SELECTION AND JUSTIFICATION OF A BENCHMARK IN DETERMINING THE LEVEL OF MATERIALITY IN AUDIT

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Determining the materiality level is a key component of an audit, impacting the reliability of financial statements. In modern conditions, calculating materiality is becoming especially relevant due to the growing complexity of business models, digitalization of the economy, and increasing demands for corporate transparency and accountability to stakeholders. As auditing standards shift from rigid prescriptions to principles based on professional judgement, the well-founded selection of a benchmark becomes the auditor’s personal responsibility and a critically important element of the methodology.

However, a methodological gap exists in practice. Despite an abundance of theoretical principles, there is a lack of universal algorithms for selecting a benchmark that can be adapted to the specifics of different organizations. The aim of this study is to develop and structure a methodology that ensures consistent and documented application of the theory. The proposed approach is designed to enhance the objectivity of the auditor’s judgement and has direct practical value for conducting effective audits of financial statements for companies across various economic sectors.

The methodology is supposed to facilitate determination of the materiality level, adapted to the conditions of auditing procedures in the Russian companies.

To achieve the aim, the following tasks are to be accomplished:

1. To examine scholarly and economic interpretations of the concept of materiality in auditing;
2. To define the role of materiality and its components in conducting an audit;
3. To develop a methodology for calculating materiality for auditing in Russian companies.

The object of the study is the financial and management reporting of JSC Holding Company Novotrans.

In contemporary economic and financial literature, most authors regard materiality as a key concept in auditing, which significantly influences the process of examining the financial statements of any organization. Understanding the essence and determining the level of materiality is crucial for professional auditors, as it helps identify which information is significant to users of the statements and how it may influence their decisions. The consistency of these decisions depends on the quality of the information received, as erroneous and incorrect economic decisions can be made based on biased information [1].

Materiality can be characterized as a calculated measure intended to highlight information that could significantly impact the validity of decisions made by users of financial statements. This necessitates a clear understanding of the criteria by which information can be classified as material or immaterial. Auditors analyze the statements and consider various factors, including the scale and nature of transactions, as well as the effect of errors and misstatements on the statements’ users.

In the field of audit, materiality serves several important functions. Firstly, it helps auditors focus on the most significant aspects of the financial statements, thereby optimizing the allocation of time and resources. Secondly, materiality serves as a foundational criterion for determining the scope of the audit.

The materiality level is the threshold value of an error in accounting or financial statements. Upon reaching this level, a user of the statements is highly likely to be unable to draw correct conclusions or make appropriate economic decisions based on them.

When rendering an auditor’s opinion, auditors take significant responsibility towards the users of the accounting statements, thereby enhancing the degree of confidence in them. Representatives of the audit firm leverage all their experience and professional authority to state that the statements are or are not fairly presented in all material respects. According to ISA 320 “Materiality in Planning and Performing an Audit”, misstatements in an audit are considered material if they could separately or in aggregate influence the economic decisions the users make in terms of financial statements [2].

In accordance with ISA 200 “Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing”, the auditor’s overall objectives are to obtain reasonable assurance that the financial statements as a whole are free of material misstatement, or are caused by fraud or error [3].

The audit team have responsibility in performing the task of calculating the materiality level. In the event of an erroneous professional judgement, auditors may render an unmodified audit opinion on materially misstated financial statements that do not reflect the organization’s true and fair view on financial position of the company. Such an outcome can lead to incorrect economic decisions being made by both the organization’s owners and its investors.

N.V. Mamushkina notes in her research that the materiality of financial statement indicators is typically determined during the audit planning stage. However, circumstances may arise during the audit that necessitate adjusting the materiality level established during planning [4].

The auditor calculates the materiality level on the basis of their professional judgement, rather than through a mechanical computation of this indicator.

M.F. Safonova points out that in the process of estimation, the auditor selects the indicator most characteristic for a particular organization. This could involve profit before tax, gross turnover, balance sheet total, equity, or the company’s total expenses. For example, for a trading company, it is advisable to use revenue for the calculation; for a manufacturing enterprise – profit or in case of loss – expenses [5].

When forming their final opinion on the materiality level, the auditor must proceed from his understanding of the needs of the users of financial reporting in terms of financial information. They must also determine the level of the defined indicators, presented in Table 1.

 

Table 1. Levels of financial indicators for the materiality level calculation

Indicator	Essence of the indicator
Materiality level for financial reporting in total	The maximum extent of distortion of financial statements, up to which they can still be considered reliable.
Materiality level for the audit procedures’ performance	It is established with the aim of reducing the probability to the maximum acceptable level whereas the aggregate of faulty and undetected misstatements in the financial statements will exceed the materiality level for financial reporting in total.
Materiality level for the component (Materiality threshold)	An audit value set to reduce the likelihood that the total of uncorrected misstatements in the financial information on a component will exceed the overall materiality level for financial reporting.

