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Audit Materiality

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Audits provide Audits provide reasonable assurance reasonable assurance that the financial statements arethat the financial statements arefree of free of material material misstatements.misstatements.

Audits provide Audits provide reasonable assurance reasonable assurance that the financial statements arethat the financial statements arefree of free of material material misstatements.misstatements.

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Materiality – Definition (Framework)

• "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. Thus, materiality provides a threshold or cutoff point rather than being a primary qualitative characteristic which information must have if it is to be useful."

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USERUSER FOCUSFOCUS

Materiality is defined in termsMateriality is defined in termsof financial statement usersof financial statement users

Materiality is defined in termsMateriality is defined in termsof financial statement usersof financial statement users

Therefore no hard and fast rulesTherefore no hard and fast rules Therefore no hard and fast rulesTherefore no hard and fast rules

Need to consider multiple users and multiple basesNeed to consider multiple users and multiple basesNeed to consider multiple users and multiple basesNeed to consider multiple users and multiple bases

Materiality can be on Qualitative/ Quantitative Materiality can be on Qualitative/ Quantitative factorsfactors

Materiality can be on Qualitative/ Quantitative Materiality can be on Qualitative/ Quantitative factorsfactors

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SET PRELIMINARY JUDGMENTSET PRELIMINARY JUDGMENTABOUT MATERIALITYABOUT MATERIALITY

Base X (function of client)Base X (function of client)

Percentage (function of audit risk)Percentage (function of audit risk)

== Preliminary estimate of materialityPreliminary estimate of materiality

Factors Affecting JudgmentFactors Affecting Judgment

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Typically 1 - 5% for net income, lowerTypically 1 - 5% for net income, lowerpercentage for larger bases such aspercentage for larger bases such as

assets or revenuesassets or revenues

High Risk Low % ML

Low Risk High % ML

(less evidence; less assurance)(less evidence; less assurance)

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Materiality / EvidenceMateriality / EvidenceRelationRelation

Increase inIncrease inMaterialityMateriality

LevelLevel

Increase inIncrease inMaterialityMateriality

LevelLevel LessLess

evidenceevidence

requiredrequired

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Materiality Level /Materiality and Audit Risk

• There is a positive relationship between materiality level and audit risk

• There is a negative relationship between materiality and audit risk

Materiality Level = Audit Evidence ↓ = Audit Risk

Materiality = Audit Evidence = Audit Risk ↓

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Materiality Should be Considered by the Auditor When:

(a) Determining the nature, timing and extent of audit procedures;

and

(b) Evaluating the effect of misstatements.

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Evaluating the Effect of Misstatements

In evaluating whether the financial statements "give a true and fair view" or "present fairly, in all material respects,", the auditor should assess whether the aggregate of uncorrected misstatements that have been identified during the audit is material

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Evaluating the Effect of Misstatements

• The aggregate of uncorrected misstatements comprises:(a) Specific misstatements identified by the

auditor; and

(b) The auditor's best estimate of other misstatements which cannot be specifically identified.

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Evaluating the Effect of Misstatements

• When aggregate uncorrected misstatements approach the materiality level the auditor would consider reducing the risk by

1. Performing additional audit procedures or

2. By requesting management to adjust the financial statements for identified misstatements

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Evaluating the Effect of Misstatements

• ExampleAn auditor discovered an overstatement of Rs. 20,000/- of inventory by verifying a sample of 100,000/- worth of inventory. The B/S value of inventory is Rs. 200,000/-. The preliminary materiality level set by the auditor is Rs. 30,000/-.

Required : Find if the misstatement is material or not.