Materiality in External Auditing of Listed Companies'

Financial Reports

1- Part 1: What is Materiality

2- Part 2: influences the scope
and nature of audit

Esam M. Hussein
 Part 1: "What is Materiality in Auditing?"
Definition of Materiality in Auditing:
• ISA 320 defines Materiality in auditing is a concept that represents the
significance or importance of an omission, misstatement, or discrepancy in
the financial statements that could influence the economic decisions of users
made on the basis of these financial statements.

The Law in USA states that information is material if "there is a substantial

likelihood that a reasonable shareholder would consider it important" in
making an investment decision.
It is a threshold or cut-off point used by auditors to guide their decisions about
the nature, timing, and extent of auditing procedures, and to evaluate the
effect of misstatements on the financial statements.
Importance of Materiality in Auditing: determine what to
concentrate on during the
audit (significant areas)

Audit Focus
Informs Risk Assessment:
focusing on material risk of material
information, thus misstatement, guiding the
Stakeholder Risk
supporting the reliability Interests Assessment overall strategy of the
of financial reports. audit.

Materiality
identifies significant
misstatements that Audit Decision Making:
require correction or Reporting Scop of about the timing, extent,
Threshold audit tests and nature (TEN) of audit
disclosure in the
testing
auditor's report.
Efficiency
Allocation of audit
resources to reduce
cost and time
Sarbanes-Oxley Act • doesn't define materiality but emphasizes the importance of material information in financial
(SOX) of 2002 reporting and internal controls.

• It requires that FS filed with the SEC must be certified and not misleading..
Sec • information is material if "there is a substantial likelihood that a reasonable shareholder
would consider it important" in making an investment decision.

• Auditing Standard No. 11 deals with considerations of materiality in planning and

PCAOB
performing an audit.

• setting accounting standards in the USA through the (GAAP)

FASB • mentions materiality as an aspect of relevance. Information is material if omitting it or
misstating it could influence decisions made by users of financial statements.

• Similar to US GAAP, IFRS defines materiality in the context of misstatements being influential
IFRS
to the economic decisions of users based on the financial statements.
Key Takeaways
• No Uniform Quantitative Measure: None of these regulations provide a
specific quantitative measure for materiality; instead, they focus on the
qualitative aspect – whether information could influence decision-making.
• Emphasis on Judgment: All frameworks emphasize the importance of
professional judgment in determining materiality.
• Focus on Investor Protection: The overarching aim is to protect
investors and other users of financial statements by ensuring the provision of
material information.

These laws and regulations are crucial in shaping the practices of financial reporting for
listed companies, ensuring that materiality is appropriately considered to maintain the
integrity and utility of financial information.
 Part 2:
How materiality influences the scope and nature of audit
procedures.
• Scope defines the areas of the business, processes, and accounts that
will be examined, and the procedures used, through TEN

• the Time period of the audit and timing of procedure,

• The Extent (depth) of the testing or verification procedures to be

performed.

• the Nature and depth of the testing or verification procedures to be

performed.
How materiality influences the scope and nature of audit procedures
Key elements of audit scope in external audits include:
• Coverage of Financial Statements: Ensuring that all major components (balance sheet,
income statement, cash flow statement, etc.) are audited.
• Specific Risk Areas: Identifying areas where there may be a higher risk of material
misstatement, such as revenue recognition or valuation of assets.
• Materiality: Focusing on items that are financially significant and that could affect the
users of the financial statements.
• Compliance with Accounting Standards: Verifying that the entity's financial reporting is
in accordance with relevant accounting standards (e.g., IFRS, GAAP).
• Internal Controls: Assessing the effectiveness of internal controls that impact financial
reporting.
 How materiality influences the scope of audit procedures.
The concept of materiality helps auditors decide what matters most during
an audit. Here's how materiality shapes the audit process:
• Determining Audit Focus: Auditors concentrate their efforts on these
areas with higher possibilities of MM.
• Risk Assessment: When planning the audit, auditors assess risks of
material misstatement at both the financial statement and assertion
levels.
• The higher the risk of MM the lower the level (value) of materiality
given to that area, and vis-versa.
Planning Materiality and Segment Materiality: Auditors may determine different levels of
materiality for different segments of the business or for specific types of transactions,
events, or account balances, thereby influencing the audit scope to focus on more
significant areas.
Level of materiality
• Level of materiality in the context of auditing refers to the threshold or
magnitude of misstatements (maximum amount (value) of misstatement or
omission) in financial statements that would likely influence the economic
decisions of users (such as investors, creditors, or regulators) taken based on
those financial statements.

• Higher level means means the item is less material

• Lower level means the item highly material.

 Level of materiality
Key Aspects of Materiality Level:
Quantitative Aspect: This refers to the dollar value or percentage of financial statement
items. For example, a certain percentage of total revenue, net income, or total assets
might be considered material.

Qualitative Aspect: Some misstatements, though small in amount, may be considered

material due to their nature (e.g., fraudulent transactions, legal compliance issues, or
related-party transactions).

Overall Materiality: The auditor sets an overall materiality level for the financial
statements as a whole.

Performance Materiality: This is set lower than overall materiality and is used to assess
individual transactions or account balances, allowing for a margin of error.
 What is Nature of the Audit?
The audit nature refers to the type or character of the audit procedures that
an auditor uses to gather audit evidence. It describes what is done during the
audit to assess the fairness of an entity's financial statements.
Key elements of audit nature in external audits include:
• Type of audit procedures: These can include analytical procedures, substantive tests of
details, tests of controls, or inspection of records and documents.
• Extent of reliance on evidence: Whether the auditor uses internal evidence (from the
company) or external evidence (from third parties).
• Audit techniques: This can involve different techniques such as inquiries, observation,
confirmation, recalculation, and re-performance.
 Influence of Materiality on Audit Procedures

• Depth and Extent of Testing: Higher risk of MM are given lower materiality values leading
to more extensive and detailed testing.
• Conversely, areas with lower risk of MM are given higher materiality values will be
subjected to less rigorous testing procedures.
• Type of Audit Procedures: the choice between test of controls and substantive testing.
For areas where risks is high, auditors might rely more on substantive testing.
• Sampling Techniques: The materiality level also affects the size and selection of samples
for testing. In areas of higher materiality level, auditors may choose smaller samples to
gain more assurance.
• Professional Judgment: Auditors use their judgment to determine the nature of the audit
procedures based on materiality. This includes deciding on the types of evidence to
gather and the methods to use for testing.
Overall Impact
• Efficiency and Effectiveness: By focusing on material aspects of the
financial statements, auditors can conduct their audits more
efficiently without overlooking significant issues. This focus ensures
that the audit is effective in reducing the risk of material
misstatement to an acceptably low level.

• Adaptability: Materiality is not a static measure. As new information

emerges during an audit, materiality levels and the related scope and
nature of audit procedures might need to be adjusted.
Conclusion

• Materiality plays a pivotal role in shaping the audit strategy. It guides

auditors on where to direct their efforts and resources, ensuring that
the audit is both efficient and effective. The auditor's ability to assess
materiality accurately is therefore crucial for the quality and reliability
of the audit outcome. Determining the level of materiality is a matter
of judgement and there is no one single correct value, it depends on
each case.