 

When estimating materiality level for financial reporting in total, a determinate percentage of the benchmark selected by the auditor is applied. Auditors consider the following financial data inputs: the company's financial performance and position amounts for prior periods, data for the elapsed portion of the reporting period, as well as forecasted data for the current period adjusted for significant changes in the entity's operations. Potential changes in the industry or economic environment in which the entity operates are also taken into account.

It is also important to note that audit firms utilize internal methodologies for calculating the materiality level and specialized software to assist in determining the appropriate benchmark and the percentage applied to it.

After determining the benchmark, the calculation of the materiality level can be directly performed.

The process of calculating the materiality level involves several stages, each requiring careful analysis and professional judgement. The stages are presented in the Figure below [6].

 

Fig. Stages of calculating the materiality level

 

Thus, after the auditors have determined the benchmark for calculating materiality at the financial reporting level in total, the next step is to calculate the materiality level for audit procedures’ performance. Following the calculation of materiality for audit procedures’ performance, the materiality threshold for uncorrected misstatements is estimated.

Based on the developed methodology, the analysis of financial and management reporting of JSC Holding Novotrans was conducted, and a benchmark for calculating the materiality level was selected.

According to data from the company’s official website, the primary activity of Novotrans is provision of railway rolling stock for lease, as well as assets for repair complexes and construction equipment. The company also offers a wide range of transport services and holds a significant market share, including its own railway rolling stock and stevedoring services [7].

Given that Novotrans is a transport and logistics company, profit before tax is considered the preferred benchmark indicator for companies in this business area.

At the next stage of the conducted analysis, changes in all performance indicators recommended by ISA 320, such as revenue, profit (loss) from sales, cost of sales, gross profit, equity, and profit before tax over a three-year period are studied for JSC Holding Company Novotrans. The results are presented in Table 2.

 

Table 2. Analysis of Benchmark Indicators of JSC Holding Company Novotrans

Indicator	Indicator Value, thousand RUB			Change in Indicator, %
	2022	2023	2024	2023 against 2022	2024 against 2023
Revenue	19,611,785	23,403,371	26,662,519	119.33	113.93
Profit (Loss) from Sales	12,424,393	11,403,973	15,060,690	91.79	132.07
Cost of Sales	6,801,471	11,540,736	11,049,076	169.68	95.74
Gross Profit	12,810,314	11,862,635	15,613,443	92.60	131.62
Equity	30,917,526	35,563,439	43,828,880	115.03	123.24
Profit Before Tax	16,762,395	9,940,595	14,349,157	59.30	144.35

 

Table 3. Benchmark Percentages Established by Practice

Indicator	Significance of Misstatements for Users of Financial Statements			Possible Range of the Benchmark Percentage, %
	High	Medium	Low
	Values of Benchmark Indicators, %
Revenue	1	3	5	1 – 5
Profit (Loss) from Sales	3	5	8	3 – 8
Cost of Sales	5	7	10	5 – 10
Gross Profit	4	6	9	4 – 9
Equity	1	3	5	1 – 5
Profit Before Tax	3	5	8	3 – 8

 

When applying professional auditor’s judgment to select a specific percentage of the chosen benchmark, the following factors are to be examined:

- no critical situations exist regarding debt covenant restrictions;

- during the audits of prior years’ financial statements, no material errors or deficiencies in the internal control system were identified;

- the organization has an internal control system that operates at an adequate level.

Taking into account all adjustments identified by the auditor, which have a one-time material effect on certain transactions within the reporting period, the significance level of misstatements for users of the financial statements has been assessed as medium.

Once the auditor has determined the significance level of misstatements, the calculation of the materiality level is performed (see Table 4).

 

Table 4. Calculation of the materiality level based on benchmark indicators

Indicator	Value of the benchmark indicator per the 2024 financial statements, thousand RUB	%	Materiality at the financial statement level, thousand RUB
Revenue	26,662,519	3	799,900
Profit (Loss) from Sales	15,060,690	5	753,100
Cost of Sales	11,049,076	7	773,500
Gross Profit	15,613,443	6	936,900
Equity	43,828,880	3	1,314,900
Profit Before Tax	14,349,157	5	717,500

 

Following the calculation of the materiality level based on the benchmark indicators, the decision is made to use Profit before Tax Indicator as the primary benchmark for determining the materiality level.

It is worth underlining that the percentage range applied to Profit before Tax Indicator typically varies from 3 % to 8 %. Given that, the significance level of misstatements has been set as medium – the final value is 5 %.

