ISA 320 – Materiality in Planning and Performing an Audit does not define materiality, but specifies that it should be based on auditors' professional judgment and highlights the three key characteristics:
- If the misstatements, including omissions, could influence the decision of financial statements users, they are considered to be material.
- Judgments about materiality are based on surrounding circumstances, which include the size and nature of the misstatement, or a combination of both.
- Judgments are based on the common financial information needs of users as a group.
When it comes to internal auditing, the idea of materiality within assurance engagements appears in the International Standards for the Professional Practice of Internal Auditing in Standard 1220: Due Professional Care. Standard 1220.A1 says internal auditors must exercise due professional care by considering the:
- Extent of work needed to achieve the engagement's objectives.
- Relative complexity, materiality, or significance of matters to which assurance procedures are applied.
- Adequacy and effectiveness of governance, risk management, and control processes.
- Probability of significant errors, fraud, or noncompliance.
- Cost of assurance in relation to potential benefits.
The question is how does an internal auditor assess materiality? Here is some guidance, which can help internal auditors incorporate materiality in their regular way of working:
- Determine the level of materiality. Considering materiality upfront can significantly influence the quality of the entire audit engagement. Changing the initially assessed materiality during the audit engagement can create problems for auditors, such as missing or inadequately planned audit procedures.
- Make an analogy between internal and external auditing. Consider the audit report audience when assessing materiality. Internal auditors can use the three materiality characteristics described in ISA 320 to guide their assessment of materiality.
- Get input from audit clients. Asking audit clients what they consider material can be of great help. Audit clients may have their own perspective about the significance of issues and their impact on business decisions.
- Consider the specifics of the audit engagement and audited matters. Even though internal auditors might develop a general approach, the specifics of audit engagements may be of great relevance in assessing materiality levels appropriately.
- Take a broader perspective. Internal auditors might consider what is material and significant for the entire organization. Even though audit engagements may have a particular focus, the outcome of business transactions affects the whole organization.
- Conduct a cost–benefit analysis. Internal auditors might ask themselves, "What are the benefits coming from the work in relation to costs and the concept of materiality?" The worst possible outcome is for auditors to perform costly procedures on immaterial issues, which result in lower benefits than the costs incurred.
- Perform back-testing of the applied approach. After the audit engagement is completed, back-testing internal audit's materiality assessment can check its quality and appropriateness. This can help auditors refine their approach and increase the quality of work in future engagements.
The concept of materiality definitely has its role within internal auditing. Although the concept is not promoted as fundamental as in external auditing, internal auditors should consider it in different phases of their engagement. Incorporating materiality into an audit engagement represents a way for internal auditors to add value to the organization and demonstrate due professional care and conformance with the Standards.