International

Audit &
Assurance
Lecture 5
Topic: Materiality
Introduction
 Materiality considerations are important in both
planning and performing the audit.
 Materiality for the financial statements as a
whole and performance materiality must be
calculated at the planning stages of all audits.
 An item might be material due to its nature, value
or impact on the users of the financial statements
as a group.
Introduction
 There are now two standards that deal with materiality
issues, ISA 320 Materiality in planning and
performing an audit and ISA 450 Evaluation of
misstatements identified during the audit.
 Significant developments include the formalization of
the concept of ‘Performance materiality’ and clarification
on the need for the users of the financial statement to be
treated as a group. There are also further guidelines for
the determination of materiality and more stringent
documentation and communication requirement.
Definitions
 Materiality, Misstatement, including omissions, are
considered to be material if they, individually or in
aggregate, could reasonably be expected to influence the
economic decisions of users taken on the basis of the
financial statements.
 Judgments about materiality are made in the light of
surrounding circumstances, and are affected by the size and
nature of a misstatements or a combination of both.
 Judgments about matters that are material to users of
financial statements are based on a consideration of the
common financial information needs of users as a group
Definitions
 Performance materiality means the amount set by the
auditor at less than materiality for the financial
statement as a whole to reduce to an appropriately low
level the probability that the aggregate uncorrected and
undetected misstatements exceeds materiality for the
financial statements as a whole.
 Performance materiality also refers to the amount or
amounts set by the auditor at less than the materiality
level or levels for particular classes of transactions,
account balances or disclosures.
Factors influencing performance
materiality
 The nature and extent of misstatements identified
in prior audits.
 The auditor’s understanding of the entity
 Result of risk assessment procedures
Impact on auditors (ISA 320.11)
 The auditor shall determine performance materiality for
purposes of assessing the risks of material misstatement and
determining the nature, timing and extent of further audit
procedures.
 Materiality assessment will help the auditors to decide.
 How many items to examine
 What items to examine
 Whether to use sampling techniques
 What level of error is likely to lead to a modified audit opinion

The resulting combination of audit procedures should help to

reduce audit risk to an appropriately low level.
Materiality criteria
 An item
Nature mightGiven
be material
the definition ofdue to
materiality its;
as an item that would
affect the readers of the financial statements, some items
might by their nature affect readers. Examples include
transactions related to directors, such as remuneration or
contracts with the company

