Materiality in Auditing

Materiality in AuditingMateriality is a concept or convention within auditing and accounting relating to the. importance significance of an amount, transaction, or discrepancy.

The auditor’s determination of materiality is a matter of professional judgment and is affected by the auditor’s perception of the financial information needs of users of the financial statements.

Information is material if its omission or misstatement could influence the economic decision of users taken based on 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 cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.

Materiality is a major consideration in determining the appropriate audit report on the issue.

EASB 2 has defined materiality as, “The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances make it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement

The auditors’ responsibility is to determine whether financial statements are materially misstated. If the auditor determines that there is a material misstatement, he or she will bring it to the client’s attention so that a correction can be made.

If the client.refuses to correct the statements, a qualified or an adverse opinion must be issued, depending on how material the misstatement is.

Therefore, auditors must have a thorough knowledge of the application of materiality. Materiality is relative to the size and particular circumstances of individual companies.

Example – Size

A default by a customer who owes only $1000 to a company having net assets of worth $10 million is immaterial to the financial statements of the company.

However, if the amount of default was, say, $2 million, the information would have been material to the omission of the financial statement of which could cause users to make incorrect business decisions.

Example – Nature

If a company is planning to curtail its operations in a geographic segment which has traditionally been a major source of revenue for the company in the past, then this information should be disclosed in the financial statements as it is by its nature material to understanding the entity’s scope of operations in the future.

Preliminary Judgment

The auditor makes preliminary judgments about materiality levels in planning the audit.

This assessment, often referred to as planning materiality, may ultimately differ from the materiality levels used after the audit in evaluating the audit findings because;

  1. the surrounding circumstances may change, and
  2. additional information about the client will have been obtained during the audit.

In planning an audit, the auditor should assess materiality at the two levels:

  1. the financial statement level, and
  2. the account balance level.

Materiality at the Financial Statement Level

Financial statements are materially misstated when they contain errors or irregularities whose effect, individually or in the aggregate, is important enough to prevent the statements from being presented fairly following Accounting Standards.

In this context, misstatements may result from misapplication of applicable Accounting Standards, departures from fact, or omissions of the necessary information.

The financial statement materiality at the financial statement level enables auditors to determine which account balances to audit and how to evaluate the effects of misstatements in financial information as a whole.

In audit planning, the auditor should recognize that there may be more than one level of materiality relating to the financial statement. Each statement could have several levels.

For the Income Statement, materiality could be related to total revenues, operating profit, net profit before tax or net profit. For the Statement of Financial Position, materiality could be based on shareholders’ equity, assets or liability class total.

The auditor’s preliminary judgments about materiality are often made six to nine months before the balance sheet date. Thus, the judgments may be based on annualized interim financial statement data.

Alternatively, they may be premised on one or more prior years’ financial results adjusted for current changes, such as the general condition of the economy and industry trends. Materiality judgments involve both quantitative and qualitative considerations.

Materiality at the Account Balance Level

Account balance materiality is the minimum misstatement that can exist in an account balance for it to be considered materially misstated.

Misstatement up to that level is known as a tolerable misstatement. The concept of materiality at the account balance level should not be confused with the term material account balance.

The latter term refers to the size of a recorded account balance, whereas the concept of materiality pertains to the amount of misstatement that could affect a user’s decision. The recorded balance of an account generally represents the upper limit on the amount by which an account can be overstated.

Thus, accounts with balances much smaller than materiality are sometimes said to be immaterial in terms of the risk of an overstatement.

However, there is no limit on the amount by which an account with a very small recorded balance might be understated.

Thus,.it should be realized that accounts with seemingly immaterial balances may contain understatements that exceed materiality.

Materiality at the account balance and class of transaction-level assists auditors in determining what items in a balance or class to audit and what audit procedures to undertake; for example, whether to use sampling or analytical procedures.

In making judgments about materiality at the account balance level, the auditor must consider the relationship between it and financial report materiality.

This consideration should lead the auditor to plan the audit to detect misstatements that may be immaterial individually but that may be material to the financial report taken as a whole when aggregated with misstatements in other account balances.

In making judgments about materiality at the account balance level, the auditor must consider the relationship between it and financial statement materiality.

This consideration should lead the auditor to plan the audit to detect misstatements that may be immaterial individually, but that, when aggregated with misstatements in other account balances, may be material to the financial statements taken as a whole.

Relationship between Materiality and Audit Evidence

Materiality is one of the factors that affect the auditor’s judgment about the sufficiency of audit evidence.

In making generalizations about this relationship, the distinction between the terms materiality and material account balance mentioned previously must be kept in mind.

For example, it is generally correct to say that the lower the materiality level, the greater the amount of evidence needed (inverse relationship).

This is the same as saying that it takes more evidence to obtain reasonable assurance that any statement in the recorded inventory balance does not exceed $100,000 than it does to be assured the misstatement does not exceed $200,000.

It is also generally correct to say that the larger or more significant an account balance is, the greater the amount of evidence needed (direct relationship).

This is the same as saying that more evidence is needed for inventory when it represents 30 percent of total assets than when it represents 10 percent.