Audit Software - User Guide

# 11 MATERIALITY

(INCORPORATING ISA 320)

# 11.1 Definition

Materiality is defined in the following terms "Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Material depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful"

The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework.

The assessment of materiality assists:

  • .As an aid, together with risk assessment, to establishing the nature, timing and extent of audit procedures to reduce the audit risk to an acceptably low level.
  • .To decide what items to examine and whether to use sampling and substantive analytical procedures in relation to classes of transactions, account balances, and disclosures.
  • .In deciding which transactions are to be tested.
  • .In evaluating potential and actual quantitative misstatements.

General Considerations in Setting Materiality Levels

In designing the audit plan, the engagement team needs to establish an acceptable materiality level so as to detect quantitative (based on the amount) material misstatements. However, the engagement team should be mindful that qualitative misstatements (based on the nature) need also to be considered. The following should be considered in setting materiality levels:

  • .The possibility of quantitative misstatements of relatively small amounts that, cumulatively, could have a material effect on the financial statements e.g. errors in month end procedures could be material if that error is repeated each month.

  • .In addition to quantitative misstatements, qualitative misstatements may materially affect the financial statements. Such misstatements and the audit approach are covered in other chapters of the manual. Examples of qualitative misstatements include:

    • .Inadequate or improper description of an accounting policy when it is likely that a user of the financial statements would be misled by the description.
    • .Failure to disclose the breach of regulatory requirements when it is likely that the consequent imposition of regulatory restrictions will significantly impair operating capability.

  • .Some areas, principally those where "sensitive" disclosures are required in the financial statements e.g. related party transactions should always be regarded as material at the planning stage.

  • .Materiality may be influenced by classes of transactions, account balances, and disclosures and their relationships, resulting in different materiality levels depending on the aspect of the financial statements being considered.

  • .The assessment of materiality and risk may be different at the planning level from that at the completion stage either due to changes in circumstances or because of change in the auditor's knowledge as a result of performing audit procedures. In some cases, during planning, materiality may intentionally be set to a lower level than is intended to be used to evaluate the results. This is done to reduce the likelihood of uncovered mistakes and also provides the engagement team with a margin of safety when evaluating the effects of misstatements discovered during the audit.

The assessment of what is material is a matter of professional judgment, and the engagement team needs to consider materiality at both the overall financial statement level and in relation to classes of transactions, account balances, and disclosures. The engagement team should also consider materiality and its relationship with audit risk when conducting an audit.

# 11.2 Relationship Between Materiality and Risk

There is an inverse relationship between materiality and the level of audit risk, that is, the higher the materiality level, the lower the audit risk and vice versa. This should be taken into account when determining the nature, timing and extent of audit procedures. If after planning for specific audit procedures, it is determined that the acceptable materiality is lower and the audit risk is increased, the engagement team would compensate for this by either:

  • .Reducing the assessed risk of material misstatement, where this is possible, and supporting the reduced level by carrying out extended or additional tests of control; or
  • .Reducing detection risk by modifying the nature, timing and extent of planned substantive procedures.

Further discussion on risk is presented in Section 7 of this Manual.

# 11.3 Overall and Individual Materiality

The setting of the materiality level may be regarded as a two-stage process:

  • .Setting the materiality level for the financial statements as a whole; and
  • .Setting a materiality level for individual audit areas, where considered necessary.

# 11.3.1 Overall Materiality Level

The overall materiality level will be used at the opinion stage to determine whether the aggregate of all misstatements do not exceed the materiality level set for the engagement. The overall materiality level is set initially at the planning stage. This has the following benefits:

  • .It ensures that the audit is focused to significant areas and therefore less attention will be given to insignificant items.
  • .The nature and extent of audit procedures will be more effective.

Details of the level chosen and the reasons for choosing it should be documented as part of the audit strategy and the overall audit plan.

In the absence of any specific recommendations in ISA 320 on the methods to be used in calculating materiality, this section of the manual provides some guidance on the setting of materiality levels using various formulae. However the manual does not dictate the methods to be adopted as there are other suitably acceptable methods of calculating materiality. Whatever method is used, the planning documentation should state the factors that have influenced the choice of materiality selected.

Appendix I: Guidance on Setting Materiality provides illustration on how to set the materiality level.

Form 5.05 - Materiality set out in Part E of the Manual should be used to record the materiality set and the basis of selection, and the materiality referenced to the audit strategy and plan.

