How would you explain materiality to a client, and how do you set it?

What the interviewer wants to hear

• Size or nature of misstatement that could change users’ decisions
• Based on a benchmark like profit before tax, revenue or total assets
• Percentage applied depends on the entity and users
• Performance materiality set lower
• Qualitative factors can make small items material

Model answer

I would say materiality is the level at which a mistake in the accounts would start to matter to the people using them, such as investors or lenders. Anything above that could change their decisions, so our audit is designed to find errors of that size. To set it, I pick a benchmark that users focus on: usually profit before tax for a profitable business, revenue or total expenses for a loss-making or not-for-profit entity, and total assets for an asset-heavy entity. I apply a percentage using judgement, for example around 5% of profit before tax. Then I set performance materiality lower, often 50% to 75% of overall materiality, depending on risk and past errors. I also keep qualitative factors in mind: a small payment to a director, a breach of a loan covenant or an illegal act can be material even if the amount is small.

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