “[ISA 530.A3]: When designing a sample, the auditor determines tolerable misstatement in order to address the risk that the aggregate of individually immaterial misstatements may cause the financial statements to be materially misstated and provide a margin for possible undetected misstatements. Tolerable misstatement is the application of performance materiality, as defined in ISA 320,2 to a particular sampling procedure. Tolerable misstatement may be the same amount or an amount lower than performance materiality.” 8|P a g e
3. c)Performance and results of substantive analytical procedures: Finally, PM influences the threshold the auditor uses, when performing substantive analytical procedures (ISA 520.A16)7 as well as the extent of the procedures performed. Illustrative example: the engagement team developed a substantive analytical procedure for reviewing the accuracy of the total payroll costs for the period, which amount to M€ 80. The auditor's expectation, based on the previous audited figures adjusted by
4. i)the known increase of the number of employees and
5. ii)the indexation of the salaries, amounts to M€ 81.8. The results of the procedure performed are therefore detailed as below: - Payroll costs (current balance): M€ 80.0 - Payroll costs (auditor's expectation): M€ 81.8 - Difference with the expectation: M€ 1.8 The auditor decides to use the assessed PM for the purposes of the investigation threshold. Let's consider the following two scenarios, where PM amounts to either M€ 2.0 (scenario
6. a)or M€ 1.5 (scenario b). Scenario a: PM = M€ 2.0 Scenario b: PM = M€ 1.5 The amount of difference from the expectation is below the threshold, therefore the auditor can positively conclude on the procedure performed without additional investigation. The amount of difference from the expectation exceeds the threshold, therefore the auditor cannot directly conclude on the procedure performed and has to perform additional investigation. 2.2.3. Impact of the Clearly Trivial Threshold The auditor sets CTT at an amount below which misstatements of amounts, would not need to be accumulated, because s(
7. he)expects that the accumulation of such amounts would clearly not have a material effect on the FS. Misstatements of amounts that are above the designated amount are accumulated (as required by ISA 450.58). They can also be distinguished between factual misstatements, judgmental misstatements and projected misstatements. If there is any uncertainty about whether one or more items are clearly trivial, the matter shall be considered by the auditor not to be clearly trivial. 7 “[ISA 520.A16]: The auditor’s determination of the amount of the difference from the expectation that can be accepted without further investigation is influenced by materiality and the consistency with the desired level of assurance, taking account of the possibility that a misstatement, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated.” 8 “[ISA 450.5]: The auditor shall accumulate misstatements identified during the audit, other than those that are clearly trivial.” 9|P a g e 3. Determining materiality (in theory) 3.1. Determining Overall Materiality Typically, auditors go through the following steps when establishing their overall audit strategy and assessing OM for a particular engagement: Identifying the common financial information needs of FS users Identifying the benchmark of most importance to users Determining the amount of the benchmark Determining the appropriate percentage of the selected benchmark 3.1.1. Identifying the common financial information needs of FS users Assessing materiality assumes the auditor being able to determine the amounts above which the decisions taken by FS users would be influenced or changed. Therefore, the auditor shall first identify the FS users and their needs. In applying his or her professional judgment, the auditor assumes that the FS users: Assumed characterstics of FS users Have a reasonable knowledge of business, economic activities, and accounting, and have a willingness to study the information in the FS with reasonable diligence; [ISA 320.4] Understand that FS are prepared and audited to levels of materiality; Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events; and Make reasonable economic decisions on the basis of the information in the FS. 3.1.2. Identifying the benchmark of most importance to FS users ISA 320 provides limited guidance to assist the auditor in identifying the benchmark of most importance to FS users. Indeed, apart from listing a number of factors to consider in its identification (refer to below extract), the standard merely states that profit before tax from continuing operations (“PBTCO”) is often used for profit-oriented entities and that when PBTCO is volatile, other benchmarks may be appropriate, such as gross