OVERVIEW
Objective
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To describe the concept of materiality and its relationship with audit risk and planning.CONSIDERATIONS
AUDIT PROCEDURES
EVALUATING MISSTATEMENTS
MATERIALITY
¾ Economic decision of users ¾ Professional judgement
¾ Amount
¾ Nature
¾ Essential procedure ¾ Evaluation materiality ¾ Planning materiality ¾ Effect on audit work ¾ Relationship with risk ¾ Changing materiality ¾ Definition
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MATERIALITY
1.1
Definition (IASB and ISA 320
Audit Materiality
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Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements … … Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. It provides a threshold or cut-off point rather than being a primary qualitative characteristic which
information must have if it is to be useful.
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Materiality is an expression of the relative significance or importance of a particular matter in the context of the financial statements as a whole.1.2
Basic principles
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“The objective of an audit is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework.” (Session 1)¾
“The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement level and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatements.” (Session 9).¾
The auditor must use their professional judgement to determine exactly what is, and what is not, material based on their understanding of the entity, its environment and its financial results and disclosures. A rigid materiality model would not be practical because of the differences between entities and the users of their financial statements.¾
Materiality may be quantitative (based on values) or qualitative (based on the nature ofthe matter). Qualitative misstatements include, for example, failure to disclose information as required by laws, regulations or GAAP (eg IFRS disclosures – but remember that IFRS only apply to material items).
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Whilst an individual amount or procedure may not be material, consideration must be given to the cumulative impact, eg: an error in a procedure may not be material, but repeating (eg each month) would
indicate a potential material misstatement;
immaterial errors in inventory, may result in a cumulative total that will be
material;
failure to apply an accounting policy (eg depreciation of buildings) may not be
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Materiality should thus be considered when: planning an audit (through its relationship with audit risk); determining audit procedures (their nature, timing and extent); conducting an audit;
evaluating errors identified during the audit process; and evaluating misstatements within the financial statements.
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CONSIDERATIONS
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The ISA refers to the use of “professional judgement” and “amount” and “nature” of misstatements as considerations.¾
However, given the importance of the concept of materiality to the objective of an audit (as defined), the users of financial statements cannot be overlooked.Example 1
Identify FOUR users of financial statements and state their information needs.
Solution
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2.1
Economic decisions of users
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The auditor ordinarily reports to the shareholders who would thus be of primary importance when setting materiality levels. However, the definition of materiality is “user-orientated” (... influence the economic decisions of users taken on the basis of the financial statements …)Illustration 1
A bank, having made a loan, will consider matters to be material if they negatively impact the company’s profit before interest (affects interest cover) and/or net assets (affects solvency)
In addition, the loan would become immediately repayable if certain criteria (eg minimum liquidity ratio) were not met. Whilst a change to the ratio may not be quantitatively material, the fact that it would trigger the loan repayment makes the change qualitatively material.
Similarly, whilst an amount may not be quantitatively material, its impact on regulatory criteria may be qualitatively material, eg triggering withdrawal of an operating licence resulting in the entity not being a going concern.
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Even with shareholders as the prime users, there will be a wide divergence of“economic decisions” made, eg the investment analysts of major pension funds (who would analyse the information in significant detail) through to individual shareholders who invest because they “trust the chief executive officer”. Such shareholders may not even look at the auditor’s report (let alone understand it).
2.2
Professional judgement
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Understanding the entity and its environment establishes a framework within which the auditor is able to apply professional judgement as to what is, and is not, material in the context of the entity, its environment and control procedures.¾
Such judgement also relates to the amount and nature of items within the classes of transactions, balances and disclosures. What is a material class of transaction (or balance) within one entity may not be considered material within another, eg rental income may not be material to revenue in an industrial entity but would be material to an entity that manages properties.¾
Understanding what is, and is not material, enables the auditor to consider theappropriate audit procedures to apply (eg sampling, substantive analytical procedures, stratification) and what to apply them to, to reduce audit risk to an acceptably low level.
2.3
Amount (quantitative materiality)
In a particular context
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Comparing an item to a category as a whole, eg an inventory error of $50,000 compared to total inventory value of $650,000.¾
May be established as a set figure or as a % of a total.¾
The error of $50,000 may be considered material to inventory, but may not be material to the statement of financial position as inventory as a whole is not a material item.In a general context
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Look at the item in relation to financial statements as a whole, eg comparison to revenue
profit before taxation total assts
capital and reserves
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Consider in relation to the elements of the financial statements, eg a different materiality level for the profit & loss account and the statement of financial position.¾
As a “yardstick”, materiality must be relevant to the user rather than the preparer of financial statements and should take into account “critical points”, eg: profit → loss (may be material to employees)
net current assets → net current liabilities (may be material to investors).
