Determining materiality for small and medium-sized entities (SMEs)
Published: 4 June 2026
Introduction
1This Sandbox initiative was convened in response to feedback received from the FRC’s Small and Medium-sized Entity (SME) project, that challenges can arise in setting materiality at an appropriate level for SME audits. This page summarises discussions in the Sandbox on the nature of the challenges, their causes, and potential solutions.
2This document is intended to support audit practitioners when applying the requirements and guidance set out in the ISAs (UK) to making materiality judgements. It reflects matters that were discussed by participants during the Sandbox initiative but should not be taken as expressing the views of any individual participant in the Sandbox, and not all participants agreed with all the views described below. It does not represent official FRC guidance or the views of the FRC.
Context
3Materiality reflects the tolerance of users of financial statements to misstatement: misstatements are material if, individually or in aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.[1]
Performance materiality is determined by the auditor at a level less than materiality, to reflect the auditor’s assessment of aggregation risk, being the probability that uncorrected and undetected misstatements exceed financial statements materiality.
As performance materiality is determined with reference to materiality, judgements made in setting materiality impact performance materiality, in conjunction with the auditor’s assessment of the likely number and size of errors.
4The auditor’s judgements over materiality and performance materiality influence the following elements of the audit, which in turn impact work effort:
- Materiality is a consideration in the design of audit procedures to detect whether any material misstatement is present, which impacts the overall granularity of audit work. This includes calculation of sample sizes and determination of whether an amount may remain untested.
- Materiality also plays a key role in the auditor’s consideration of the results of testing, and whether identified misstatements are material to the financial statements as a whole.
Performance materiality is inherently linked to the risk of an entity’s financial statements being materially misstated. It is important that in setting performance materiality, the auditor does not lose sight of the underlying engagement risk.
5In the sandbox, there was a variety of views on the extent to which materiality impacts work effort. The impact may be low where significant use is made of data analytics. However, the impact is normally greater where the audit approach consists predominantly of sample-based substantive testing. Participants noted that a weaker control environment and limited finance team resource may limit the auditor’s ability to take a testing approach other than substantive sampling for SMEs.
It was agreed that low materiality is not the only factor that may give rise to sample sizes that the auditor considers excessive: for example, this may also occur if the auditor does not accurately pinpoint risk by assertion or take full account of audit evidence obtained from other procedures.
However, there was consensus that the setting of materiality has sufficient impact on work effort and the assessment of errors for there to be value in producing an output from the Sandbox.
6Participants noted the tension between the need for judgement in the setting of materiality and the use of standardised ranges in most methodologies.
Footnotes
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[1]
ISA (UK) 320, Materiality in planning and performing an audit, paragraph 2.
Use of ranges
7While materiality is an area of professional judgement, common practice is to identify an applicable benchmark (e.g. profit before tax, total assets, net assets) relevant to the users of the financial statements and to apply an expected range to this. It was generally agreed that it is helpful to make use of expected ranges for several reasons:
- They provide practitioners with a consistent framework for their materiality assessment.
- Where they are set at a level that is unlikely to give rise to inappropriately high materiality, they act as a quality control.
- They can provide practitioners with an efficient way to determine and document their materiality assessment.
8In 2017, the FRC performed a thematic review,[1] which identified percentage ranges that participating firms typically applied against key performance indicators to set materiality. Participants commonly held the view that these ranges have become a standard, from which practitioners may not have confidence to deviate, even when the resulting level of materiality does not appropriately reflect the tolerance to misstatement of users of the accounts. It was noted that the thematic review was performed on larger entities within the FRC’s regulatory scope and that the ranges may not be appropriate to smaller entities. Additionally, performance materiality may be set at too low a level, if there is a lower risk of material misstatement in the financial statements.
9Fear of regulatory censure was identified as a reason why ranges have been set at their current levels and why practitioners may be reluctant to select a level of materiality falling outside their methodology’s normal range. It was observed that materiality is not “right or wrong” and that there could be significant differences between the judgement of different professionals. Clear documentation of an appropriate justification for the judgement is critical. While some participants were confident that a clearly justified judgement would be sufficient, other were concerned that inspectors would automatically criticise use of a materiality figure that fell outside their methodology’s guidance or common practice.