profit or total revenues9. Factors which may influence the identification of a relevant benchmark [ISA 320.A3] Elements of the FS (e.g. assets, liabilities, equity, revenues, expenses) Whether there are items on which the attention of the users of the particular entity’s FS tends to be focused (e.g. for the purpose of evaluating financial performance, users may tend to focus on profit, revenue or net assets) Nature of the entity, where the entity is in its life cycle, and the industry and economic environment in which the entity operates Entity’s ownership structure and the way it is financed (e.g. if an entity is financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity’s earnings) Relative volatility of the benchmark 9 “[ISA 320.A5]: Examples of benchmarks that may be appropriate, depending on the circumstances of the entity, include categories of reported income such as profit before tax, total revenue, gross profit and total expenses, total equity or net asset value. Profit before tax from continuing operations is often used for profit-oriented entities. When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues.” 10 | P a g e To remediate this lack of guidance in the ISAs, Big 4 firms have developed detailed internal materials to assist practitioners to identify the relevant benchmark based on the facts and circumstances of the audit engagement. These internal firm’s guidelines help to drive consistency in their audit practice. First of all, a broadly shared guideline consists of giving a preference for an earnings-based benchmark (like Profit before tax (“PBT”) or PBTCO) for equity issuers. Indeed, it can reasonably be assumed that the primary users of FS are shareholders and potential investors and that the main decisions taken by these FS users are to purchase, sell or hold their investment in these entities. The stock price being a key element in this decisionmaking process, identifying the financial metrics which most influence the stock price is fundamental in establishing the materiality. Looking at the key performance indicators (“KPI”) regularly published by the issuer and at the main drivers monitored by financial analysts (e.g. Earnings per share (“EPS”) or Earnings before interest, tax, depreciation and Amortization (“EBITDA”)) helps in finding the relevant benchmark, on which to base the materiality. Except for particular situations (like start up entities or entities experiencing losses), the operating performance of the entity and an earnings-based benchmark (like PBT or PBTCO) will be the most relevant metric to consider for equity issuers. Although not stated in ISA 320, this presumption is clearly embodied in each Big 4 firm methodology. Other constructive elements observed in this regard in the firms’ methodologies include the following: Categorization of the benchmarks into the following measurement bases: o earnings-based measures: PBT, Earnings before interest and tax ("EBIT"), EBITDA and gross margin; o activity-based measures: revenues and operating expenses; and o capital-based measures: equity and assets Lists of generally accepted benchmarks and/or other metrics due to the nature of the entity (profitable entities, entities that are not profitable or operate near or at break-even, start-up entities) and/or its industry (e.g. banks, insurance...) Various illustrative examples explaining the reasoning behind the selection of a specific benchmark (e.g. highly leveraged entities, entities primarily generating profit from lending activities...) 3.1.3. Determining a value for the selected benchmark Determining a value for the benchmark is not always straightforward, not only because this exercise may require to adjust or “normalize” the amount for any specific non-recurring situations or events10, but also because the preliminary assessment is made at an early stage in the audit process. It may therefore need to use forward-looking information or extrapolation. Obviously, as the audit progresses, the auditor needs to reconsider the preliminary amount determined, in case of change in the circumstances or new information. 10 “[ISA 320.A6]: For example, when, as a starting point, materiality for the financial statements as a whole is determined for a particular entity based on a percentage of profit before tax from continuing operations, circumstances that give rise to an exceptional decrease or increase in such profit may lead the auditor to conclude that materiality for the financial statements as a whole is more appropriately determined using a normalized profit before tax from continuing operations figure based on past results.” 11 | P a g e 3.1.4. Determining benchmark the appropriate percentage of the selected ISA guidance is rather limited with regard to the percentage to be applied by the auditor to a chosen benchmark.11 This gap is however addressed in the Big 4 firms’ audit methodologies. Indeed, firms have developed quantitative and qualitative guidance for helping their auditors to determine the percentage to be applied against a selected benchmark in a consistent manner. These guidelines always include an illustration of presumed12 reasonable ranges of percentages to be applied to a chosen benchmark. Although one may question the appropriateness of such guideline, all 4 firms except Firm C provide two clear separate ranges: (
