Understanding Audit Materiality: Concept, Calculation & Application

Your auditor mentioned that a AED 45,000 error is "immaterial" and doesn't require adjustment, but you're confused because that seems like a significant amount—how do auditors actually determine what's material versus immaterial, and why does it matter for your audit opinion? Materiality is the fundamental threshold concept in auditing (defined by ISA 320) that determines which misstatements are significant enough to influence users' economic decisions, but many UAE business owners don't understand how auditors calculate materiality benchmarks (typically 0.5-2% of revenue, assets, or profit), why different thresholds apply to different items, and how materiality directly impacts audit scope, procedures, and costs.

With 37 years conducting audits for 28,000+ UAE businesses across all sizes (from AED 2M startups to AED 500M+ corporations), Farahat & Co's auditors apply materiality judgments daily across diverse industries and regulatory environments. Our technical expertise ensures materiality is set appropriately—not so low that audit costs become excessive, yet not so high that material misstatements go undetected.

This comprehensive materiality guide explains:

• ISA 320 definition and why materiality exists (cost-benefit of auditing to 100% accuracy)
• Quantitative calculation methods: revenue, assets, and profit benchmarks with UAE examples
• Performance materiality: the lower threshold auditors use during fieldwork (70-80% of overall)
• Clearly trivial threshold: when errors are so small they don't even need to be tracked
• Qualitative factors: when AED 5,000 can be material despite being quantitatively immaterial
• Real-world examples: how materiality applies to AED 5M, AED 50M, and AED 200M companies
• Impact on audit fees: why lower materiality = higher audit costs (+25-40%)
• Revision during audit: when auditors must recalculate materiality mid-engagement

Whether you're a AED 3M trading company wondering why your auditor is testing AED 30K+ transactions, a AED 80M manufacturer questioning why a AED 120K inventory error requires adjustment, or a CFO negotiating audit scope and trying to understand the cost implications of materiality levels, this expert guide—based on thousands of materiality determinations—demystifies this critical audit concept.

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What is Materiality? The Fundamental Audit Concept

ISA 320 Definition

From International Standard on Auditing 320:

"Misstatements, including omissions, are considered to be material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements."

Plain English Translation:

Materiality is the threshold that separates:

• Material errors → Significant enough to change user decisions → Must be corrected or disclosed
• Immaterial errors → Too small to affect user decisions → Can be left uncorrected (if management agrees)

Why Materiality Exists:

100% Accuracy is Impossible and Uneconomical:

• Financial statements contain thousands of transactions
• Testing every transaction would cost more than the audit provides value
• Some level of aggregated error is acceptable if below materiality threshold
• Materiality allows auditors to focus on what matters

Example:

Company A: AED 100M revenue

• Materiality: AED 500,000 (0.5% of revenue)
• Scenario 1: Auditor finds AED 450K error (below materiality) → Can remain uncorrected if qualitatively immaterial
• Scenario 2: Auditor finds AED 600K error (exceeds materiality) → Must be corrected or disclosed

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Users of Financial Statements & Their Decisions

Who Uses Your Financial Statements?

External Users:

1. Banks & Lenders

   • Decision: Approve AED 5M loan or not?
   • Care about: Asset values (collateral), profitability (repayment capacity), debt levels

2. Investors & Shareholders

   • Decision: Invest AED 10M or not?
   • Care about: Profit trends, return on investment, financial health

3. Customers & Suppliers

   • Decision: Enter long-term contract or not?
   • Care about: Going concern, ability to fulfill contracts

4. Regulatory Authorities

   • Decision: Company compliant or not?
   • Care about: Accurate reporting, tax compliance, license requirements

Material = Would Change Their Decision

Example:

Bank Loan Decision:

• Company reports profit: AED 8M
• Bank approves loan based on profitability
• If auditor finds AED 2M error: Actual profit AED 6M (25% overstatement)
  • Material! Bank might have declined loan with AED 6M profit
• If auditor finds AED 200K error: Actual profit AED 7.8M (2.5% overstatement)
  • Likely immaterial - Bank decision wouldn't change

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Quantitative Materiality: Calculation Methods

Common Benchmark Formulas

Auditors typically use these percentages of financial statement items:

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Choosing the Right Benchmark:

Question 1: Who are the primary users?

• Banks/Lenders → Focus on assets (collateral) and debt capacity
• Investors → Focus on profit and return
• Regulators → Focus on revenue (for licensing, tax)

Question 2: What's the company's situation?

