Choosing a materiality benchmark
Which benchmark suits overall materiality for profitable, loss-making, non-profit and asset-holding clients, and how to write a rationale that holds up.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
Many audit files record materiality as a benchmark, a percentage and a result. The percentage gets the attention: is it at the top or bottom of the firm's range? The benchmark is often chosen by default, usually profit before tax, because that is what was used last year. Yet the benchmark is the bigger judgement. Apply a sensible percentage to the wrong benchmark and the result is still wrong, sometimes by a wide margin, because the benchmark decides what kind of figure materiality is measured against.
ISA 320 says that determining materiality involves professional judgement, and that a percentage is often applied to a chosen benchmark as a starting point. Choosing that starting point well depends on asking who uses the statements and what they look at.
What users of the statements care about
ISA 320 lists factors that affect the choice of benchmark:
- the elements of the statements, such as assets, liabilities, equity, revenue and expenses;
- whether there are items on which users tend to focus;
- the nature of the entity, where it is in its life cycle, and its industry and economic environment;
- its ownership structure and how it is financed;
- the relative volatility of the benchmark.
The question behind all of them is the same: if the statements were wrong, which figure would make a reasonable user change their decision? For a lender to a trading company, that is often profit and the ability to service debt. For a donor to a charity, it is how the money was spent. For a shareholder in a property company, it is the value of the property.
Profit, revenue, assets or expenses
| Benchmark | Suits | Watch for |
|---|---|---|
| Profit before tax from continuing operations | Profit-oriented entities with stable profits | Volatile or near break-even profit |
| Revenue | Entities where users focus on activity, or where profit is volatile or small | High-volume, low-margin businesses where revenue overstates the scale of risk |
| Gross profit | Trading entities with large, stable margins | Changes in cost classification |
| Total expenses | Non-profit entities and those funded to spend | Capital spending outside expenses |
| Total assets or net assets | Investment and property holding entities, start-ups with little activity | Assets carried at values that are themselves uncertain |
| Equity | Entities whose users focus on net worth | Equity distorted by large revaluations or accumulated losses |
The benchmark's source matters too. At planning, figures are usually from management accounts, budgets or last year's results; ISA 320 allows the auditor to use them, adjusted for significant changes. The rationale should say which figures were used.
Loss-making, non-profit and asset-holding clients
Four kinds of client cause most of the difficulty.
Loss-making or break-even clients. A percentage of a small loss produces a materiality so low that it means nothing to users. ISA 320 allows the auditor to use normalised profit, adjusted for exceptional items, or to choose a different benchmark. A start-up burning cash with little revenue may be better served by total expenses or total assets.
Owner-managed companies. Where the owner takes most of the profit as remuneration, reported profit is close to whatever the owner decides it should be. ISA 320's application material recognises that profit before the owner's remuneration and tax may be more relevant in that case.
Non-profit organisations. A school, church or foundation usually aims to spend what it receives, so surplus is small and uninformative. Donors and funders care about expenditure and how it was applied; total expenses or total revenue is usually more relevant.
Asset-holding entities. A company that holds property or investments may have little revenue and volatile profit driven by fair value movements. Total assets or net assets reflect what users look at. The materiality approval article works through a property-holding example.
Writing the rationale
A benchmark rationale is not a restatement of the benchmark. A strong one covers:
- Who the users are: shareholders, a lender, funders, a regulator.
- What they focus on, and why the chosen benchmark reflects it.
- Why the benchmark is stable enough, or how it was normalised, and for what.
- Which figures were used: draft statements, management accounts, budget or prior year.
- Why the alternatives were rejected, briefly.
"Profit before tax, standard benchmark" does none of this. "Revenue, because the company's profit has swung between small profits and losses for several years as it invests in expansion, while its lender monitors turnover against facility covenants; profit was rejected as too volatile to reflect what the lender relies on" does all of it.
The facts behind the rationale are usually already on the file. When staff generate working papers in Achekam, Achekam reads the engagement's facts, a person confirms what it cannot read, and another person approves the profile before a dry run shows the papers to be created. The facts confirmed there, about what kind of entity this is and how it is financed, are the same facts the benchmark rationale should cite.
Why Achekam suggests no percentage
In Achekam, staff propose overall, performance and clearly-trivial materiality from a benchmark with a written rationale. Achekam suggests no percentage, and the engagement partner approves, never the preparer. A new approval replaces the old one, which is kept.
The absence of a suggested percentage is deliberate. The percentage belongs to the firm's methodology and the partner's judgement. If your methodology has ranges for each benchmark, cite the range in the rationale and explain where in it you landed and why.
Approval matters downstream. In Audit Intelligence, no sample size is proposed without approved materiality and a confidence level. In a group audit, the Group Audit Control Tower records each component's scope, materiality and component auditor, so the group benchmark and its rationale shape every component figure that follows. Setting the lower figures from overall materiality is covered in performance materiality and clearly trivial amounts.
ICAEW's practical guide to materiality in the audit of financial statements covers the ISA requirements on choosing a benchmark, setting performance materiality and evaluating identified misstatements.
A question for every planning meeting
Before anyone mentions a percentage, ask the engagement partner one question: "If these statements were wrong, which number would the main user care about?" Write the answer down. It is the first line of the rationale.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
