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What is the concept of ‘Materiality’, and how is it applied in an Audit?


The word "materiality" basically means how important or significant something is in relation to the financial statements as a whole.


ISA 320 Materiality in Planning and Performing an Audit says [defines] the following about the term:


A matter is material if its omission or misstatement would reasonably influence the economic decisions of users taken on the basis of the financial statements.’


This definition basically says that whether something is "material" or not depends on how big the item is or how important the error or omission on the financial statements is.


The main objective of the external audit is for the auditor to express an opinion on whether or not the financial statements show a true and fair view of the business (or present fairly in all material respects).


This level of assurance is high but not absolute.


This is because the auditor can't test every single transaction or event that goes into a reporting entity's financial statements.


In addition to this limitation, there is also a degree of estimation in financial statements. Because of this, it is generally accepted in the business world that financial statements will never be 100% accurate in every way.


Example

A manufacturing company is in the business of manufacturing coffee powder.


At the end of the year, several containers with different ingredients go into making coffee powder.


These containers must be valued to be included in the reporting entity's closing inventory valuation.


All of these kinds of products will be called "work-in-progress," and work-in-progress will always contain a degree of estimation in relation to the actual cost of the product still in production at year-end, together with estimations of overhead absorption (both fixed and variable) such as factory heat and light and direct labour costs.


Most of the time, these valuations are done by management based on their "best estimates."

The example above showed how a reporting entity would use accounting estimates to create a balance for the financial statements (i.e. work-in-progress, which will be included within current assets).


In this case, the auditor will follow a certain standard for auditing:


ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures.


Types of Materiality

There are two types of materiality:

  • Financial Statement Materiality; and

  • Performance Materiality.

Financial statement materiality is calculated for the financial statements as a whole (see later), and this calculation is based on the auditor's experience and judgement.

Performance materiality is the amount or amounts set by the auditor that are less than materiality for the financial statements as a whole.


This is done to make it less likely that the total number of uncorrected and undetected mistakes will add up to more than what is considered "material" for the financial statements.


Thus, performance materiality reduces the probability that the aggregate amount of uncorrected and undetected misstatements exceeds the materiality level for the financial statements.


The level of performance materiality selected is a matter of professional judgment and is impacted by the auditor’s understanding of the client, including the types and amounts of misstatements found during previous audits of the client; these matters impact the auditor’s expectations regarding misstatements that might be present in the current period. The performance materiality level can be set at different levels for different accounts.


Example

An audit senior has determined that the materiality of financial statements for the audit of ABC Corporation is RM65,000.


Here are some excerpts from the financial statements of ABC Corporation:

  • Turnover - RM7.5 million

  • Trade and other receivables - RM2.6 million

  • Cash at the bank - RM0.75 million

  • Trade payables - RM1.4 million

Now think about what would happen if the financial statement materiality of RM65,000 was used for all of the above areas.


There will be several balances or parts of balances that the auditor does not test because they are less than the RM65,000 "materiality level" for financial statements.


Suppose the auditor only looked at what was important in the financial statements. In that case, the untested items could have misstatements that could add up to material [big] misstatements when added to other misstatements. This is where the idea of how important performance materiality is comes into play.

So, performance materiality is a lower level of materiality than that set for the financial statements as a whole.


This lower level of materiality is used during sampling to reduce the risk of small errors [immaterial misstatements] becoming big ones [material] when they are added up.


ISA 320 adds to the definition of performance materiality by saying that 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.’


There are no formulas in ISA 320 that say how performance materiality should be calculated. Instead, the auditor uses his or her own judgement, taking the following things into account:

  • The nature and extent of misstatements that were identified in prior year audits;

  • The auditor's understanding of the entity and the environment in which it operates; and

  • The result of the auditor's risk assessment procedures.

Calculation of financial statement materiality

Again, it's up to the auditor's professional judgement to come up with a materiality level for the financial statements as a whole.

But over the years, it has become common to put percentages on certain parts of the financial statements and use those numbers to figure out the materiality level of the financial statements.


For example:

  • ½ to 1% of turnover

  • 1 to 2% of gross assets (non-current + current assets (also known as the statement of financial position/balance sheet total))

  • 5% of profit before tax

  • 2 to 5% of net assets

Whilst not as common in real-life practice, it is not unheard of for ½ to 1% of gross profit to be included in the above percentage calculations.


Most audit methods use the "averaging" method to determine financial statement materiality level.


This is where three elements of the financial statements will be used, percentages applied and then an average worked out to arrive at a financial statement materiality level.


Example

Here are some extracts from a client's financial statements from the planning stage:

  • Turnover - RM27.5 million

  • Profit before income tax - RM2.5 million

  • Non-current assets [NBV] - RM1.2 million

  • Current assets - RM4 million

Using the averaging method, financial statement materiality at the planning stage can be calculated as follows: