AUDIT AND ASSURANCE
BY: SALIMOV MIRZOHID
LECTURE:9
Definition
Materiality – information is material if its omission or misstatement could influence the
decisions of primary users taken on the basis of the financial statements. … Materiality
depends on the nature and/or size of the items to which the information relates. It is entity
specific. The IASB does not (cannot) specify a uniform quantitative threshold.
Definition
Performance materiality – the amounts set by the auditor at less than materiality for the
financial statements as a whole to reduce to an appropriately low level the probability that the
aggregate of uncorrected and undetected misstatements exceeds materiality for the financial
statements as a whole.
Qualitative Materiality
Benchmarks for assessing materiality qualitatively include, for example, disclosure
requirements detailed by IFRS Standards and statutory disclosure requirements. These
may be subdivided into:
❖ objective disclosures that can be easily determined and verified (e.g. disclosures
concerning changes in accounting policies or prior period errors); and
❖ subjective disclosures (e.g. wholly narrative disclosures).
Example 2 Qualitative Materiality
Boros & Co is conducting the audit of Juggler Co, a listed company with extensive holdings of
non-current assets.
Juggler Co is reluctant to disclose how it applies its accounting policies for depreciation and
revaluation in its financial statements, especially in light of some significant changes in the
utilisation and market value of some of its non-current assets.
Considering Juggler Co’s operating environment and business model, Boros & Co deems the
nondisclosure of Juggler’s accounting policies to be material and has requested Juggler & Co
to disclose them. Failure to do so might result in a modification of the audit opinion.
Amount (Quantitative Materiality)
Past practice has, over time, established general percentage guidelines for the
calculation of an initial materiality level at the planning stage. For example:
5–10% net profit before taxation
1–2% net assets
½ –1% total assets
½ –1 % revenue
In general, less than the lower end of a range is immaterial and greater than the
upper end is material; the "grey area" in between is a matter for professional judgment.
In this approach, profit, net assets, total assets and revenue are considered the main
quantitative elements in the financial statements. The auditor then uses professional
judgment to determine:
•which element is the prime driver for materiality, or, more usually, which combination;
and
•where, within the range, to set materiality.
Example 3 Benchmark
High-turnover, low-margin operations would probably use revenue as the
benchmark as this would be the key to their success.
Industrial entities would typically use assets and revenue as benchmarks, with
profits as an indicator within the range suggested by assets and revenue.
Asset-based entities (e.g. property management and development) would use
assets as the benchmark.
Nature (Qualitative Materiality)
Misstatements are more likely to be considered material when they:
➢ Affect trends in profitability or mask a change in trend, or change a loss into profit;
➢ Affect compliance with loan covenants, contracts or regulatory provisions;
➢ Increase management compensation or indicate a pattern of management bias;
➢ Involve fraud;
➢ Affect significant financial statement elements.
Some transactions are material by nature, such as transactions with directors.
Activity 1 Planning Materiality
The draft financial statements of an audit client show the following:
Revenue $5,000,000
Net assets $6,250,000
Profit before tax $417,000
Required:
[Link] on the suitability of setting a materiality level for planning purposes at:
1.$20,000
2.$40,000
3.$100,000
[Link] a materiality level that may be more suitable (if any).
Effect on Audit Work
Example 4 Materiality Level
Having set a materiality level for the financial statements as a whole, the auditor may
(through judgment and expectations from experience of there being various errors in
the transactions and balances) set different performance materiality levels for
transactions, assets and liabilities (e.g. 50%, 75% and 50%) of the financial statement
materiality level when considering substantive testing.
Therefore, all balances greater than the performance materiality level will be tested
with the remaining items in the sample being selected using, for example, random
selection.
The performance materiality level would be used if sample sizes were calculated
using a materiality level.
Activity 2 Trade Receivables
Trade receivables total approximately $210,000, made up as follows:
Value range Total
Number of
$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
Prepayments amount to $16,450.
No material misstatements were found in the previous year's audit.
Required:
Suggest how a financial statement materiality level of $25,000 may affect audit
procedures on trade receivables and prepayments.
Relationship of materiality with Audit Risk
Example 5 Materiality Level and Audit Risk
If the materiality level is lowered for a given population, more items will be greater
than the materiality level.
In this case, more items can be considered as potential material misstatements,
which, if left untested, increases audit risk.
So, by testing all items greater than performance 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.
Key Point
A lower materiality level should be set if the risk of material misstatement is assessed
as high.
Setting the materiality level lower reduces detection risk because:
❖ more audit work will be performed;
❖ sample sizes will be larger.
Changing Materiality as the Audit Progresses
Example 6 Changing Materiality Level
During an audit, material overstatements in the quantity and valuation of inventory are
noted. An increase in audit risk may be identified, requiring re-working the financial
statement materiality calculations.
The materiality level will need to be lowered, and further testing carried out (e.g. larger
sample sizes or additional items now greater than the materiality level will need to be
tested).
The auditor will need to use professional judgment to determine if a higher level of
testing is required on other balances and the effect on performance materiality.
Documentation
Activity 3 Documentation
List the key matters that should be documented concerning materiality.
Concerning materiality, the auditor will be expected to document:
▪ The materiality level for the financial statements as a whole and the underlying factors
considered in its determination.
▪ Any materiality levels, if applicable, for particular classes of transactions, balances and
disclosures that are important to users of the financial statements (with underlying
factors).
▪ Performance materiality with underlying factors.
▪ Any revision of any materiality level and why each revision was necessary.
▪ Reasons for any adjustments made that relate to material misstatements.
▪ All uncorrected misstatements and the aggregate of such errors for each class of
transaction, balance and disclosure, with reasons why each error (and aggregate total) is
not considered material.
1. The external auditor of Aaron Co has set a planning materiality threshold of $40,000
and a performance materiality of $30,000. The audit testing approach to the following
financial statement items is being considered.
[Link], a director of Aaron Co, owes $1,000 to the company (borrowed during the year).
[Link] income of $35,000.
Which of the two items should be tested?
A. Neither 1 nor 2
B. Both 1 and 2
C. 1 only
D. 2 only
2. As an audit team member with two years of experience, you were assigned to
carry out a test of details on directors’ expenses. The result of the test showed
that in several cases involving the same director, the Chief Financial Officer
(CFO) had authorised the over payment of his expenses. Each expense item
was less than the performance materiality level.
What action should be taken?
A. Draw conclusion
B. Discuss with senior member of the audit team
C. Extend sample
D. Discuss with the CFO
3. Which of the following best describes a material item?
A. Its omission or misstatement could influence the decisions of primary users of
the finance statements
B. It is large in relation to the same figure in previous years
C. It amounts to more than 10% of the total of which it forms a part
D. It is one that would reduce a company’s profits
4. The following statements relate to the effect of materiality on audit work:
[Link] matters identified as material must be subject to tests of details
[Link] that are immaterial are not subject to audit procedures
Which of these statements are true?
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2
5. A starting point for determining materiality is to apply a percentage to a chosen
benchmark. Estate Co is a property development company.
Which of the following benchmarks would be the most appropriate starting point
for determining materiality for Estate Co?
A. Profit
B. Assets
C. Revenue
D. Cashflow