Small misstatements that are still material
When a misstatement below overall materiality is still material because of covenants, trends, ratios or pay, and how to record that judgement.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
The misstatement is a small fraction of overall materiality. The client would rather not post it, the senior has marked it "not material", and the file is ready for the partner. Then someone notices what the adjustment touches: the interest cover ratio in the bank facility, which the company passes narrowly before the adjustment and fails after it.
Size is where materiality starts, not where it ends. This article covers when a misstatement below the overall threshold should still be treated as material, and how to show that judgement on the file so a reviewer can follow it.
Users' decisions, not only amounts
ICAEW explains that materiality is first and foremost a financial reporting concept and is not defined in ISA 320, but that ISA 320 highlights that misstatements are material if they could influence the decisions of users of the financial statements. ICAEW also notes that, under ISA 320, judgements about materiality depend on the surrounding circumstances, including the size and the nature of a misstatement, and rest on users' common needs as a group. Its guide to materiality in the audit of financial statements sets out that reasoning in full.
The overall materiality figure is a planning tool: a way of deciding how much work to do and where. It is not the definition of materiality. When the team evaluates actual misstatements, the question goes back to its source. Could this error, in this company, change what a reader does?
Covenants, ratios, trends and pay
ACCA explains that some misstatements may be evaluated as material even when they are below materiality for the statements as a whole, for example those that affect regulatory compliance, debt covenants, earnings trends, key ratios or management compensation. Each of those has a reader behind it:
- Regulatory compliance. Where a regulator or licensing condition sets a minimum based on reported figures, a small error near the line matters to the regulator.
- Debt covenants. A lender reads specific ratios, and an error that moves the company across a covenant changes the lender's rights.
- Earnings trends. A small error that turns a decline into growth, or a loss into a profit, changes the story a shareholder or buyer reads.
- Key ratios. Gross margin, the current ratio and gearing are the figures funders, analysts and tender evaluators use.
- Management compensation. A bonus or profit share based on reported profit gives management a reason to prefer one answer, so an error in management's favour is sensitive whatever its size.
Beyond ACCA's list, it is worth asking of every uncorrected item whether it involves a director or related party, whether it could be concealing something deliberate, and whether it sits in a disclosure a reader relies on for reasons other than the numbers.
Reassess materiality first
ACCA explains that before deciding whether uncorrected misstatements are material, individually or in aggregate, the auditor should reassess materiality to confirm that it remains appropriate in the context of the entity's actual results, since planning materiality was based on projected or draft statements.
Do this before the qualitative evaluation. If profit came in well below the budget used at planning, overall materiality may now be too high, and an error that looked small against the planning figure may be large against the right one. The qualitative question only makes sense once the quantitative threshold is right.
In Achekam, staff propose overall, performance and clearly-trivial materiality from a benchmark with a written rationale, and the engagement partner approves it, never the preparer. Achekam suggests no percentage. When materiality is revised at completion, the new approval replaces the old one and the old one is kept, so the file shows both figures and both rationales.
Recording the reasoning against the adjustment
A qualitative judgement that exists only in the partner's head will not survive review or inspection. Write it next to the misstatement.
In Achekam, lead schedules are built from the engagement's trial balance with each figure traceable to its lines, and staff can record an audit adjustment on a line with a reason. Use that reason for more than arithmetic; say what the adjustment touches. "Accrued interest understated; below performance materiality, but moves interest cover in the facility agreement from compliant to breach; treated as material, client asked to correct" tells a reviewer everything in one line. Findings can also be raised from a working paper and closed or withdrawn later, which suits a qualitative issue that needs follow-up, such as checking the covenant definitions in the facility agreement.
Why the completion summary will not do this for you
Achekam's completion stage has a Summary of Uncorrected Misstatements, and at present it stays empty, because no screen or route writes to the misstatement register it reads. The server code to record or project a misstatement exists, but no route calls it. That is a current limitation, so the team keeps the evaluation of uncorrected items, qualitative assessment included, on its own working paper. Keeping the uncorrected misstatements summary shows one way to build it.
Even a populated register would only add figures. It cannot know about a covenant or a bonus scheme. The qualitative column always needs a person.
Examples in words for a small company
- The bonus. A trading company pays its managing director a bonus on profit before tax. The team finds a small cut-off error that inflated profit. It is below performance materiality, but it raises the director's bonus. The partner treats it as material by nature and asks for correction.
- The tender threshold. A construction client must show a minimum net asset value to stay eligible for a public tender. A small overstatement of work in progress keeps it just above the line. A decision-maker relies on exactly that figure, so the error is material.
- The trend. A family company reports a small profit after a run of losses. An unrecorded supplier invoice, small in amount, would put the year back into a loss. The bank's credit committee will read the trend, so the team evaluates the error as material.
- The genuinely trivial. A rounding difference in a staff welfare account, below the clearly trivial amount and touching no ratio, covenant or person's pay. Nothing to accumulate and nothing to evaluate.
How the overall threshold is chosen in the first place is covered in choosing a materiality benchmark. Whatever figure the partner approves, the evaluation at the end comes back to the reader: who relies on this number, and would this error change what they do?
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
