More than 50,000 people work at audit firms across Australia and New Zealand. These professionals help maintain economic integrity by auditing financial statements of thousands of organizations. Audit measures are the foundations of this vital financial oversight process.
Auditors use these measures as quantitative reference points to determine materiality thresholds. Profit Before Tax (PBT) stands out as the most relevant metric for users of financial statements. This makes PBT the best benchmark to determine materiality in audit procedures. The materiality can change substantially – ranging from 3 to 10 percent of PBT. A company’s status as listed or unlisted plays a key role in this determination.
This piece gets into the details of selecting audit benchmarks. We’ll see how teams can set performance materiality between 85 to 50 percent of the materiality amount. Our audit and assurance teams serve more than 3,000 public companies and tens of thousands of other organizations each year. That’s why we need to really understand these measures. They help us deliver the quality and value that’s become central to public discussions over the last several years.
Defining Audit Benchmarks and Their Role in Audit Planning
Audit standards are significant reference points that guide the audit process. Standards can be defined as “a reference point to which an internal audit function can compare itself”. These standards directly influence how auditors review financial information and set appropriate thresholds to examine.
Materiality vs Performance Materiality: The Main Difference
The foundation of audit planning rests on overall materiality. This represents the maximum amount that financial statements can be misstated while still considered free from material misstatement. Auditors usually determine this during planning by using selected standards like Profit Before Tax (PBT).
On the other hand, performance materiality works as a “working materiality” set below overall materiality. SA 320 defines it as “the amount or amounts set by an auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the total of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole”.
The difference exists because:
- Performance materiality creates a safety buffer against aggregation risk
- It helps auditors do sufficient (but not excessive) work
- Auditors set it between 50-85% of overall materiality based on entity-specific factors
Entity-level control deficiencies, past misstatements, and management’s willingness to fix misstatements affect this range.
Standards Matter in Audit and Assurance Engagements
Standards play several vital roles in effective auditing:
1. Risk Assessment: Standards help auditors understand performance measures’ implications when reviewing audit risk. External standards highlight unique performance measures of a business unit.
2. Strategic Analysis: A deep strategic analysis before risk assessment lets auditors include more information whatever the performance measures’ standards. This leads to a balanced review of business units.
3. Professional Development: Chief Audit Executives learn from “a consistent and timely stream of information” through benchmarking reports. This helps them build stronger departments.
4. Better Efficiency: Standards work as tools that “allow to promote good practice and identify opportunities for improving efficiency and reducing costs”.
Standards might be “an imprecise science,” but they give valuable guidance to audit committees and chief audit executives about their audit function’s position compared to peers. On top of that, they help set proper materiality levels that affect the nature, timing, and scope of audit procedures.
Selecting the Right Benchmark: Metrics and Scenarios
The choice of a benchmark plays a vital role in the audit process. This choice affects materiality calculations and ended up defining the scope of audit procedures.
Profit Before Tax (PBT) as a Default Benchmark
Most profit-oriented entities use Profit Before Tax (PBT) as their main benchmark. Big accounting firms prefer earnings-based benchmarks like PBT for equity issuers. Shareholders and potential investors rely on these metrics to make investment decisions. In fact, dissecting key performance indicators that the entity publishes and metrics that financial analysts track helps identify the most relevant benchmark. PBT connects directly to what users value most in financial statements – the entity’s operating performance.
When Total Assets or Revenue Become More Relevant
In spite of that, some entity types need different benchmarks. Investment funds or trusts use total assets as their default benchmark since users care more about asset values than earnings. Companies that trade mainly for capital gains, like investment property firms, also use total assets because they generate profit through rising asset values. More importantly, revenue might work better than PBT when users’ focus changes due to business acquisitions or restructuring.
Volatility in PBT: Using Normalized Metrics
PBT’s volatility can be managed by adjusting for non-recurring items. Using an average PBT over 3-5 years helps smooth out these fluctuations. If the volatility continues after normalization attempts, stable metrics like total revenues or net assets provide a more reliable benchmark.
Startups and Capital-Intensive Entities: Total Expenses as Benchmark
Startup entities that focus on capital expenditure or asset development without much revenue use total assets as their benchmark. Other startups without major capital spending use total expenses as their main benchmark. The benchmark selection might need updates as entities move through different lifecycle stages, from startup to growth phase, to match their changing business priorities.
Performance Materiality and Aggregation Risk Management
Performance materiality serves as a vital safety mechanism in the audit process. This figure works beneath the surface, unlike overall materiality, and ensures audit quality through risk management.
SA 320 Definition of Performance Materiality
SA 320 precisely defines performance materiality as “the amount or amounts set by an auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the total of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole”. This creates a buffer zone that acknowledges a basic audit reality – planning to detect only individually material misstatements misses the risk that several smaller misstatements could collectively cause material misstatement.
Setting Performance Materiality: 50% to 85% Range
Professional judgment, not mechanical calculation, determines performance materiality. This figure typically ranges between 50% and 85% of overall materiality. Higher-risk entities need lower percentages near 50%, while lower-risk entities can use percentages up to 85%. This judgment affects:
- Extent of audit sampling
- Scope of areas subject to testing
- Margin for possible undetected misstatements
Control Deficiencies’ Effect on Performance Materiality
The quality of control environment directly shapes performance materiality decisions. Entity-level control deficiencies, history of misstatements, and management’s readiness to correct errors all shape this determination. A major deficiency happens when control problems “adversely affects the company’s ability to initiate, authorize, record, process, or report external financial data reliably”. Poor internal controls mean performance materiality must be set lower.