Materiality at the planning stage should be set using the most recent management accounts. If these are not available then the current period budget or then the last year's audited financial statements should be used. If reliable information is available at the planning stage, the overall materiality level set at the planning and opinion stages will be the same. As more up-to-date financial information becomes available, the level set may need to be modified. If, exceptionally, modification results in a significant reduction in the materiality level, it may be necessary to extend audit tests already completed.

Once the draft financial statements become available, an opinion materiality level should be determined. This level should be used as a factor in considering whether areas of uncertainty or disagreement in the financial statements are sufficiently material to require an audit qualification [if the uncertainty is not adequately disclosed, or the disagreement cannot be resolved]. Consideration should also be given to the effect of the opinion materiality level on the level set for individual audit areas.

# 11.3.2 Materiality Level for Individual Areas

As well as the overall materiality level, particular items may be of such significance that the user of the financial statements may apply a different materiality level to them. This may be connected with the nature of the item (for example, any misstatement will be considered significant) or the effect of the item changing (for example, the effect any misstatement will have on key ratios or indicators in the financial statements).

Note: When using statistical sampling, the materiality level chosen for the individual area is adjusted by the risk factor chosen, to arrive at an adjusted materiality level used for sampling purposes, or which can be used as the tolerable error rate - See Section 17 for further discussion.

# 11.4 Influences and Other Considerations Including Fraud on Setting Materiality

# 11.4.1 General Influences

General factors to consider when deciding both the overall materiality level and the level used for individual items include:

  • Users of financial statements

    • .Who are the users are and what do they need to know (for example, the financial statements of a private owner-managed entity will have a different readership than those of a listed entity).
    • .Which figures or information in the financial statements are they particularly interested in.
    • .What level of error in these figures will affect the users.

  • .The Nature of Reporting Based on the Type of Entity

    • .Different sectors produce very different financial statements based on the nature of their activity. For a business generating profits from a relatively low total asset base, a materiality level based on the profit and loss account is likely to be more meaningful; by contrast for a business with high total assets but low profits, a materiality level based on total assets is likely to be more relevant. If the business has high turnover but low profits in an individual year, it may be more appropriate to base materiality on turnover or on an average of profits for previous years.

  • . Losses and Net Liabilities

    • .In general, the magnitude of losses should be ignored when setting materiality if the business has a strong net assets position. If the business is close to a break-even point, or has net liabilities, the formulae given in the appendices should not be used. Instead, consideration should be given to how the business is to be funded, and what level of liabilities or profits would cause the sources of finance to be withdrawn.

# 11.4.2 Influences on Materiality of Individual Items

Factors which may influence the judgement on setting the materiality of an item may include:

  • . Sensitive items: These would include transactions with related parties, illegalities and irregularities.
  • . Infrequent or unusual occurrences: These would include areas where there has been a change in accounting policy, or a departure from a treatment normally required.
  • . Special circumstances:
    • .If the business is being reviewed for a potential takeover or sale.
    • .Where the going concern basis may be inappropriate.
    • .Whether immaterial items (such as illegal payments) may lead to discoveries of material errors.
    • .The specific terms of the engagement may impose additional responsibilities, for example, looking for fraud. Such procedures may be strictly outside the scope of the audit, but can be taken to affect materiality levels if they are carried out at the same time.

# 11.4.3 The Effect of the Item in the Financial Statements

The effect on the financial statements of the item being misstated will depend on the absolute amount of the item itself. The following factors should also be considered:

  • . The amount relative to the other figures in the financial statements g. how large the item is relative to other current assets or liabilities, total assets or liabilities, shareholders funds, profits or income. A small error may have the effect of turning a small profit into a small loss, or a positive net current assets figure into a negative.
  • . Measures of liquidity or solvency for instance, whether a small error will significantly affect debt to equity or working capital ratios, or cause ratios or limits in relation to borrowings to be exceeded.
  • . Other key ratios and trends e.whether an error will effect asset turnover, profit margin or return on capital ratios or effect profitability, current asset and other liquidity ratios.
  • . Tax Charge e. whether an error would have a significant tax effect, for example, on capital expenditure and disallowable items.
  • . Subsequent financial statements e. whether a small difference will impact greatly on the financial statements in future years.
  • . Directional testing considerations. When setting a materiality level for a particular item, consider whether a different materiality level applies to the corresponding item which is the subject of the directional test.