• Profitable, stable → Use profit before tax
• Loss-making → Use revenue, assets, or equity (profit not reliable)
• Highly leveraged → Use equity or assets
• Small margins → Use gross profit or revenue

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Real-World Materiality Calculations (UAE Examples)

Example 1: Trading Company (DMCC)

Company Profile:

• Revenue: AED 25M
• Total Assets: AED 8M
• Profit Before Tax: AED 1.2M
• Industry: Electronics trading
• Users: Bank (AED 3M facility), shareholders

Benchmark Analysis:

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Auditor's Choice: Revenue benchmark → AED 187,500 materiality

Rationale:

• Trading companies: Revenue is stable and key metric
• Bank focuses on revenue (business volume) and profit capacity
• Profit can fluctuate year-to-year (less reliable)
• Set materiality: AED 185,000 (rounded)

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Example 2: Real Estate Holding Company (DIFC)

Company Profile:

• Revenue: AED 3.5M (rental income)
• Total Assets: AED 180M (investment properties)
• Profit Before Tax: AED 2.8M
• Industry: Real estate investment
• Users: Investors, potential acquirers

Benchmark Analysis:

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Auditor's Choice: Assets benchmark → AED 2,700,000 materiality

Rationale:

• Real estate: Asset values are what investors care about
• Property valuations can swing AED millions
• Revenue (rent) is relatively small/stable
• Set materiality: AED 2,500,000 (rounded)

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Example 3: Startup Tech Company (Dubai South)

Company Profile:

• Revenue: AED 1.2M (year 2 of operations)
• Total Assets: AED 2.5M
• Profit Before Tax: AED (800K) LOSS
• Equity: AED 1.5M
• Industry: SaaS technology
• Users: VC investors considering Series A funding

Benchmark Analysis:

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Auditor's Choice: Equity benchmark → AED 60,000 materiality

Rationale:

• Loss-making companies: Profit benchmark not applicable
• VCs care about burn rate and remaining equity/runway
• Revenue still scaling (not stable benchmark)
• Set materiality: AED 60,000 (rounded)

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Performance Materiality: The Working Threshold

What is Performance Materiality?

Performance Materiality = Lower threshold used DURING audit fieldwork

Typical Range: 70-80% of overall materiality

Purpose: Create a "buffer" or "safety margin"

Why Needed?

Problem Without Performance Materiality:

• Overall materiality: AED 500K
• Auditor tests to AED 500K threshold
• Finds 8 separate errors: AED 55K, AED 48K, AED 62K, AED 51K, AED 59K, AED 44K, AED 58K, AED 47K
• Total: AED 424K (below AED 500K individually, but aggregate = AED 424K approaches materiality)
• Risk: Small additional error → Exceeds materiality → Qualified opinion

Solution: Performance Materiality:

• Overall materiality: AED 500K
• Performance materiality: AED 375K (75% of overall)
• Auditor tests to AED 375K threshold
• Creates AED 125K buffer for aggregation of small errors
• Reduces risk of exceeding overall materiality

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Performance Materiality Calculation

Formula: Performance Materiality = Overall Materiality × (70-80%)

Example:

JAFZA Trading Company:

• Overall materiality: AED 200,000
• Performance materiality: AED 150,000 (75%)

What this means during audit:

• Auditor investigates all errors > AED 150K (not AED 200K)
• More transactions tested than if using AED 200K threshold
• Creates AED 50K "cushion" for small errors

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Factors Affecting Performance Materiality %

Higher Risk = Lower % (More Buffer Needed)

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Examples:

Low Risk Company:

• Strong internal controls
• Clean prior year audit (zero adjustments)
• Experienced finance team
• Performance materiality: 80%

High Risk Company:

• Weak internal controls
• First-time audit with messy books
• Multiple errors found in planning
• Performance materiality: 70% or lower

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Clearly Trivial Threshold: When Errors Don't Even Matter

Definition

Clearly Trivial = Errors so small they're not worth tracking

Typical Range: 3-5% of overall materiality

Purpose:

• Reduce administrative burden on auditor
• Focus on errors that could actually aggregate to material

Example:

Company Materiality: AED 500,000

• Overall materiality: AED 500,000
• Performance materiality: AED 375,000
• Clearly trivial: AED 15,000-25,000 (3-5% of AED 500K)

Application:

Error Found: AED 8,000

• Below clearly trivial threshold (AED 15K)
• Auditor action: Note it exists, but don't track or request adjustment
• Rationale: Even 50 such errors (AED 400K total) wouldn't be material

Error Found: AED 22,000

• Above clearly trivial threshold (AED 15K)
• Auditor action: Document in summary of uncorrected misstatements
• Rationale: Multiple such errors could aggregate to material

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Qualitative Materiality: When Small Amounts Are Material

Quantitatively Immaterial, Qualitatively Material

Sometimes AED 5,000 can be material despite being below quantitative threshold.

