Technical Articles

International Journal of Government Auditing – July 2011

Establishing Judgments about Materiality in Government Audits: Experiences of Chinese Local Government Auditors

Materiality is a basic auditing concept that the Financial Accounting Standards Board (FASB) defines as “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”[1] The China National Audit Office introduced the concept of materiality into Chinese government auditing in 2003, defining it as the “magnitude of an omission or misstatement of information in auditees’ financial statements. And this magnitude possibly influences the judgment and decision of financial statement users.”[2]

Materiality plays a critical role in identifying the information available to auditors for analysis. Auditors often set materiality levels for detecting errors and irregularities, typically requiring adjustments to financial statements only for material items.

Materiality models and practical guidelines have been developed for corporate auditing. However, research and professional guidelines on government materiality judgments are relatively scarce in English or Chinese literature.

Corporate materiality models tend to emphasize quantitative factors. For example, one popular model for determining corporate audit materiality, known as the “rule of thumb,” takes a base (such as revenues, expenditures, or assets) and multiplies it by a percentage to set materiality thresholds.[3] In our experience, government auditors tend to focus more on qualitative factors, perhaps because they, on behalf of the nation and public interest, are under far more pressure for accountability than are corporate auditors responsible only to individual companies and relevant shareholders. As DeZoort et al. note, a “higher level of accountability pressure may contribute to auditors’ emphasis on qualitative materiality judgment.”[4] However, some government auditors, ignoring the differences between government and corporate audits, take the rule of thumb or another corporate materiality model as their guideline. Arguing the need to review and develop guidelines on U.S. government audit materiality, Ramand and VanDaniker note that “government auditors do not agree on an appropriate base for calculating materiality” and “current practice varies widely.”[5]

Given the significant differences between government and corporate audits, it may be unreasonable for government audits to draw directly on existing materiality models developed from corporate settings. Instead, government auditors should develop their own models suitable to their situation. This article explores a materiality method that is grounded on qualitative factors.

A Qualitative Factors Framework for Government Audit Materiality Judgment

The government audit materiality framework we propose comprises the following qualitative factors, conceptualized from our practical experience of government audit and tested by many authentic government audit cases in our office and other local audit offices.

  • Political Sensitivity. Accounts or transactions with significant political implications should be taken as material information. Auditors should identify issues of high political sensitivity, especially those relating to laws or policies.
  • Public Concern. Areas with significant social effects and of public concern should be regarded as material. For example, our experience indicates that in audits of public schools, tuition fee accounts, which affect many local families with schoolchildren, are material. In many cases, media reporting or disclosure focuses on areas of public concern.
  • Internal Control Efficiency. Where internal controls are weak or inefficient, auditees’ account data tend to be invalid or unreliable. In these situations, information relevant to the control weaknesses should be considered material. For example, while auditing a city-owned company, we found serious problems in inventory management, where products in storage were allowed to be delivered with only a signature of the director accountant. We identified the inventory account as a material area and eventually discovered that the inventory manager had forged the accountant’s signature and stolen a large number of products from the inventory.
  • Type of Fund. Type of fund is also a critical factor for judging materiality. For instance, in China, funds designated as “restricted”—such as disaster funds for civil offices to spend for supporting disaster victims and land funds for local land offices to spend for compensating landlords who sell their land to the government—may be spent only for specific purposes. In practice, we regard restricted funds as highly material areas, but in dealing with unrestricted funds we are less stringent. For example, the remainder of an “office fund” (an unrestricted fund for administrative purposes such as meetings, office stationery, and telephone fees) should normally be transferred to the next accounting period. If, however, the remainder is used instead as part of a bonus scheme, we might not regard it as a serious problem.
  • Experience/benchmark. Government auditors sometimes judge material accounts or transactions by referring to their past experience or similar cases.

The following three case studies demonstrate how the qualitative factors framework can be applied and tested in three actual audits carried out by local Chinese auditors.

Case Study One: Local Education Office

In 1999, the Huazhou City Audit Office audited the local education office.[6] The basic education department, which managed all local schools, was considered the most important and powerful of the office’s 10 departments. Its decisions and practices often affected the public, especially those families with schoolchildren.

The education office gave this department the right to require schools to pay them administrative and other fees. This conflicted with government policies, which stated that only the education office headquarters had this right.

Futhermore, this department’s account did not appear in the education office’s general accounts. Only the department kept the ledger details. Previously, government auditors had asked to see the ledger, but the department director had refused to provide it.

The government auditors identified the following qualitative materiality factors in analyzing this situation:

  • Public Concern: The practices of this department were of high public concern, directly affecting families with schoolchildren.
  • Internal Control Efficiency: The office inappropriately allowed this department to collect fees directly from schools.
  • Internal Control Efficiency: The department ledger was not controlled by the education office.
  • Experience: The previous refusal to cooperate with government auditors implied that some serious problems were being hidden.

Based on this analysis, the auditor judged the account of this department as material.

Actions and Results. The auditors inquired at local banks and collected details about the department bank accounts and the director’s personal bank account. They found that the department director had made a single deposit of a large amount of cash (approximately equal to 10 years of his salary) into his personal account. At the same time, the auditors contacted schools to confirm that this department had directly collected money from them for exam design fees. As this suggested fraud, the auditors referred this matter to local law enforcement officials, who conducted a further investigation. The director later admitted that the large sum of money in his bank account was part of the exam design fees from local schools.