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The auditor must take into account that some balances are capable of “precise determination” and dictated by law and regulations – whilst others are not and are determined by opinion and judgement rather than fact.Capable of Not capable of
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E.g. directors’ emoluments and share capital¾
Any error (however small) may be considered material and adjusted, especially as the precise amount is required to be disclosed by law.¾
E.g. inventory provisions, contingent liabilities and asset useful lives.¾
The depreciation charge based on 5 years may be material to profit & loss, but if based on 6 years it may not be – 5 or 6 years is a matter of opinion and judgement. Both could be equally acceptable.2.4
Nature
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The nature of materiality implies misstatements based on the qualitative aspects of data. Examples include: inadequate or improper description of an accounting policy improper application of an accounting policy
failure to disclose fraud
improper classification of financial statement elements failure to disclose a breach of regulatory requirements
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The increased complexity of disclosure requirements (eg under IFRS) and recentdevelopments in corporate governance have resulted in increased difficulty for auditors to determine if a particular disclosure is materially misstated, eg where directors have to give a review of the business and the risks the business faces. A significant element of this would be determined by the directors’ interpretation of past and future events and risks, making the disclosure subjective (and thus more difficult to determine materiality).
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AUDIT PROCEDURES
3.1
Planning (preliminary) materiality
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At the planning stage, the assessment of initial quantitative materiality is based on the latest available reliable financial information related to specific account balances and classes of transactions, eg pre-audit draft financial statements or general ledger trial balance.¾
Past practice has, over time, established general % guidelines for the calculation of an initial materiality level at the planning stage, eg:5 – 10% profit ½ – 1% net assets 1 – 2% total assets ½ – 1 % revenue
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Within this approach, profit, net assets, total assets and revenue are considered the prime quantitative elements within the financial statements. The auditor then uses professional judgement to determine: which element is the prime driver for materiality, or, more usually, which
combination; and
where within the range to set materiality.
Example 2
Turnover $5,000,000
Total assets $6,250,000
Profit before tax $417,000
Required:
(a) Commenting on the suitability of setting a materiality level for planning purposes at:
(i) $20,000 (ii) $40,000 (iii) $100,000.
(b) Justify a materiality level which you consider to be more suitable (if any).
Solution
(a) (i) (ii) (iii) (b)
3.2
Effect on audit work
3.2.1
Materiality level
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All matters that are identified as being material must be subject to detailed audit work, eg tested in detail. The auditor must then use their judgement as to how to deal with the remaining items, eg sampling or analytical review.Example 3
Trade receivables total approximately $210,000 made up as follows:
Value range Number of Total
$000 balances $000
10 – 15 2 22.3
5 – 10 6 41.5
1 – 5 40 87.0
0 – 1 ___ 89 _____ 59.6
137 210.4
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Prepayments amount to $16,450.
Required:
Suggest how a materiality level of $25,000 may affect audit procedures on trade receivables and prepayments.
Solution
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3.2.2
Tolerable error
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The concept of tolerable error is basically the maximum error within a population that the auditor is prepared to accept and still conclude that the result from the sample has achieved the audit objective. It is usually aligned with audit sampling, sampling risk (see Session 19) and testing control effectiveness (see Session 13).¾
Having set a materiality level, the auditor may (through their judgement) set a tolerable error as a % (usually 50% or 75%) of the materiality level when considering substantive based testing. Thus all balances greater than the tolerable error level will be tested and if sample sizes are calculated through using a tolerable error, the lower the tolerable error, the higher the sample size.3.3
Relationship with audit risk
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The relationship between materiality and the level of audit risk is described as “inverse” For example, as the materiality level is lowered (↓), audit risk is increased (↑) (and vice versa).¾
The auditor compensates for this increase in audit risk by either: reducing control risk (if possible) and carrying out extended or additional tests of
the effectiveness of controls, or
reducing detection risk by modifying the nature, timing and extent of planned
substantive procedures.
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As an example, if, for a given population, the materiality level is lowered, more items will be greater than the materiality level. There are therefore more items that can be considered as potential material errors, which if left untested, increases audit risk. So, by testing all items greater than materiality (in this example there will be more of them, hence more work) the level of audit risk can be reduced back to an acceptable level.3.4
Changing materiality as the audit progresses
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Setting the materiality level at the planning stage of the audit only takes into account the detail, understanding and balances known at that stage. As the audit progresses, evidence gathered may require re-assessment of the level of materiality.¾
For example, adjustments made to the original account values, will mean thatmateriality calculations will need to be re-worked. If this results in a reduction of the materiality level, audit risk will increase and further testing will need to be carried out (e.g. larger sample sizes or additional items now greater than the materiality level will need to be tested).
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EVALUATING MISSTATEMENTS
4.1
Essential procedures
The aggregate of uncorrected misstatements must be assessed (as material or not material) in evaluating fair presentation of the financial statements as a whole
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Uncorrected aggregate misstatements comprise: specific misstatements (including those rolled forward from previous periods) best estimate of other misstatements (i.e. projected errors).