Qualitative Factors That Make Small Amounts Material:

1. Nature of the Item

Example: Director Compensation

• Overall materiality: AED 300,000
• Error: AED 15,000 undisclosed director bonus
• Quantitatively: AED 15K < AED 300K (immaterial)
• Qualitatively: MATERIAL (related party disclosure required, sensitive nature)

2. Regulatory/Legal Impact

Example: License Fee

• Overall materiality: AED 200,000
• Error: AED 8,000 unpaid DMCC license renewal fee
• Quantitatively: AED 8K < AED 200K (immaterial)
• Qualitatively: MATERIAL (could cause license suspension, going concern issue)

3. Fraud or Intentional Misstatement

Example: Cash Theft

• Overall materiality: AED 500,000
• Error: AED 12,000 cash stolen by employee
• Quantitatively: AED 12K < AED 500K (immaterial)
• Qualitatively: MATERIAL (fraud always material regardless of amount)

4. Covenant Violations

Example: Bank Covenant

• Bank loan covenant: Maintain debt/equity ratio < 2.0
• Current ratio: 1.98 (compliant)
• Error found: AED 25,000 debt omission
• Corrected ratio: 2.03 (violation!)
• Quantitatively: AED 25K may be immaterial
• Qualitatively: MATERIAL (triggers covenant breach, loan callable)

5. Trend Changes

Example: Profit to Loss

• Reported: AED 50,000 profit
• Error: AED 80,000 expense omission
• Corrected: AED (30,000) LOSS
• Overall materiality: AED 400,000
• Quantitatively: AED 80K < AED 400K (immaterial)
• Qualitatively: MATERIAL (changes company from profitable to loss-making)

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Impact on Audit Scope & Costs

How Materiality Affects Your Audit

Lower Materiality = More Testing = Higher Audit Fees

Example Comparison:

Company: AED 50M revenue trading company

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Cost Impact: +25-60% when materiality reduced by half

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Negotiating Materiality with Auditors?

Can You Request Higher Materiality to Reduce Fees?

Short Answer: No (Professional Standards Apply)

Why Not:

• ISA 320 requires auditor to set materiality using professional judgment
• Auditor considers user needs, not just client preference
• Regulators/banks may have expectations on materiality levels
• Auditor's professional liability depends on appropriate materiality

What You CAN Do:

• Improve bookkeeping quality → Reduce audit hours (not materiality, but reduces fee)
• Engage auditor early → Avoid rush premiums
• Multi-year engagement → Year 2+ efficiency gains

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Revision of Materiality During Audit

When Auditors Recalculate Materiality

Materiality is Set at Planning Stage, But Can Be Revised:

Reasons for Revision:

1. Financial Results Differ Significantly from Planning

Example:

• Planning (based on budget): AED 100M revenue expected
• Materiality set: AED 750,000 (0.75% of AED 100M)
• Actual results: AED 65M revenue (35% below budget)
• Revised materiality: AED 487,500 (0.75% of AED 65M)
• Impact: Must perform additional testing on items AED 488K-750K

2. Change in Circumstances

Example:

• Company announces sale of business during audit
• New users: Potential acquirers (much more scrutiny)
• Auditor action: Reduce materiality to reflect higher user expectations

3. Discovery of Fraud

Example:

• Material fraud discovered
• All fraud amounts become material (qualitative override)
• May reduce overall materiality due to increased risk

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Frequently Asked Questions

1. My auditor says AED 85,000 error is immaterial, but that's a lot of money! Why isn't it material?

It depends on your company size and the benchmarks used.