Moreover, the calculated materiality amounts derived from other indicators, such as revenue, profit (loss) from sales, cost of sales, gross profit, and equity are significantly higher than the amount based on profit before tax. Using these higher values could result in a materiality threshold that is exceedingly elevated, potentially failing to capture all misstatements identified during the audit.

It is important to note that profit before tax can be volatile from year to year, fluctuating both upward and downward. However, this indicator is most frequently used by financial statement users to assess a company’s performance. Consequently, the materiality level in terms of profit before tax ensures the most accurate determination of a threshold that can effectively guide the scope and depth of audit procedures for various sections of the financial statements.

Once the benchmark for calculating materiality at the financial reporting level in total is determined, the materiality for the audit procedures’ performance indicator can be calculated. The materiality level for the audit procedures’ performance is applied for testing specific items in financial reporting or classes of transactions to ensure that the total of undetected and uncorrected misstatements does not exceed the total materiality. The auditor’s professional judgement is based on the analysis of the company’s risk factors. This decision considers the absence of significant prior-period adjustments and a low overall risk of material misstatements. Contributing factors to the latter include stable management, lack of undue pressure on financial results, and operation in a low-risk industry. Based on this assessment, an adjustment of 25 % is applied to the total materiality level.

After applying this adjustment to the total materiality at the financial reporting level and achieving the estimated materiality level for the audit procedures’ performance, it is necessary to determine the materiality threshold for inclusion of misstatements in the total of uncorrected ones. Besides, calculation of the materiality threshold requires determining a percentage for inclusion of misstatements in the total of uncorrected ones.

Accordingly, an analysis of the following factors is conducted, including:

- the number and magnitude of misstatements identified during audits of prior years;

- the assessment of audit risks;

- the client expectations regarding the information to be obtained due to the audit.

This threshold is typically set at 0 %, 3 %, 5 %, or 10 % of the total materiality.

As mentioned earlier, no proposed but unrecorded audit adjustments were identified during audits in previous periods. Furthermore, only a minor number of misstatements are recorded, all of which are corrected by management.

Considering the factors listed above, it was decided to set the threshold for recording misstatements in the aggregate of uncorrected items at 10% of materiality level for financial reporting in total.

Based on these decisions, the materiality level for the audit of the accounting (financial) statements of JSC Holding Company Novotrans for 2024 year was determined. The calculation results are presented in Table 5.

 

Table 5. Calculation of the materiality level for the audit of JSC Holding Company Novotrans for 2024

Components	Materiality level
Benchmark value, thousand RUB	14,349,157
Percentage value, %	5
Materiality for financial reporting in total, thousand RUB	717,500
Adjustment to total materiality, %	25
Materiality for the audit procedures’ performance, thousand RUB	539,000
Threshold percentage for uncorrected misstatements, %	10
Threshold for uncorrected misstatements, thousand RUB	71,750

 

The results presented in this table can serve as a crucial guide for the subsequent stages of auditing the financial and accounting statements of JSC Holding Novotrans during the audit process. This calculation was conducted based on the methodology developed within this study.

Materiality in auditing is one of the key concepts defining the quality and effectiveness of the audit. It represents a threshold value of an error or misstatement in the financial statements that could influence the economic decisions of the users of those statements. The concept of materiality is closely linked with the auditor’s professional judgement, experience, and understanding of the audited company’s specific circumstances.

Materiality establishes the boundaries for professional judgement and serves as a criterion for distinguishing important information from insignificant data.

The selection of the benchmark and its correct calculation can ultimately have a direct impact on the audit outcomes. An incorrect choice or erroneous calculation could lead to undetected misstatements in the financial statements, which would result in wrong conclusions regarding the company’s financial position. Therefore, auditors must approach the calculation of materiality with exceptional professionalism and responsibility.

Overall, the materiality level is a critical component of the audit process and helps ensure the accuracy and reliability of a company’s financial statements.

About the authors

I. O. Botov

Siberian State Transport University

Author for correspondence.
Email: Igor.nsk123@gmail.com

Graduate Student

Russian Federation, Russia, Novosibirsk

M. A. Podkopaev

Siberian State Transport University

Email: podkopaev-maks@mail.ru

Graduate Student

Russian Federation, Russia, Novosibirsk

E. G. Zharikova

Siberian State Transport University

Email: jarikovalena@mail.ru

Candidate of Pedagogical Sciences, Associate Professor

Russian Federation, Russia, Novosibirsk

E. A. Kosorukova

Siberian State Transport University

Email: kosorukova74@mail.ru

Candidate of Economic Sciences, Associate Professor

Russian Federation, Russia, Novosibirsk

References

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