10The distinction between larger, more complex and smaller, less complex entities was made: review findings from audits of larger, more complex entities may not be appropriate to those of smaller entities, but firms may apply findings universally.
11It was noted that for small audits, it may be more efficient for an auditor to select a standardised materiality percentage that they are satisfied will not overstate the user’s tolerance to error, rather than undertake more extensive work to justify setting materiality at a higher level, and that this should not be discouraged.
12However, there was a general view that, where the practitioner assesses the appropriate level of materiality to fall outside of their methodology’s standard, there should be flexibility for judgement to be applied, subject to quality controls, such as consultation with a secondary Responsible Individual, or technical partner. Several participants noted that their methodologies allow practitioners flexibility, but they may be reluctant to use it. Therefore, the issue is not necessarily in the methodology, but that practitioners may need encouragement to use their judgement to set materiality at a higher level than their default position, where appropriate.
Users of the financial statements
13The expected influence of a misstatement on different users of the financial statements was considered. It was noted that there are some situations in which materiality might commonly be higher. For example, materiality for small subsidiaries within a large group may be higher than for similar stand-alone entities, because the primary user of the financial statements is the parent company, whose tolerance for error is influenced by the size of the group. In this situation, there may not be external users of the subsidiary accounts, and the tolerance of external users of the group accounts will also be determined in the context of the group. Likewise, materiality may be higher for companies with concentrated, private ownership and no external finance. There was discussion around the possibility of having increased materiality ranges for specific situations such as these, which participants generally supported.
However, there are also situations, for example where an entity is close to breaching the borrowing covenants of external providers of finance, which may reduce the appropriate level of materiality for an SME.
14It was noted that the FRC has recently published guidance on materiality in SME audits within Practice Note 28.[1] Additionally, updated guidance on materiality in the audit of financial statements is anticipated to be issued by the ICAEW later in 2026. It was agreed that provision of further detailed examples by the FRC would not therefore be appropriate.
15There was discussion around how to identify the tolerance to error of different users. It was noted that, where there are limited users of the financial statements, the auditor could engage with the users to understand their tolerance. For example, in some group situations the only user may be the parent company and the auditor might discuss what the parent considers to be material. In owner-managed businesses, users may be limited to owner-managers and providers of finance. Discussions with an owner-manager might include what the owner-manager would consider to be material in the context of the financial statements and other financial reporting (such as management accounts and covenant reporting) and their assessment of what other users would consider to be material.
Footnotes
Other suggestions
16The possibility of a further thematic review was discussed, although the risk that this could further embed the current ranges into market practice was identified.
17Provision of examples was discussed, both examples of judgements that might be made in different situations and examples of appropriate documentation of judgements. However, there was a concern that these examples might inappropriately become standard templates.
18Second opinions, whether a formal technical consultation or a documented discussion with a peer or methodology provider, were considered to be a way in which firms could maintain quality control, while allowing individual practitioners to exercise judgement.
19Individual practitioners’ reluctance to consider whether it is appropriate to set materiality outside of what they consider to be standard could be addressed through training. Methodology providers noted that they could play a role both through training and through the methodology and templates provided.
20Engagement between firms and their supervisors may be useful to ensure a shared understanding of the level of justification and documentation required to support materiality decisions. Additionally, the FRC has announced its intention, in collaboration with the Recognised Supervisory Bodies (RSBs), to establish a working group to create a more consistent, risk-based and proportionate approach to audit inspection for SME audits.
21While not specifically related to materiality in SMEs, setting component materiality in group audits was raised as an area that is commonly considered to be challenging. In general, firms and methodology providers use a standard table of multipliers to cap aggregate component materiality and it was not considered that additional guidance (for example on allocating materiality between components) was required. It was noted that not all methodologies provide multipliers, giving rise to difficulties for firms using these methodologies. While this can be an issue, it was agreed that it does not fall within the remit of the Sandbox.
Conclusion and further considerations
22In summary, and subject to the caveats set out in paragraph 2, the Sandbox discussions indicated that a market practice has developed in the setting of materiality, which may give rise to disproportionate levels of work in some circumstances. The majority of factors causing this are most appropriately addressed by the firms and methodology providers in conjunction with their supervisors. However, there is also a role for the FRC in collaborating with the RSBs to achieve consistency and proportionality of approach to audit inspection for SMEs.
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Published: 4 June 2026