Context is Everything:

Scenario A: Small Company (AED 3M revenue)

• Materiality: AED 22,500 (0.75% of AED 3M)
• Error: AED 85,000
• AED 85K > AED 22.5K → MATERIAL (must be corrected)

Scenario B: Large Company (AED 200M revenue)

• Materiality: AED 1,500,000 (0.75% of AED 200M)
• Error: AED 85,000
• AED 85K < AED 1.5M → Immaterial (can remain uncorrected)

Explanation:

• AED 85K is 0.04% of AED 200M (tiny percentage)
• Would not influence decisions of users (banks, investors)
• In context, it's like AED 0.85 error in AED 2,000 budget (insignificant)

However, Check Qualitative Factors:

• If fraud: Material regardless of amount
• If related party: May require disclosure despite being quantitatively immaterial
• If affects trend: Profit to loss → Material

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2. Can I negotiate materiality with my auditor to reduce audit fees?

No. Materiality is set by auditor using professional standards, not client preference.

Why You Can't Negotiate:

Professional Standards (ISA 320):

• Auditor must set materiality using professional judgment
• Consider user needs (banks, investors, regulators)
• Cannot compromise audit quality for fee reduction
• Professional liability requires defensible materiality

Regulatory Expectations:

• Banks may expect certain materiality levels (often 0.5-1% revenue)
• Free zone authorities have audit quality expectations
• Setting too-high materiality = inadequate audit

What Happens If Auditor Sets Materiality Too High:

• Material errors go undetected
• Users make decisions based on wrong information
• Auditor faces professional liability
• Regulatory action against auditor

Better Approaches to Reduce Fees:

• Improve bookkeeping quality (reduces audit hours, not materiality)
• Prepare complete schedules in advance
• Engage auditor early (avoid rush premiums)
• Multi-year engagement (efficiency gains from year 2)
• Fix prior year findings proactively

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3. We have 5 small errors totaling AED 180K. Each is immaterial individually. Do we need to correct them?

It depends on whether the aggregate exceeds materiality.

Example:

Your Company:

• Overall materiality: AED 200,000
• Performance materiality: AED 150,000

Errors Found:

1. Inventory overstatement: AED 45,000
2. Accrued expense omission: AED 38,000
3. Prepayment misclassification: AED 32,000
4. Depreciation understatement: AED 28,000
5. Accounts receivable overstatement: AED 37,000

• Total: AED 180,000

Analysis:

Individual Assessment:

• Each error < AED 200K materiality → Individually immaterial

Aggregate Assessment:

• Total: AED 180K < AED 200K materiality
• Just below threshold (90% of materiality)

Auditor's Likely Conclusion:

• Request correction even though aggregate < materiality
• Reason: AED 180K is very close to AED 200K threshold
• Risk: Additional undiscovered errors could push total over AED 200K
• Prudent to correct to create margin

If Total Was AED 120K:

• Likely outcome: Can remain uncorrected (60% of materiality, comfortable margin)
• Document as uncorrected misstatements
• Consider in forming audit opinion

Management's Options:

1. Correct all errors (cleanest approach)
2. Correct only some (bring total to comfortable level, e.g., AED 100K)
3. Leave uncorrected (if auditor comfortable with AED 180K aggregate)

Most Common: Companies correct all or most errors to avoid audit qualification risk

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Conclusion

Materiality is the fundamental concept that makes auditing practical and cost-effective—without it, audits would require testing 100% of transactions at prohibitive cost. Understanding how auditors calculate materiality benchmarks (typically 0.5-2% of revenue, assets, or profit depending on company circumstances), why performance materiality creates a buffer during fieldwork, and when qualitative factors override quantitative thresholds empowers UAE business owners to understand audit scope, anticipate which errors require correction, and appreciate why certain items receive extensive audit focus.

Your Materiality Understanding Framework:

Materiality = Threshold separating material from immaterial misstatements Calculation uses benchmarks (0.5-1% revenue most common for trading/services) Performance materiality = 70-80% of overall (working threshold during audit) Clearly trivial = 3-5% of materiality (don't even track these small errors) Qualitative factors override quantitative (fraud, related parties, covenants) Materiality impacts audit fees (lower materiality = +25-60% higher fees) Cannot negotiate materiality (professional standards, not client preference) Aggregate errors matter (multiple immaterial errors can become material in total)

At Farahat & Co, our 37 years of UAE audit experience means:

• Appropriate materiality setting for your company size and industry
• Clear communication of materiality thresholds upfront (no surprises)
• Balanced approach: Not so low that costs are excessive, not so high that errors go undetected
• Consideration of user needs: Banks, investors, regulators, free zone authorities
• Transparent documentation: You understand why errors require (or don't require) correction

Questions about materiality in your audit? Contact our team for a consultation. We'll explain how materiality applies to your specific situation and what it means for your audit scope and opinion.