Value –size Some items will be significant in the financial

statements by virtue of their size, for example, if the
company had bought a piece of land with a value
which comprised three quarters of the asset value of
the company, that would be material. That is why
materiality is often expressed in terms of percentages
(of assets, of profit)
Impact Some items may by chance have a significant impact
on financial statements, for example, a proposed
journal which is not material in itself could convert a
profit into a loss. The difference between a small
profit and a small loss could be material to some
readers.
Factors influencing benchmarks
 Elements of the FS (eg assets, liabilities, equity,
etc)
 Whether there are items on which users tend to
focus
 Nature of the entity, industry and economic
environment
 Entity’s ownership structure and financing
 Relative volatility of the benchmark
Rules on materiality
 It is clear from the points made about materiality criteria
that materiality is judgmental, and an issue that auditors
must be aware of when approaching all their audit work.
 Materiality has both qualitative and quantitative aspects
 However, generally accepted rules about materiality exist.
 Examples are:
 Items relating to directors are generally material
 Percentage guidelines are often given for materiality
Benchmarks
 PBT (5%), PAT(5-10%), Gross profit (1/2-1%), Revenue
(1/2-1%), and Total Assets (1-2%), Net Assets (2-5%)
 While materiality must always be a matter of
professional judgment for the auditor, it is helpful to
have some rules to bear in mind. Reasons for this are:
 The rules give the auditor a framework within which to
base his thoughts on materiality
 The rules provide a benchmark against which to assess the
quality of auditing, for example, in the event of litigation
of disciplinary action.
Problems with materiality
 Materiality is a matter of judgment for the auditor.
Therefore, prescriptive rules will not always be helpful
when assessing materiality.
 The percentage guidelines of assets and profits that are
commonly used for materiality must be handled with
care. The auditor must bear in mind the focus of the
company being audited.
 In some companies, post tax profit is the key figure in
the financial statements, as the level of dividend is the
most important factor in the accounts.
Problems with materiality
 In owner managed businesses, if owners are paid a salary and
are indifferent to dividends, the key profit figure stands
higher in the income statement, say at gross profit level.
 Some companies are driven by assets rather than the need for
profits. In such examples, higher materiality might need to be
applied to assets. In charities, costs are the driving factor.
 While rules or guidelines are helpful, auditors must
always keep in mind the nature of the business they are
dealing with. Materiality must be tailored to the business and
the anticipated user of financial statements, or it is not truly
materiality.
Evaluating Material Misstatements
 ISA 450 Evaluation of misstatements identified
during the audit provides more specific guidance
on the documentation and communication of
errors identified.
 ISA 450.5 states; ‘The auditor shall accumulate
misstatements identified during the audit, other
than those that are clearly trivial’
Immaterial misstatements
 Whereas immaterial misstatements were not required to be
communicated in the past, now all misstatements must be
communicated on a timely basis to management with a
request that the misstatements are corrected.
 In the event that these errors remain uncorrected, the auditor
is obliged to communicate the individual uncorrected
errors to those charged with governance together with the
effects on the audit opinion.
 For those errors that remain uncorrected, management must
provide written representations that they believe the effects
of the errors (individually and in aggregate) are immaterial.
Evaluating Material Misstatements
 ISA 450.15
 The auditor shall include in the audit documentation:
 a. the amount below which misstatements would be
regarded as clearly trivial.
 b. all misstatements accumulated during the audit
and whether they have been corrected.
 c. the auditors conclusion as to whether uncorrected
misstatements are material, individually or in
aggregate, and the basis for that conclusion.
Summary
 A misstatement is material if it is important
enough for those reading the Financial
 Statements to care that it is wrong.
 There are 2 types of materiality:
 ● QUANTITATIVE (Material by size)
 ● QUALITATIVE (Material by nature/Impact on
the FS).
Summary
 Quantitative materiality
 As a guide, errors are typically assessed as material
if they are above any of the following levels:
 ● 0.5 – 1 % of Sales Revenue (Turnover)
 ● 1 – 2 % of Total Assets
 ● 5 – 10 % of Profit Before Tax.
 These are guidance only – different audit firms will have
their own figures, as it is a matter of professional
judgement.
Summary
 Qualitative materiality
 Some errors in the FS are important because
of WHAT they are, rather than the actual size of
the error. For example:
 ● anything involving the directors (eg their pay).
 ● anything suggesting fraud or illegal acts.
Summary
 Performance materiality
 ISA 320 also requires the auditors to set a level of
performance materiality.
 Performance materiality should be a smaller amount
than the overall materiality and, the total of:
 1. The identified but uncorrected misstatements, and
 2. The expected unidentified misstatements should be
less than performance materiality at the end of the audit.
Summary
 Materiality is likely to be assessed at the Interim
Audit stage – which is before the client’s
accounting year has finished. The figures used
are therefore likely to be last year’s, or the
budget, or the current year’s figures to date plus
forecasts for the final few months.
 As such, the materiality assessment may change
when the final audit is started, once a better idea
of the current year’s actual results is known.
Question 1
 You are the manager responsible for the audit of Albreda Co. The
draft consolidated financial statements for the year ended 31 March
20x8 show revenue of $42.2 million ((20x7 $23.4million), profit
before taxation of $1.8 million (20X7 $ 2.2 million) and total assets
of $30.7 million (20X7 $ 23.4 million). In March 20X8, the
management board announced plans to cease offering ‘home
delivery’ services from the end of the month. These sales amounted
to $0.6 million for the year to 31 March 20X8 (20X7 $0.8million).
A provision of $0.2million has been made at 31 March 2008 for the
compensation of redundant employees (mainly drivers).
 Required
 Comment upon the materiality of these two issues
Answer
 Home delivery sales
 The appropriate indicator of materiality with
regards to the home delivery sales is revenue, as
the home delivery sales form part of the total
revenue of the company.
 $0.6 million is 1.4% of the total revenue for 20X8
 An item is generally considered to be material if it
is in the region of 0.5% - 1% of revenue, so the
home delivery services are material.
Answer
 Provision
 The appropriate indicators of materiality with regard to the
provision are total assets and profit, as the provision impacts both
the statement of financial position (it is a liability) and the statement
of comprehensive income (it is a charge against profit.
 $0.2 million is 0.65% of total assets in 20X8. As an item is generally
considered to be material if it is the region of 2-5% of total assets,
the provision is not material to the statement of financial position.
 However, $0.2 million is 11% of profit before tax for 20X8. An item
is considered material to profit before tax if it is in the region of 5%.
Therefore, the provision is material to the statement of
comprehensive income.
Answer
 Working1

0.6/42.2 *100 = 1.4%

 Working 2
0.2/30.7*100 = 0.65%

 Working 3
0.2/1.8*100 = 11%
Question 2
 Explainthe concepts of materiality and
performance materiality in accordance with ISA
320 Materiality in Planning and Performing an
Audit.