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Lecture 0424

The document discusses the concept of materiality in auditing and how it is determined. It explains that materiality is a matter of professional judgement and is set based on quantitative benchmarks like gross profit as well as qualitative factors. Overall materiality is set for the financial statements as a whole, while performance materiality is used in conducting the audit and is lower than overall materiality.

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21 views

Lecture 0424

The document discusses the concept of materiality in auditing and how it is determined. It explains that materiality is a matter of professional judgement and is set based on quantitative benchmarks like gross profit as well as qualitative factors. Overall materiality is set for the financial statements as a whole, while performance materiality is used in conducting the audit and is lower than overall materiality.

Uploaded by

jasonnumahnalkel
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Lecture0424

Determining & Using Materiality


Materiality
Overall & Specific Materiality
Materiality
• How much is material and has the potential to affect users?
• Who are the users?
• Shareholders are interested in Profit (Share Price and Dividends)
• Lenders (Total Assets that will be used as collateral against loan)
• Their view of materiality may vary. E.g. What is material for
Institutional investors may not be so for individual investors.
Materiality a Matter of Professional Judgment
• Taking into consideration the needs of various users
• The auditor tries his best to set a kina amount as materiality
• So he uses his professional judgment in determine materiality
• There is no specific amount or rule in the ISA
• Therefore Accounting Firms use their professional judgment to set
materiality
• And it various from client to client
Professional Judgment
• So, professional judgment means
oPrior experience with the client
oknowledge of industry
oObservation
oknowledge of the client and industry
oPrior auditors report

• Use that knowledge to set the overall materiality. That is professional


judgment.
Overall Materiality
• Start with setting overall materiality
• Set materiality for the financial statements as a whole
• It is the maximum amount by which the auditor believes the financial
statements could be misstated and still not affect the decisions of
reasonable users.
• So, at this stage, we set K 300, 000 as the amount. If this is the
materiality for the whole financial statement, what does that mean?
It means as long as our misstatement do not exceed this figure either
individually or in aggregate, we consider the financial statements to
be fairly presented.
Overall Materiality Benchmark
1. Benchmark
2. Percentage to apply to benchmark
• Benchmark could be Profit, Total Assets or Total Revenue
• Now benchmark is determined by users of financial statements
• If users are interested in total revenue then that’s your benchmark
• If total assets is important than that’s the benchmark
• If total assets is important than that’s the benchmark
• What is the key number that they will look at hence benchmark.
Compute Materiality for Overall Financial
Statements
• In Practice, Gross Profit is considered as having the greatest
importance to users
• Therefore, it is used as the benchmark
• And normally 3 -7 % of Gross Profit is computed as Overall Materiality
• If Gross Profit is not useful measure (e.g. NGO’s) then use
- Revenue or Expenditure 1 – 3 percent
- Assets 1 – 3 percent
- Equity 3 – 5 percent
Example
• If Gross Profit for a client is K 10 million and the auditor sets 7 percent
as gross profit as materiality then K 0.7 million is overall materiality.
• That is any misstatement individually or in aggregate valuing K 0.7
million or less may not affect users of the financial statement.
• Any misstatement above this is considered material.
• If you reduce the overall materiality you do a lot of work
• If it comes down to 5 % then its K 0.5 million. Misstatements between
K 0.5 million to K 0.7 million are now considered material hence more
work.
Quantitative vs Qualitative
• Setting a percentage against a benchmark and setting a figure is
quantitative. Qualitative factors also affect materiality
• Some Qualitative factors include;
- Misstatement that may affect loan covenants
- E.g. Bank may set working capital at K 500, 000.
- Otherwise bank may want its money back, or increase interest rate,
or penalize the company
- If there is a misstatement and it makes working capital fall below
K500, 000 then there is a concern. Current ratio is also important.
Qualitative Factors
- Misstatement that may make a slight loss to a slight profit. E.g.
Reporting a K 10, 000 profit instead of K 50, 000 loss is important. Its
taking one from a loss situation to a profitable situation.

- Break-even Point. E.g. A misstatement makes a company reach the


breakeven point closer than anticipated, making the users believe tat
the company performed well when it has not.

- Management incentive – bonuses may be based on profit or sales.


E.g. Management gets 3 % bonus for K 1 million sales and sales was
only K 0.9 million. They may fudge this number to qualify 3 % bonus.
• Stock Market Pressure. E.g. The stock market may require the
company to earn K 3 per share. If any misstatement that is going to
bring Earnings Per Share close to K 3 is important.

• Risk of Bankruptcy. E.g. If the company is on the verge of bankruptcy


then that is important too. They may fail to meet the numbers.

• Fraud. E.g. Any misstatement that is due to fraud is always important


regardless of whether it is big or small. If there is a fraud somewhere,
there is fraud somewhere else due to double entry accounting. If
there is a fraud in accounts receivable, sales will be affected.
Three Factors that Affect Materiality
• Benchmark
• Quantitative Professional
Judgment is Used
• Qualitative
Document How Overall Materiality is Set
• The Accounting Firm must document why it selected a particular
benchmark
• How it computed the overall materiality
• Qualitative Factors it considered

• Basically, overall materiality is set by looking at the financial


statement as a whole.
Overall Materiality by An Accounting Firm
Analysis
• Set out this one and select one benchmark and overall materiality.
• Instead of setting only one percentage, it set two and provides
opportunity for professional judgement.
Analysis
• As long as individual or combined error from profit is less than 3 or K 221,
we are good. In a sense, it’s ok.

X * 0.03 = K 221
X = K 7.366 million

• If the error is more than 6 percent then the error is material. We have a
problem, so it needs to be corrected or addressed.
• If the error is between 3 and 6 percent then you are required to use your
professional judgment. You either decide whether the error is material and
the financial statements are not fairly stated or not. You can do the same
thing with current assets, total assets and current liabilities.
Performance Materiality
• From the overall materiality, performance materiality is computed.
• It would be lower than the overall materiality.
• This is the materiality that the auditor uses in conducting the audit.
• And it is set for each account balances, transactions and disclosures.
ENDS

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