Scope and objectives
The concept of materiality in the context of an audit of financial statements. Materiality refers to the level at which a misstatement or omission in the financial statements could influence the economic decisions of users of those statements. The auditor’s responsibility is to apply the concept of materiality appropriately in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements.
The financial reporting frameworks generally discuss the concept of materiality and provide a frame of reference for the auditor in determining materiality for the audit. However, if the applicable financial reporting framework does not include such discussion, the characteristics of misstatements and judgments about matters that are material to users of the financial statements provide the auditor with a frame of reference.
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. The auditor assumes that users have a reasonable knowledge of business and economic activities and accounting, understand that financial statements are prepared, presented, and audited to levels of materiality, recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events, and make reasonable economic decisions on the basis of the information in the financial statements.
The concept of materiality is applied by the auditor both in planning and performing the audit and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report. Materiality and audit risk are considered throughout the audit, in particular when identifying and assessing the risks of material misstatement, determining the nature, timing, and extent of further audit procedures, and evaluating the effect of uncorrected misstatements on the financial statements.
In planning the audit, the auditor makes judgments about the size of misstatements that will be considered material. These judgments provide a basis for determining the nature, timing, and extent of risk assessment procedures, identifying and assessing the risks of material misstatement, and determining the nature, timing, and extent of further audit procedures.
SA 320 also provides a definition of performance materiality, which means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.
Determining Materiality and Performance Materiality when Planning the Audit
The process of determining materiality and performance materiality during the planning phase of an audit. Materiality refers to the amount or level of misstatement that would influence the decisions of users of financial statements. It involves exercising professional judgment to identify an appropriate benchmark that will serve as a starting point in determining materiality. The choice of benchmark depends on various factors such as the elements of financial statements, the nature of the entity, its ownership structure, and the industry and economic environment in which it operates.
The auditing standards provides examples of appropriate benchmarks, such as profit before tax, total revenue, gross profit, total expenses, total equity, or net asset value. The auditor must also consider relevant financial data, including prior periods’ financial results and financial positions, period-to-date financial results and financial position, and budgets or forecasts for the current period.
The materiality relates to the financial statements on which the auditor is reporting, and when the financial statements are prepared for a period of more or less than twelve months, materiality relates to the financial statements prepared for that period.
SA 320 also highlights considerations specific to small entities, such as the use of alternative benchmarks when profit before tax is nominal, and the influence of legislative and regulatory requirements on the determination of materiality for certain entities, such as governments and related entities. In an audit of entities doing public utility programs/projects, total cost or net cost may be appropriate benchmarks, and where an entity has custody of assets, assets may be an appropriate benchmark.
SA 320 provides guidance on the factors to consider when determining materiality and performance materiality for financial statements during the planning phase of an audit, emphasizing the importance of exercising professional judgment and considering the specific circumstances of the entity being audited.
Materiality Levels for Particular Classes of Transactions, Account Balances or Disclosures
The concept of materiality levels in auditing. Materiality refers to the amount of an error or misstatement in an organization’s financial statements that would be considered significant enough to potentially influence the economic decisions of users of those statements.
That may be certain classes of transactions, account balances, or disclosures where misstatements of lesser amounts than the overall materiality level for the financial statements as a whole could still significantly impact users’ economic decisions. The SA 320 provides examples of factors that could indicate the existence of such classes, such as legal and regulatory requirements or industry-specific disclosures.
SA 320 also notes that the auditor should determine a “performance materiality” level, which is used to assess the risk of material misstatement and determine the nature, timing, and extent of further audit procedures.
Finally, that the auditor may find it useful to understand the views and expectations of those charged with governance and management when assessing whether certain classes of transactions, account balances, or disclosures exist where misstatements of lesser amounts could still be significant.
Performance Materiality
The concept of performance materiality in the context of an audit. Performance materiality is a level of materiality that is set by the auditor at a lower level than materiality for the financial statements as a whole. The purpose of setting performance materiality is to reduce the risk that the aggregate of uncorrected and undetected misstatements in the financial statements exceeds materiality for the financial statements as a whole.
