AUDIT MATERIALITY

OVERVIEW

Objective

To describe the concept of materiality and its relationship with audit risk.

MATERIALITY
IASC definition
Basic principles

Economic decisions of users

CONSIDERATIONS Amount
Nature

AUDIT
Planning materiality
PROCEDURES
Effect of audit work
Relationship with risk

EVALUATING
Essential procedure
MISSTATEMENTS

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1 MATERIALITY

1.1 IASC1 “Framework” definition

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 cutoff point
rather than being a primary qualitative characteristic which information must have if it
is to be useful.

1.2 Basic principles

Materiality should be considered when:

carrying out an audit (and its relationship with audit risk);

determining audit procedures (their nature, timing and extent);
evaluating misstatements.

ISA 320 also repeats, as a standard, the objective of an audit (see Session 1).

2 CONSIDERATIONS

The ISA refers to “professional judgement” and “amount” and “nature” of

misstatements as considerations. However, given the importance of the
concept of materiality to the objective of an audit (as defined), the users of
financial statements must not be overlooked.

Example 1

Identify FOUR users of financial statements and state their information needs.

Solution

1
The International Accounting Standards Committee’s Framework for the Preparation and
Presentation of Financial Statements

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2.1 Economic decisions of users

The auditor ordinarily reports to the shareholders who are of primary

importance when setting materiality levels.

Different users base their assessment of materiality on different criteria.

Illustration 1

A bank considering a loan application will consider matters to be material if

they affect the company’s:

− profit before interest (affects interest cover)

− net assets (affects solvency).

2.2 Amount

In designing the audit plan, the auditor sets an acceptable materiality level so
as to detect quantitatively material misstatements.

In a particular context In a general context

Comparing an item to a Look at item in relation to

category as a whole. Eg an financial statements as a whole.
inventory error of $50,000 Eg comparison to
compared to total inventory
– revenue
value of $650,000.
– profit before taxation
– total assets
– capital and reserves.

As a “yardstick”, materiality must be relevant to the user rather than the

preparer of financial statements.

“Critical points” include those at which:

profit → loss
net current assets → net current liabilities.

Misstatements of relatively small amounts could, cumulatively, have a

material effect on financial statements.

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Some balances are capable of “precise determination” – others are not.

Capable of Not capable of

Eg directors’ emoluments and share Eg inventory provisions and contingent
capital liabilities
Any error (however small) may be Some degree of latitude is acceptable.
considered material and adjusted.

2.3 Nature

Examples of qualitative misstatements

inadequate or improper description of an accounting policy

failure to disclose the breach of regulatory requirements.

3 AUDIT PROCEDURES

3.1 Planning materiality

Assessment based on latest available reliable financial information related to

specific account balances and classes of transactions.

% guides
5 – 10% profit
½ – 1% net assets
1 – 2% total assets
½ – 1 % revenue.

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).

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Solution

(a)

(i)

(ii)

(iii)

(b)

Materiality assists in determining an effective audit approach eg

− what items to examine
− whether to use sampling (see Session 16) and/or analytical
procedures (see Session 15).

3.2 Effect on audit work

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
___ _____

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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3.3 Relationship with audit risk

The relationship between materiality and the level of audit risk is described as
“inverse” (ie the higher the materiality level, the lower the audit risk and vice
versa).

For example, if acceptable materiality level is lower (↓), audit risk is

increased (↑). The auditor compensates for this by either:

reducing CR (if possible) and carrying out extended or additional

tests of control, or

reducing DR by modifying the nature, timing and extent of planned

substantive procedures.

4 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.

Uncorrected misstatements =

specific misstatements (including previous periods)

+ best estimate of other misstatements (ie projected errors).

Further considerations, if aggregate may be material:

any further adjustments which management propose or are prepared

to make;

the impact (if any) on critical points;

whether projected errors can be reduced (to bring the aggregate

below an acceptable threshold) by extending audit procedures.

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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:

(i) all three errors affect profit;

(ii) only error (2) affects profit.

If any remaining (unadjusted) aggregate may be material the auditor’s report should be
modified in accordance with ISA 700 (see Session 17).

FOCUS

You should now be able to

define and illustrate the concepts of materiality”

assess planning materiality

explain the significance of unadjusted differences and evaluate the effect of

misstatements.

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EXAMPLE SOLUTIONS

Solution 1 – Users and their information needs

Users Information needs

Investors (owners) and their Providers of capital are concerned with the risk and
advisers return of their investment. They need information
− for decision-making (buy, hold or sell?)
− to assess the enterprise’s ability to pay
dividends

Employees and their Stability and profitability of employers

representatives
Ability to provide remuneration, retirement
benefits and employment opportunities

Lenders (eg banks) Whether loans and interest will be paid when due

Suppliers and other trade Whether amounts owing will be paid when due
creditors

Customers Continuance – important for long-term

involvement with, or dependence on, the enterprise

Governments and their Allocation of resources and, therefore, activities of

agencies (eg tax authorities) enterprises

Information to regulate activities, determine

taxation policies and as the basis for national
income and similar statistics

Public Contribution to local economy including number of

employees and patronage of local suppliers

Trends and recent developments in prosperity and

range of activities

Management To plan, make decisions and control operational

activities.

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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.

(ii) $40,000 – this is more suitable in that it lies within the % ranges for
turnover and profit before tax. However, it may still be regarded as
too low in relation to the balance sheet.

(iii) $100,000 – although suitable for the audit of the balance sheet, this is
likely to be considered too high for classes of transactions and material
error in the income statement may 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 and the income statement than the balance
sheet, $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

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 23).

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 15).

Prepayments

If $16,450 is in line with the prior period then it is unlikely to be materiality

incorrectly stated and audit tests may be limited to an analytical comparison
with the prior year.

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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

balance sheet. 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.

However, if the incorrect cut-off (say) was in error, management should be prepared to
adjust for it. (If not, this might raise doubts about whether the “error” was by accident
or design.)

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