8. i)one for listed entities and PIEs (incl. entities in regulated industries) and (
9. ii)one for the other entities. The firm using common ranges for both PIEs and non-PIEs audit engagements has the highest upper percentages (as compared to the ranges applicable only for PIE audits of the other three firms) for the 5 common observed benchmarks illustrated below. Overview of % ranges to be applied to certain common benchmarks observed at Big 4 firms for PIEs audit Earnings-based measures PBT / PBTCO Activity and capital-based measures EBITDA Revenue Equity or net assets Total assets •Firm A • 5% to 8% • 2% to 3% • 0.5% to 1% • 1% to 2% • 0.5% to 1% •Firm B • Up to 5% • Up to 2.5% • Up to 1% • Up to 1% • Up to 1% •Firm C • 5% to 10% • 3% to 5% • 0.8% to 2% • 1% to 3% • 1% to 2% •Firm D • 3% to 5% •- • 0.5% to 1% • 0.5% to 2% • 0.5% to 1% The absence of guidance in the standards may be one of the reasons of the large variances observed in percentage ranges between the Big 4 firms. We will see in section 4 if these variances have an influence on the observed OM percentages when analyzing the results of our PIE audits’ sample. In addition to the above, Big 4 firms also provide practitioners with qualitative factors for assessing the appropriate level of a chosen benchmark. 11 “[ISA 320.A8]: For example, the auditor may consider five percent of profit before tax from continuing operations to be appropriate for a profit-oriented entity in manufacturing industry, while the auditor may consider one percent of total revenue or total expense to be appropriate for a not-for-profit entity. Higher or lower percentages, however, may be deemed appropriate in the circumstances.” 12 Ranges given in the methodologies are rebuttable and auditors still have the possibility, where deemed appropriate, to use a percentage outside the firm’s range. 12 | P a g e Among the factors, the presence or absence of which will influence the percentage retained, we can notably quote the following: - the business environment of the entity (stable vs volatile; viable vs eroding); the debt arrangements (traded debt or covenants); the consideration of specific factors (e.g. the entity operates in a highly regulated industry); the relative sensitivity to changes (e.g. where small changes in the earnings may have limited vs significant impact on users); the wide vs limited distribution of, or use of, the FS; the ranges used by analysts as well as market reaction to a profit warning. Beyond these qualitative and quantitative guidelines, the following requirements or guidance observed at some Big 4 firms’ merit being mentioned: Specific consultation requirements in certain situations or when certain criterias are met (e.g. when the auditor plans to set OM based on a percentage higher than 5% of PBT or EBIT for a listed entity, an entity in regulated industries or other PIEs) Calibration of the assessed OM with other supporting benchmarks or relevant metrics to validate the chosen percentage and benchmark Assessment whether OM is appropriate compared to prior period amount and benchmark Quantitative guidance for assessing the need for revision of the OM 3.1.5. Specific materiality of a lesser amount The auditor shall also determine if there are one or more particular CoTs, accounts balances or disclosures for which misstatements of a lesser amount than OM could reasonably be expected to influence the economic decisions of FS users13. This could relate to sensitive areas such as particular disclosures like management remuneration or EPS, or the compliance with legislation or certain contracts (e.g. bank covenants). To perform this assessment, the standard provides certain factors to be considered by the auditor as shown in the below extract: Factors which may indicate lower materiality levels for particular CoT, account balances or dsclosures [ISA 320.A11] Whether law, regulation, or the applicable financial reporting framework affect user's expectations regarding the measurement or disclosure of certain items (e.g. related party transactions, remuneration of management and TCWG 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 (e.g. R&D costs for a pharmaceutical company) Whether attention is focused on a particular aspect of the entity's business that is separately disclosed in the FS (e.g. disclosures about segments or a significant business combination) 13 “[ISA 320.10]: 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, accounts balances or disclosures.” 