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Further considerations to be taken by the auditor, if the aggregate is considered tobe material, include: the possibility of further adjustments which management are prepared to make; the impact (if any) on critical points;
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The above would also be considered where the aggregate is below the materiality level and the auditor considers the possibility that undetected errors plus the aggregate would exceed the materiality level.¾
A standard approach is to discuss with management the larger uncorrectedmisstatements, which, when adjusted, would result in the aggregate being lower than the materiality level.
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Where the misstatements being discussed have been extrapolated, the client may argue that only the actual errors found should be considered (which invariably may not be material). If, after extended audit procedures, the auditor concludes that theextrapolated aggregate is still material, the impact on their report must be considered (see Session 30).
4.2
Determining evaluation materiality
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Having determined the planning materiality levels, many auditors apply the same levels when evaluating misstatements, eg if an error is greater than 1% of total assets, it is material.¾
Another accepted practice is to consider the % error of the specific account balance or transaction (eg inventory, depreciation charge). A general rule of thumb is: Less than 5%, unlikely to be material Greater than 10%, consider as material.
Between 5% and 10%, apply judgement and consider the context and nature of the
error before reaching a decision.
Example 4
During the course of an audit, the following errors are discovered.
(1) Trade accounts receivable overstated by $40,000
(2) Inventories overstated by $58,000
(3) Trade payables understated by $80,000
$100,000 is considered to be material.
Required:
Determine the minimum adjustment (if any) that must be made for the presentation of the financial statement to be evaluated as fair if:
FOCUS
You should now be able to:
EXAMPLE SOLUTION
Solution 1 — Users and their information needs
Users Information needs
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Investors (owners) andtheir advisers
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Providers of capital are concerned with the risk and return of their investment. They need information for decision-making (buy, hold or sell?) to assess the enterprise’s ability to pay
dividends
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Employees and theirrepresentatives
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Stability and profitability of employers Ability to provide remuneration, retirement benefits and employment opportunities¾
Lenders (e.g. banks)¾
Whether loans and interest will be paid whendue
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Suppliers and other tradecreditors
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Whether amounts owing will be paid when due¾
Customers¾
Continuance – important for long-terminvolvement with, or dependence on, the enterprise
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Governments and their agencies (e.g. tax authorities)¾
Allocation of resources and, therefore, activities of enterprises¾
Information to regulate activities, determine taxation policies and as the basis for national income and similar statistics¾
Public¾
Contribution to local economy includingnumber of employees and patronage of local suppliers
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Trends and recent developments in prosperity and range of activities¾
Management¾
To plan, make decisions and control operational activities.Solution 2 — Planning materiality
(a)
Suitability of levels
(i) $20,000 – this is likely to too low as it falls below the lower limits for turnover, total assets and profit before tax.
(iii) $100,000 – although suitable for the audit of the statement of financial position, this is likely to be considered too high for classes of transactions. Material errors in the
statement of comprehensive income may therefore not be detected by audit procedures.
(b)
Recommendation
This is clearly a matter of judgement, however, as profit before tax is a function of the make-up of balances and transactions (and at this stage in the audit only draft), it is more likely that preliminary materiality will be determined in relation to turnover and/or total assets. As there is no overlap of these ranges – no one range will satisfy both. Therefore, an amount could be set to satisfy just one judged on the needs of users. (For example, if users are more interested in revenues than assets/liabilities, $50,000 may be appropriate.) Alternatively, an amount could be set between ranges as a compromise, say $60,000.
WORKING
% $000
Turnover ½ – 1 25 – 50
Total assets 1 – 2 62.5 – 125
Profit before tax 5 – 10 20.8 – 41.7
Solution 3 — Effect on audit work
Trade receivables
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Although there is no one trade account receivable balance greater than $25,000 the 8 largest balances total $63,800 and have the greatest potential for containing material error (of overstatement). These individual balances are likely to be tested in detail (see Session 24).¾
The average balance in the range $1,000 – $5,000 is $2,100 and the average balance less than $1,000 is $670. If the profile of these balances is similar to the previous year audit tests may not be detailed, but take the form of analytical procedures (see Session 16).Prepayments
Solution 4 — Evaluation of aggregate misstatement
(i)
All three items affect profit
In aggregate, net profit and net current assets are overstated by $178,000 – which is material. A minimum adjustment of $78,000 is therefore needed. For example, if the understatement of trade payables is due to liabilities for purchases having been omitted, then if management are prepared to adjust the trade payables to correct the $80,000 understatement, the remaining unadjusted aggregate, $98,000 is less that the materiality limit.
(ii)
Only (2) affects profit
The misstatements on receivables and payables must be reflected elsewhere in the statement of financial position. For example, cash at bank may be overstated (or bank overdraft understated) if the errors are due to incorrect cut-off on cash receipts and payments. The effect on net assets and profit is therefore only $58,000 which is not material.