# 11.4.4 Accounts Preparation Materiality

If the firm is preparing the financial statements for the entity, the setting of an accounts materiality level i.e. the amount that would cause us to amend the financial statements is quite a separate decision from setting the materiality level for audit purposes. A number of the factors that will influence our choice of audit materiality level will also influence the choice of accounts materiality level. In such cases the entity may require their draft figures to be adjusted for any errors, even if the errors are immaterial in auditing terms.

# 11.4.5 Materiality and Groups

If the firm audits a group and reports on the subsidiary's financial statements, then in auditing the subsidiaries, the firm's assessment of materiality should be as described above. In particular, the engagement team should consider the likely users of the subsidiary's financial statements and the importance the users will attach to the subsidiary's financial statements compared to the consolidated financial statements. Each component in the group should be regarded as a separate entity for the purposes of audit planning, setting materiality levels and reporting.

If the firm does not report on the subsidiary's financial statements, materiality levels should normally be determined by reference to the group. The engagement team should discuss with group management the implications of the restricted examination of the subsidiary. Group management may wish to make a more detailed assessment of the subsidiary than is implied by choosing its materiality level by reference to its importance to the group. Group-based materiality levels should be used when considering any consolidation adjustments, and to evaluate the total unadjusted errors of all the components and the parent company.

# 11.4.6 Entities with Several Branches or Divisions

Larger entities may have several different branches, divisions or locations with autonomous or semi-autonomous accounting systems. In these circumstances, the engagement team should normally determine materiality in relation to the key components of the financial statements, irrespective of the number of branches, divisions or locations. However the engagement team should confirm with management whether they want to consider each branch or division as a separate entity. If so, separate materiality levels should be set for each branch.

# 11.5 Evaluating the Effects of Misstatements

The engagement partner should assess whether the aggregate of uncorrected misstatements that have been identified during the audit are material taking into account the overall materiality level. The aggregate of uncorrected misstatements comprise the:

  • .Specific misstatements identified by the engagement team including the net effects of uncorrected misstatements identified during the audit of previous periods; and
  • .The engagement team's best estimate of other misstatements which cannot be specifically identified e.g. projected errors.

On the other hand, the engagement team may identify that the aggregate of the uncorrected misstatements approaches the materiality level. In such a case, the engagement partner should consider whether it is likely that undetected misstatements, when taken with aggregate uncorrected misstatements could exceed the materiality level.

If the engagement partner concludes, in both the above scenarios, that the misstatements may be material the partner may either:

    1. 1)Consider reducing the audit risk by extending the audit procedures; or
    2. 2)Requesting the management to adjust the financial statements.

If the management refuses to adjust the financial statements or the engagement partner is not able to conclude that the aggregate of the uncorrected misstatements is not material, then consideration should be given to modifying the auditor's report (See Section 25 of this manual). The engagement partner may also consider communicating the misstatements with those charged with governance (See Sections 27.3 and 27.4 of this manual).

APPENDIX I: GUIDANCE ON SETTING MATERIALITY

The range of values approach should normally be considered. Form 05.05 in Part E of the Manual should be used to document the materiality level set.

Other measures may be appropriate, for example a materiality level based on working capital, or on shareholders' funds if the users are interested in the equity base. Alternative approaches are used world-wide and the measures addressed here are for guidance only.

1. RANGE OF VALUES

Six possible measures of audit materiality are given for the financial statements as a whole:

  • .5% of turnover or revenues;
  • .1% of turnover or revenues;
  • .5% of pre-tax profit, before significant directors' profit-related bonuses, significant directors' remuneration (if substantial amounts of profit are voted as remuneration) and perhaps exceptional items (depending on their nature);
  • .10% of pre-tax profit, before significant directors' profit-related bonuses, significant directors' remuneration (if substantial amounts of profit are voted as remuneration) and perhaps exceptional items (depending on their nature);
  • .1% of total assets (before deducting liabilities); or
  • .2% of total assets (before deducting liabilities).

The materiality levels set should normally be within the range of factors stated above. Pre-tax profits should not be used if there are losses or profits are distorted for any reason. Form 05.05 can be used to summarise the results and the reasons for choosing a particular method.

Last Modified: 7/9/2019, 10:45:48 AM

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