The regulator visited eight audit firms to discuss the concept of materiality and review their related audit methodology and guidance, as well as reviewing relevant aspects of the procedures performed on the audit of 32 entities in a variety of sectors.

The FRC reported it was pleased that the majority of the key messages for audit firms from its previous report in 2013 have been addressed. These include an increase in the emphasis within the firms’ methodologies on the application of judgment when determining overall materiality and performance materiality; providing industry-specific guidance for many sectors and demonstrating the consideration of risk in setting performance materiality.

However, it made a number of recommendations to improve practice. The FRC found three of the audit firms have introduced guidance to encourage audit teams to reduce performance materiality to reflect the increased risk of first year audits. It said other firms should consider whether a lower performance materiality is appropriate for first year audits, given the increased risks associated with these audits and determine whether guidance in this area should be mandated.

Audit teams should ensure that if adjusted profit is used as a benchmark, it is a true reflection of the needs of users of the financial statements. If adjusted profit is used, auditors should explain why they have made the adjustments and how the benchmark selected better responds to the needs of the users of the financial statements.

The report analysed the auditor’s reports across the FTSE 350, where a profit measure was used as the materiality benchmark and found the most common percentage used is 5%. The FRC said that while it does not support a blanket 5% threshold, since there was evidence some audit committee chairs regard this as ‘standard’, it is particularly important to explain the judgments taken when a level in excess of 5% is set.

Audit firms should provide audit teams with guidance on setting component materiality, including both how to address the relative sizes of components and the particular risks arising in certain components.

The report said standard setters should consider whether auditors would benefit from guidance regarding setting component materiality and how it relates to overall materiality and the impact that it has on the audit work performed. It found a number of audit firms do not provide such guidance to their audit teams, which it said leads to inconsistencies in practice, both within and between firms.

In addition, the FRC recommended audit firms should consider how they can better explain the concept of performance materiality in their reports. As one of the influences on performance materiality is the auditor’s view of the control environment at the entity, the difference between overall materiality and performance materiality can give investors some insight into this area.

Finally, the FRC noted that firms’ methodologies typically provide little or no guidance on how to calculate materiality for loss making entities, a point it says it has raised with the firms.

Melanie McLaren, FRC’s executive director for audit and actuarial regulation, said: ‘In future with technological advances the importance of materiality may reduce as companies and their auditors become able to more cost-effectively, and accurately, interrogate and adjust financial information. However this is not yet the case.

‘Today, the assessment of materiality drives the scope, nature and extent of the auditor’s work. Appropriate quantitative and qualitative assessment of materiality affects audit quality.

‘We are pleased to see the audit firms take action following our 2013 thematic review. Auditors should be encouraged by investor feedback on the transparency afforded by UK extended auditor reports and redouble their efforts to communicate the reasons for and implications of the materiality threshold applied in specific audits.’

Audit quality thematic review materiality is here.

Report by Pat Sweet