13 | P a g e 3.2. Determining Performance Materiality As explained in paragraph 2.2.2. of this report, PM plays a key role in the assessment of the RoMM and in the determination of the nature, timing and extent of the audit procedures. Its determination is not a simple mechanical calculation and involves the exercise of professional judgment. Factors influencing PM Auditor’s understanding of the entity, updated during the performance of the risk assessment procedures [ISA 320.A13] Nature and extent of misstatements identified in previous audits and thereby the auditor’s expectations in relation to misstatements in the current period The above considerations are embodied and further developed in the Big 4 firms’ audit methodologies, especially with regard to the key elements of the entity’s understanding to be considered. For illustrative purposes, the following factors are regularly quoted by the firms for determining the “haircut” percentage14 to be applied to the OM. - the history of misstatements; the effectiveness of the control environment; the changes in the business environment; the engagement risk; the attitude of management towards misstatements; the aggregation risk for misstatements; the turnover of senior management or key accounting personnel. To complement the above, each firm except one, also set its own grid of expected percentages to be applied to OM in determining PM. The positioning of the auditor in the grid will vary depending on his or her evaluation of the relevant qualitative factors. Expected percentages to be applied to the OM when determining the PM: Firm A: 2 grade scale 50% or 75% Firm B: 3 grade scale 50%, 75% or 90% Firm C: Firm D: No predetermined grid 3 grade scale 50%, 65% or 75% Based on this matrix, a consensus seems to emerge in the Big 4 firms’ audit methodologies for applying, as a maximum haircut, a rate of 50% for engagements having the "worst" qualitative factors as listed above (i.e. higher risks, deficiencies in internal controls, history of misstaments, etc...). This is not necessarily the case on other engagements. 14 When an auditor assesses the PM as 75% of the OM, this means a percentage reduction of 25% is applied to the OM (referred to as the “haircut”) 14 | P a g e To conclude this paragraph, the following guidelines have been observed at some firms, and are worth mentioning: Presumption of higher likelihood that misstatements may occur within the FS when corrected and uncorrected misstatements in the prior period exceed 25% of the OM. Use of the low range of the grid when misstatements due to fraud are experienced. Consultation requirement, if the amount determined as the PM exceed 80% of the OM. Expectation to set the PM at 50% of the OM in case of first-year audit. 3.3. Determining Clearly Trivial Threshold ISAs do not provide any qualitative guidance on the factors that may be considered by the auditor for setting CTT. Big 4 firms’ methodologies give some guidance to assist the auditors in their assessment even if it remains quite limited. These guidelines remind auditors that CTT should be determined using professional judgment and that factors similar to the ones used when determining PM could be considered. This includes: - the history of misstatements, whether corrected or uncorrected; and the expectations of the entity or those charged with governance. All the firms however have issued quantitative guidance specifying “clearly trivial” limits that can be used by practitioners. Clearly trivial threshold15 (expressed as % of the OM) Firm A: 5% (by default) or lower 15 Firm B: 0%, 3%, 5% or 10% Firm C: Firm D: Up to 5% 3% to 5% Based on section 4.5, a consensus around 5% of OM seems to be broadly shared among the Big 4 firms to determine the amount of CTT. This percentage corresponds to the upper limit of all the firms except one. The methodology of the Firm D has been updated to “Up to 5%” since the survey. 15 | P a g e 4. Determining materiality (in practice) After having observed how Big 4 firms’ methodologies support auditors in exercising their judgment to assess materiality, this section of the report depicts and analyzes, based on a sample of PIE audits, how audit professionals are applying their network guidance in practice. To this end, 495 PIE audit files from 2116 different EEA countries have been analyzed. Audit files selected cover accounting periods ranging from 31 December 2018 Year-End to 31 December 2020 Year-End. The selected sample was distributed as follow: Number of PIEs audit files per Big 4 firm: 152 160 140 Number of PIEs audit files per industry sector: 188 200 180 121 120 115 107 160 140 116 120 100 Including: Real Estate industry