Aggregation Risk in Multi-location Audits
Aggregation risk – the chance that combined uncorrected and undetected misstatements exceed materiality – becomes stronger in multi-component audits. This happens because audit teams perform procedures separately in components of all sizes. The Australian Auditing Standards point out that “generally, aggregation risk increases as the number of components increases at which audit procedures are performed separately”. Teams must carefully establish component performance materiality to alleviate this increased risk.
Industry-Specific Benchmarking Insights from Experts
Each industry has unique traits that affect how we measure audits. Auditors with experience adapt their methods based on what specific sectors and clients need.
Investment Funds: Total Assets as Primary Metric
Investment funds choose total assets over Profit Before Tax (PBT) as their standard measure. This choice makes sense because users care more about the fund’s asset base than its earnings. Asset managers’ performance indicators naturally focus on assets under management (AUM) and cost-to-income ratios. Non-bank deposit takers use 1% of total assets as their materiality benchmark because it shows how well the entity performs.
Retail and Airlines: PBTCO as Benchmark Despite Low Margins
The Profit Before Tax from Continuing Operations (PBTCO) remains the right benchmark even in businesses with thin profit margins. Retail businesses prove this point – they stick with PBTCO despite their narrow margins. Airlines also use PBTCO or net assets/equity as their materiality benchmarks. They apply 1%-2% for high-risk work and 1%-3% when risks are lower.
Growth-Stage Startups: Revenue vs Asset Focus
Business models determine how startups measure performance. Startups that focus on capital spending or asset growth without much revenue naturally use total assets as their benchmark. Those without big capital investments look at total expenses instead. These startups typically use 0.5%-1.5% for high-risk projects. Their benchmark choices change as their business priorities evolve.
Group Audits: Component Materiality Allocation
Group audits need special attention when allocating component materiality. The component materiality must stay below group materiality to lower aggregation risk. The combined component materiality levels can be higher than group materiality. Mathematical models help determine the maximum combined component materiality (MACM). This usually equals 2.5 times group materiality for audits with five components. Components get different materiality levels based on their size, risk profile, and legal requirements.
Conclusion
Audit benchmarks form the foundation of effective audit practices. Our exploration shows how these benchmarks work as key reference points to determine materiality. Profit Before Tax stands as the preferred benchmark for most profit-oriented entities, though some cases need alternatives like total assets, revenue, or normalized metrics.
Performance materiality works as a vital safety net in the audit process. Auditors set this figure between 50% and 85% of overall materiality to handle aggregation risk and ensure thorough work without excess testing. Entity-specific factors like control environment quality and past misstatements help adjust this range.
Different industries need different benchmarks. Investment funds use total assets instead of PBT, while startups look at total expenses or assets based on their business model. Group audits need special focus on component materiality allocation because of higher aggregation risk.
Audit professionals should pick the right benchmarks by looking at entity traits, industry standards, and what users expect. This careful selection shapes the scope of audit procedures and the quality of financial statement audits. When auditors become skilled at these benchmarking principles, they can deliver the integrity and value that stakeholders want.
Good benchmark selection does more than just meet rules – it builds a stronger financial oversight process that organizations rely on throughout Australia, New Zealand, and beyond. These core principles will keep directing audit professionals as they adapt to changing business scenes and what regulators expect.
Key Takeaways
Understanding audit benchmarks is essential for effective financial oversight, as these quantitative reference points directly influence materiality thresholds and audit scope decisions.
- Profit Before Tax (PBT) serves as the default benchmark for most profit-oriented entities, typically ranging from 3-10% depending on company risk profile and listing status.
- Performance materiality operates as a safety buffer set between 50-85% of overall materiality to manage aggregation risk and prevent multiple small misstatements from becoming material.
- Industry-specific benchmarks optimize audit relevance – investment funds use total assets, startups focus on total expenses, while volatile entities benefit from normalized metrics.
- Control environment quality directly impacts materiality decisions – entities with weak internal controls require lower performance materiality percentages to compensate for increased risk.
- Group audits demand special component materiality allocation using mathematical models where aggregate component materiality can exceed group materiality by up to 2.5 times to manage multi-location risks.
Proper benchmark selection transcends compliance requirements – it strengthens the entire financial oversight framework that thousands of organizations rely on for maintaining economic integrity and stakeholder confidence.
FAQs
Q1. What is the primary benchmark used for determining materiality in audits?
Profit Before Tax (PBT) is generally considered the primary benchmark for determining materiality in audits of profit-oriented entities. However, alternative benchmarks may be more appropriate in certain scenarios.
Q2. How is performance materiality different from overall materiality?
Performance materiality is set lower than overall materiality to create a safety buffer against aggregation risk. It’s typically set between 50-85% of overall materiality, depending on entity-specific factors like control environment quality and misstatement history.
Q3. When should auditors consider using benchmarks other than Profit Before Tax?
Auditors should consider alternative benchmarks when PBT is volatile, for entities like investment funds (where total assets are more relevant), or for startups focusing on capital expenditure. Revenue or total expenses may also be appropriate in certain circumstances.
Q4. How does the control environment affect performance materiality?
The quality of an entity’s control environment directly impacts performance materiality. Entities with weaker internal controls or a history of misstatements require lower performance materiality percentages to compensate for increased risk.
Q5. What special considerations are needed for group audits regarding materiality?
Group audits require careful allocation of component materiality. The aggregate of component materiality levels may exceed group materiality, typically up to 2.5 times for five-component audits. Components receive varying materiality allocations based on size, risk profile, and statutory requirements.