Similarly, the auditor may set a performance materiality level for a particular class of transactions, account balance, or disclosure to reduce the risk that the aggregate of uncorrected and undetected misstatements in that particular class exceeds the materiality level for that class. The determination of performance materiality requires professional judgment and is influenced by the auditor’s understanding of the entity, updated during the risk assessment procedures, and the nature and extent of misstatements identified in previous audits.
The SA 320 also emphasizes that planning the audit solely to detect individually material misstatements overlooks the fact that the aggregate of individually immaterial misstatements may cause the financial statements to be materially misstated. Therefore, the determination of performance materiality is crucial for reducing the risk of undetected material misstatements in the financial statements.
Revision as the Audit Progresses
The importance of revising materiality during the audit process. Materiality is the amount or amounts used to determine the significance of an audit finding. The auditor is required to revise materiality for the financial statements as a whole if they become aware of information during the audit that would have caused them to determine a different amount initially.
The auditor may also need to revise materiality as a result of changes in circumstances that occurred during the audit, such as a decision to dispose of a major part of the entity’s business, or new information that has come to light. For example, if actual financial results are likely to be substantially different from the anticipated period-end financial results used initially to determine materiality for the financial statements as a whole, the auditor should revise that materiality
If the auditor concludes that a lower materiality for the financial statements as a whole than initially determined is appropriate, they should determine whether it is necessary to revise performance materiality, which is the amount set to reduce the risk of the aggregate of uncorrected and undetected
misstatements in the financial statements exceeding materiality for the financial statements as a whole. The auditor should also assess whether the nature, timing, and extent of the further audit procedures remain appropriate in light of the revised materiality. This requires professional judgment and may be affected by the auditor’s understanding of the entity and its operations, as well as any misstatements identified in previous audits.
Documentation
The audit documentation is a record of the audit work performed, the conclusions reached, and the evidence obtained during the audit. This documentation provides evidence to support the auditor’s opinion and is the basis for the auditor’s report. The text highlights that the audit documentation must include certain amounts and factors related to materiality.
Firstly, the documentation must include materiality for the financial statements as a whole. This includes the materiality level determined by the auditor for the financial statements as a whole based on the auditor’s professional judgment. Materiality is the magnitude of an omission or misstatement of financial information that would change the economic decisions of the users of the financial statements.
Secondly, if applicable, the documentation must include the materiality level or levels for particular classes of transactions, account balances or disclosures. The auditor may determine materiality levels for certain specific classes of transactions or account balances based on their relevance to users’ decisions, regulatory requirements, or other factors.
Thirdly, the documentation must include performance materiality. Performance materiality is an amount set by the auditor to reduce the risk of undetected misstatements to an appropriately low level. It is usually lower than materiality for the financial statements as a whole and may be set for individual account balances or transactions.
Finally, the documentation must include any revisions made to materiality levels as the audit progressed. This includes any adjustments made to materiality levels based on new information or changes in circumstances that arose during the audit. The documentation must also include the factors considered by the auditor in making these revisions.
Overall, the documentation of materiality-related amounts and factors is important for ensuring that the audit work performed is properly documented, and the evidence obtained is sufficient to support the auditor’s opinion.
Materiality in Planning and Performing an Audit”
The “Materiality in Planning and Performing an Audit,” specifically regarding the treatment of materiality in audits of public sector entities. The previous version of the document included specific references to the unique considerations of auditing public sector entities, such as the influence of legislative and regulatory requirements and the financial information needs of legislators and the public. However, in the revised version, these specific references have been deleted, and the standard has been made to apply equally to all entities, regardless of their form, nature, and size.
The revised version does retain some references to the potential use of different benchmarks for determining materiality in audits of public sector entities, such as total cost or net cost, and the possibility that assets may be an appropriate benchmark for entities with custody of assets. These references are retained to acknowledge the potential for unique circumstances in audits of public sector entities, which may require the use of different materiality benchmarks
Quiz: Materiality in Planning and Performing an Audit
1. What is the definition of materiality in the context of an audit of financial statements?
a) The level of misstatement that influences economic decisions of users of financial statements.
b) The accuracy of financial statements as determined by the auditor.
c) The level of financial risk associated with an entity.
d) The threshold for detecting fraud in financial statements.
