July 13, 2026
Beyond the 5% Rule: Transforming Audit Materiality with Blockchain and Explainable AI
By Achintya Ghayal
Professional judgment has never been a matter of strictly objective analysis and materiality has long been assessed in a manner that went beyond the results of objective calculations. In fact, for a long time, auditors have used certain benchmarks, such as 5% of net earnings or 1% of total assets, as a starting point for materiality considerations.
Of course, these benchmarks are very helpful, but they were never designed to be used in isolation. In fact, auditors have long considered various qualitative factors in the course of their planning activities. However, as the complexity of financial reporting has increased, these fixed benchmarks have proven increasingly less relevant for reflecting the views of financial statement users regarding what is material.
The listed companies are now under more intense scrutiny. The enhanced financial reporting obligations, the rise of ESG reporting and the threat of cybersecurity breaches have changed the landscape of assessing information. Under these circumstances, relatively immaterial discrepancies or nonfinancial matters below the conventional thresholds may have a bearing on judgment and undermine confidence.
In this article, there is no implication that auditors ignore their professional judgment and blindly follow a certain percentage. Rather, there is a structural issue that has been pointed out with regards to reviewing, documenting and assessing materiality judgments throughout an engagement.
To fill this gap, this article proposes an Adaptive Materiality Framework that can be used for a systematic re-evaluation of materiality when risk events arise. This framework is not intended to supplant professional judgment or existing audit procedures. Rather, it is a systematic way of identifying risk events, recalculating thresholds with specified inputs and tracing logical adjustments made with a clear rationale.
The Adaptive Materiality Framework: Key Distinctions
The goal of the Adaptive Materiality Framework is to fill a gap in traditional audit planning, whereby once materiality is determined, it is seldom remeasured systematically even when new risk factors arise. This framework does not supersede existing standards or professional judgment; rather, it is used in conjunction with them.
In this approach, auditors would begin with a baseline, such as a percentage of net income, revenues or total assets, as in firm methodology. The difference is in the manner of the baseline. Rather than being constant, it is now open to review whenever there are considerations of risk. The considerations are those that auditors already review but are not necessarily quantified within materiality limits.
The recalculation process has three structured inputs, which are financial sensitivity, ESG disclosure risk and operational or cyber disruption risks. These three inputs are linked to distinct types of risk that can influence how financial information is viewed by stakeholders. When there are risks identified by one or more inputs, it is possible to reduce materiality to ensure that important information is not missed due to a traditional cut-off point.
One of the hallmarks of the framework is documentation. Every change of materiality is accompanied by a reason for the change. The importance of traceability is what ensures that the adaptive method is distinct from the traditional method of change.
Step-by-Step Recalculation Process
The Adaptive Materiality Framework provides a replicable procedure that allows auditors to reassess materiality as new information emerges. Professional judgment remains central, but the procedure promotes consistency and clarity.
The process begins with establishing baseline materiality using existing benchmarks embedded within firm methodologies. This serves as the foundation for audit planning. As the engagement progresses, the audit team monitors for trigger events such as financial volatility, emerging ESG disclosures and operational or cybersecurity disruptions. Not every identified matter requires recalculation and the framework provides guidance for determining when reassessment is appropriate.
When a trigger event is identified, the auditor evaluates it against the three structured inputs. These inputs translate qualitative risk considerations into a basis for reassessing materiality, particularly where stakeholder sensitivity is high. When recalculation is warranted, both the adjustment and its justification are documented in a standardized format.
This cycle continues throughout the engagement. The recalculation process is depicted in Exhibit 1 and reflects a structured evaluation that begins with a trigger event and concludes with a documented determination.
Exhibit 1. Step-by-Step Recalculation Process Step 1. Establish Baseline Materiality - Define initial threshold using company benchmarks (i.e., 5% of Net Income) Step 2. Identify Trigger Event - Detect significant risks that may warrant recalculating materiality, such as financial sensitivity, ESG disclosure issues, operational/cyber risk, business and cyber disruptions, etc. Step 3. Reassess Materiality Level - Use structured inputs to determine threshold adjustment, such as financial sensitivity, ESG risk, operational disruption, etc. Step 4. Document Materiality Changes - Record revised threshold and rationale in a standardized format Step 5. Evaluate and Monitor - Continuously monitor changes and reassess materiality as new risks emerge Adjusting materiality should be a documented and structured process that turns risk insights into clear audit decisions. |
Establishing the Inputs Used in the Recalculation Process
The Adaptive Materiality Framework relies on three structured inputs to guide decisions regarding when and how materiality thresholds should be reconsidered.