Case Study Two: The Antidrought Team

During a 2007 audit of the local water office, auditors received a confidential report from a staff member on the antidrought team, a department of the water office, alleging that the team captain might be appropriating the national disaster fund as his own personal fund.[7] The auditors decided to conduct a more detailed audit of the antidrought team.

In analyzing this situation, the auditors identified the following qualitative materiality factors:

  • Political Sensitivity: Anti-drought projects have significant political and social influence, as they directly affect agricultural development and the life of farmers in this city, where farmers constitute 80 percent of the local population.
  • Type of Funds: Anti-drought funds are disaster funds, a restricted fund in China.
  • Internal Control Efficiency and Experience: The accountants and captain in the audited entity claimed that all the disaster funds had been spent to purchase anti-drought machines. But auditors noticed that all these funds had been withdrawn in cash from the team bank account. Because buying machinery involves a great deal of money, these transactions are normally carried out using bank transfers rather than cash.
  • Internal Control Efficiency and Experience: When the auditors conducted a physical inventory, they found that some machines were old and lacked trademarks. Furthermore, some original invoices for the purchased machines were from the retail market, rather than directly from the supplier. (In China, factory invoices are marked as “industrial” and retail invoices are marked as “commercial.” In this case, some original invoices were commercial.) From past experience, the auditors knew that commercial invoices are easily obtained and sometimes illegal. For this reason, the audited entity should have obtained industrial invoices as a valid and reliable evidence of purchase.

Based on this analysis, the auditor judged this fund as material.

Actions and Results. The auditors requested further evidence from third parties. Because the machine supplier had declared bankruptcy, the auditors asked the local tax authority to review the machine purchase transactions. They found that the tax account listed lower costs and fewer machines than the team financial statements, strongly suggesting that some funds were being used illegally. Auditors reported this issue to local law enforcement. As further evidence was collected and revealed, the team captain admitted that he illegally appropriated some disaster funds and used them to bribe relevant officials. He also admitted that to deceive the auditors, most machines had been borrowed from other entities several days before the physical inventory and some original invoices had been falsified to hide the crime.

Case Study Three: The Crystal Lamp

During an audit of a public hotel project, government auditors were interested in a special chandelier in the hotel lobby that, according to hotel financial accounts, was valued at about US$150,000 (1 million RMB).[8] After reviewing the initial audit evidence, the auditors identified the following qualitative materiality factors:

  • Internal Control Efficiency: The purchase of this expensive chandelier should have been open to all local suppliers to ensure a reasonable price. However, the hotel contacted only one supplier when making the purchase and kept the purchase secret from others. The supplier did not provide relevant technical information about the chandelier, such as manuals, certificates, or maintenance brochures. Nor did the hotel require the supplier to provide such information.
  • Experience: This purchase was made during a time when the hotel faced financial difficulties and lacked cash. It seemed unusual for the hotel to spend this amount of money for a decorative item at such a difficult time.

Based on this analysis, the auditors determined that this purchase was material.

Actions and Results. When the auditors attempted to contact the supplier, they found that the company had been incorporated into a new company. When the auditors reviewed the supplier’s account at the new company, they found that the supplier had not manufactured the chandelier but had purchased it from another city for only US$45,000 (0.3 million RMB) and then had sold it to the hotel for US$150,000 (1 million RMB), a difference of US$105,000 (0.7 million RMB) between the market value and the purchase price.

Furthermore, when the auditors invited a financial specialist to assess the chandelier’s value, the specialist asserted that it was made of glass, not crystal, indicating fraud. After the government auditors reported this issue to law enforcement, the hotel manager admitted that the supplier had bribed him to make this purchase at the inflated price.


Materiality is contextual. Materiality models focusing on quantitative factors, developed for corporate audit practice, may not be suitable in the government audit context. From our experience and knowledge, we conceptualized five qualitative factors—political sensitivity, public concern, internal control efficiency, type of funds, and experience/benchmark—and tested and applied these qualitative factors in three actual government audit cases. The results suggest the feasibility of these factors, which may not only serve as a reference to government auditors in assessing material information, but also contribute to future government audit standards and guidance with respect to materiality. However, because this qualitative factors framework is grounded in our experience and case studies in the context of Chinese government audits, any generalization of our findings should involve research on other countries’ government audit work.

For additional information, contact the authors at or

[1]Financial Accounting Standards Board, Original Pronouncements as Amended. Statement of Financial Accounting Concepts No. 2: Qualitative Characteristics of Accounting Information (May 1980).

[2]Chinese National Audit Office, Chinese Audit Principles and Standards (2003). The authors are responsible for the translation of this definition.

[3]For example, 0.5 to 1 percent of revenue, 5 percent of profit before tax, or 1 to 2 percent of total assets might be set as materiality thresholds.

[4]T. DeZoort, P. Harrison, and M. Taylor, “Accountability and Auditors’ Materiality Judgements: The Effects of Differential Strength on Conservatism, Variability and Effect,” Accounting, Organisation and Society, vol. 31, no. 1 (2006): pp. 373-390.

[5]K. Raman and R. VanDaniker, “Materiality in Government Auditing,” Journal of Accountancy (February 1994): pp. 71-76.

[6]This case was provided in an oral narrative by auditors in the Huazhou City Audit Office. The authors of this article are responsible for the editing and analysis of this case.

[7]The Shengyang branch of the China National Audit Office (CNAO) provided this case study, which first appeared on the CNAO Web site, primarily in Chinese. The authors are responsible for the translation, editing, and analysis of this case.

[8]The Changzhou City Audit Office provided this case, which was first written in Chinese on the CNAO Web site. The authors are responsible for the translation, editing, and analysis of this case.