What is materiality?

Materiality refers to quantative and qualitative omissions or misstatements that make it probable the judgement of a reasonable person would have been changed or influenced. These omissions or misstatements can be individually or in the aggregate material. Accountants and auditors are concerned about this. Remember what will be in your reports:

Review report: "Based on my review, I am not aware of any material modifications that should be made...." Audit report: "In my opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ....."

Materiality needs to be considered at two times, in

Planning the audit and designing audit procedures. Evaluating whether financial statements taken as a whole are presented fairly, in all material respects, is accordance with GAAP.

Materiality and Planning the Audit Financial Statement Level - The planning starts here!

Begin by making a preliminary estimate about materiality levels for balance sheet and income statement. See pages 226 - 227 for some rules of thumb. Select the smallest estimate for purposes of developing your audit plan. If o $100,000 would materially misstate income, and o $200,000 would materially misstate total assets Your audit plan should be designed to detect omissions or misstatements, which individually or in the aggregate, equal $100,000.

Account Balance Level - Allocate materiality to each account. Remember that financial statement audits are done on an account by account basis. Therefore, you need to estimate how much error you can tolerate in each account before you conclude that the account is materially misstated. Two ways to allocate materiality. See page 229.
o o

In proportion to the account's balance. This is the more mechanical approach. In proportion to how difficult it is to audit the account. This is a more judgemental approach.

Materiality and Evaluation of Audit Findings

The auditor aggregates errors the client has not corrected. These include o Known misstatements - errors that you actually found. o Likely misstatements - errors that a sampling program indicates have a high probability of existing. The auditor determines if these errors materially misstate any o account balance, o financial statement subtotal, or o Financial statement total. For an example, see page 730.

Audit Risk Audit risk is the risk that an auditor will fail to modify his or her opinion when the financial statements contain a material misstatement. For each line in the financial statements, auditors want audit risk to be low for each assertion. How to get low audit risk. Auditors must evaluate the three components of audit risk. The combination of these three components determines whether or not there is low audit risk.

Inherent risk - How susceptible is an assertion to a material misstatement, assuming no controls? o High inherent risk if account is prone to misstatement. o Low inherent risk if account is not likely to contain a misstatement. o Inherent risk is based on factors Peculiar to a specific assertion. EG, Accounts receivable must be shown a realizable value. This is an accounting estimate. Valuation is very difficult for A/R. That affects many accounts. EG, the company is having financial problems. They may try to overstate sales (occurrence) and understate expenses (completeness).

Control Risk - How likely is it that a material misstatement will not be detected and corrected by controls relevant to an assertion? o High Control Risk if Controls for a particular assertion are not operating effectively, or

The auditors decide that it would not be efficient to test the controls. Low Control Risk if tests of controls show the controls to be effective.

Detection Risk - How likely is it that the auditor will not detect a material misstatement in an assertion? o High detection risk - It is very likely that the auditor will fail to detect a material error. In other words, the auditor reduces substantive testing. o Low detection risk - There is very little chance that the auditor will fail to detect a material error. In other words, you do extensive substantive testing.

AR = IR * CR * DR

The auditor knows that audit risk must be low for each assertion. Next, the auditor evaluates the assertion's inherent risk. o Hi if prone to misstatement. o Lo if not prone. Third, the auditor evaluates control risk. o Hi if controls are poor or you decide not to test controls. o Lo if your testing indicates that controls are OK. Finally, the auditor sets detection risk. o Hi when assertion not likely to be materially misstated or controls are good. This means reduced substantive testing. o Lo when assertion is likely to be misstated and you are not relying on controls. This means extensive substantive testing. Since detection risk is the last item to be figured out, the audit risk equation can be rewritten as:
DR = AR --------IR * CR

All substantive testing approach. - Auditor tests the assertion on or after the balance sheet date. Generally, IR and CR are Hi, while DR is low. For example, o Cash can be tested with 100% substantive testing by confirming the balance with the bank and reviewing the year-end bank reconciliation. o Depreciation expense can be tested with 100% substantive testing by recomputing depreciation for each asset. o Dividends paid can be tested with 100% substantive testing by multiplying dividend amount per share * times number of shares outstanding. Rely on controls and reduce substantive testing approach. Generally, IR and CR are low to moderate, and DR is moderate to hi. For example, o Confirm accounts receivable 2 months before balance sheet. Rely on controls over processing of accounts receivable to reduce risk that error will not occur during

the final two months of the year. Rely on analytical procedures to detect unusual situations that might arise. Confirm accounts receivable as of balance sheet date. However, auditor sends out fewer confirmations because internal controls over accounts receivable are good.