Financial Sensitivity. Financial sensitivity refers to the degree to which financial performance is affected by small changes in transactions or estimates. In volatile environments, even minor misstatements can materially influence trends and ratios relied upon by investors and analysts.
Indicators of heightened financial sensitivity include unstable income streams, significant period-end fluctuations, low profit margins, and extensive use of estimates and accruals. Elevated financial sensitivity supports the use of lower materiality thresholds.
ESG Disclosure Risk. As ESG information becomes more integrated into investor analysis and regulatory frameworks, gaps or inaccuracies in such disclosures may influence stakeholder perceptions beyond immediate financial performance. ESG disclosure risk refers to the possibility that non-financial information, such as environmental performance or governance practices, may be material to stakeholders. Elevated ESG risk may warrant reconsideration of materiality.
Operational and Cyber Disruptions. Operational issues, system disruptions and cybersecurity incidents may signal weaknesses in internal controls, even if they have not yet resulted in material misstatements. Such disruptions may increase the likelihood of error or fraud, so they merit increased audit attention. Incorporating operational and cyber disruptions into materiality considerations helps ensure that audit focus remains aligned with emerging risks.
Why Blockchain Anchoring and Explainable AI Are Important
Within the Adaptive Materiality Framework, blockchain anchoring and explainable artificial intelligence are used to strengthen documentation rather than replace professional judgment. Through blockchain anchoring, the rationale for materiality adjustments can be recorded on a permissioned, immutable ledger accessible to the audit team, reviewers and regulators.
Explainable AI complements this process by providing a standardized means of communicating rationales. Rather than relying on narrative workpapers of varying detail, explainable AI enables concise explanations that clearly link risk inputs to materiality thresholds.
Case Illustration: Cantaloupe Inc.
The application of the adaptive approach can be illustrated using the SEC enforcement action involving Cantaloupe Inc. In June 2023, the SEC charged the company with improper revenue recognition related to transactions occurring between 2017 and 2018. The company overstated revenue by $2.56 million in 2017 and by $2.05 million during the first three quarters of 2018. Although these amounts fell below the 5% threshold, they were deemed material and misleading.
Under the Adaptive Materiality Framework, these misstatements would have been evaluated differently once risk signals emerged. Significant quarter-end revenue variability indicated heightened financial sensitivity, meaning even relatively small misstatements could distort performance trends. In addition, the nature of the misstatements reflected operational risk related to revenue recognition timing.
Taken together, these factors support reducing the materiality threshold below conventional levels. Under the revised threshold, the misstatements would not be considered immaterial and would be identified for further testing earlier in the audit process. The rationale for this adjustment would be documented and anchored for subsequent review.
Adaptive Materiality: A Flexible Framework for Modern Audit Realities
While fixed materiality benchmarks have long provided a useful starting point, today s reporting environment demands greater flexibility. Financial volatility, expanded ESG reporting and evolving risk exposures make it impractical to rely solely on percentage-based thresholds. The Adaptive Materiality Framework addresses this challenge by allowing materiality to be recalculated as risk conditions change.
By integrating structured risk inputs with transparent documentation, the framework improves consistency and inspection readiness without displacing professional judgment. When applied thoughtfully, the framework enables firms to align materiality judgments with the realities of modern audits.
About the Author: Achintya Ghayal is a Data Science major with a strong focus on accounting, auditing and emerging technologies. His work explores how innovations such as blockchain, artificial intelligence and sustainability analytics can modernize traditional financial practices.
Works Cited
1. Public Company Accounting Oversight Board. Auditing Standard 2105: Consideration of Materiality in Planning and Performing an Audit. PCAOB, 2020.
2. Public Company Accounting Oversight Board. Staff Audit Practice Alert No. 11: Considerations for Audits of Internal Control over Financial Reporting. PCAOB, 2013.
3. Securities and Exchange Commission. In the Matter of Cantaloupe, Inc. Release No. 33-11202, 27 June 2023
4. AICPA. Materiality in Audit: Practice Aid for Auditors, 2019.
5. International Auditing and Assurance Standards Board. ISA 320: Materiality in Planning and Performing an Audit. IFAC, 2019.
6. Financial Accounting Standards Board. Concepts Statement No. 8: Conceptual Framework for Financial Reporting, Chapter 3 Qualitative Characteristics of Useful Financial Information. FASB, 2018.
7. Committee of Sponsoring Organizations of the Treadway Commission. Enterprise Risk Management Integrating with Strategy and Performance, 2017.
Author's Note: AI-assisted tools were used solely for editorial support, including grammar, wording and flow. All ideas, analysis and conclusions are the author s own.
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