Answer: a)
2. The concept of materiality is only applied during the planning phase of an audit.
Answer: False
3. Who is responsible for exercising professional judgment in determining materiality for an audit?
a) The entity being audited.
b) The auditors.
c) The financial reporting framework.
d) The regulatory authorities.
Answer: b)
4. What factors may influence the auditor’s determination of materiality?
a) Financial reporting framework.
b) Financial information needs of users.
c) Nature and size of the entity.
d) All of the above.
Answer: d)
5. Why is performance materiality set at a lower level than materiality for the financial statements as a whole?
a) To reduce the risk of undetected misstatements.
b) To meet regulatory requirements.
c) To align with the financial reporting framework.
d) To provide a margin of safety for the audited entity.
Answer: a)
6. Which of the following can be appropriate benchmarks for determining materiality?
a) Profit before tax.
b) Total revenue.
c) Total equity.
d) All of the above.
Answer: d)
7. Materiality levels for particular classes of transactions, account balances, or disclosures are always the same as materiality for the financial statements as a whole.
Answer: False
8. What is the purpose of setting performance materiality?
a) To determine the financial risk associated with an entity.
b) To assess the risk of material misstatement.
c) To evaluate the effectiveness of internal controls.
d) To determine the materiality of individual transactions.
Answer: b)
9. When should materiality be revised during the audit process?
a) At the beginning of the audit.
b) During the planning phase.
c) When new information or changes in circumstances arise.
d) At the end of the audit.
Answer: c)
10. What must be included in the audit documentation regarding materiality?
a) Materiality for the financial statements as a whole.
b) Materiality for particular classes of transactions, account balances, or disclosures.
c) Performance materiality.
d) All of the above.
Answer: d)
Additional question:
11. What is the purpose of determining materiality during the planning phase of an audit?
a) To assess the entity’s financial health.
b) To identify areas of risk in the financial statements.
c) To set a benchmark for evaluating the significance of misstatements.
d) To calculate the audit fees for the engagement.
Answer: c)
12. Materiality levels are fixed and do not change throughout the audit process.
Answer: False
13. What factors should auditors consider when revising materiality during the audit?
a) Changes in the entity’s financial performance.
b) New information or circumstances that affect the financial statements.
c) Regulatory changes impacting the industry.
d) All of the above.
Answer: d)
14. Why is performance materiality set at a lower level than materiality for the financial statements as a whole?
a) To provide a safety net in case of material misstatements.
b) To allow for minor errors in immaterial account balances.
c) To align with the auditors’ professional judgment.
d) To meet the expectations of regulatory authorities.
Answer: b)
15. What is the role of audit documentation in relation to materiality?
a) To record the auditor’s determination of materiality.
b) To provide evidence of the auditor’s compliance with materiality requirements.
c) To justify the selection of specific benchmarks for materiality.
d) All of the above.
Answer:d)
16. What is the relationship between materiality and audit risk?
a) Materiality determines the level of audit risk.
b) Audit risk determines the level of materiality.
c) Materiality and audit risk are unrelated concepts.
d) Materiality and audit risk are considered together throughout the audit.
Answer: d)
17. Materiality is solely determined by the auditor’s professional judgment.
Answer: False
18. When determining materiality, what factors should auditors consider regarding the financial information needs of users?
a) Users’ ability to make informed economic decisions based on the financial statements.
b) Users’ understanding of the uncertainties and judgments involved in financial reporting.
c) Users’ knowledge of the entity’s industry and economic activities.
d) All of the above.
Answer: d)
19. Why is it important for auditors to document their determination of materiality?
a) To provide evidence of compliance with auditing standards.
b) To facilitate peer review of the audit work performed.
c) To support the auditor’s professional judgment in case of scrutiny.
d) All of the above.
Answer: d)
20. How does performance materiality differ from materiality for the financial statements as a whole?
a) Performance materiality is set at a higher level than materiality for the financial statements.
b) Performance materiality is used to assess the risk of material misstatement.
c) Performance materiality is determined by the regulatory authorities.
d) Performance materiality is specific to individual account balances.
Answer: b)
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