Audit Materiality

Information is material if it is likely to influence financial statements users’ decisions. The major reason for thinking about materiality is to try to fine tune the audit for effectiveness and efficiency.

The auditors’ materiality decision is a multi-factor decision involving both quantitative and qualitative aspects. Calculated materiality amounts derived using quantitative approaches may be increased or decreased based on the auditors’ professional judgment about the possible effect of qualitative factors such as:

 Risk of earnings manipulation, for example, management motivation to “manage” or “smooth” earnings

 Possible effect on misstatements on trends, such as profitability trend

 Presence of restrictive debt covenants

 Magnifying effect of misstatement on share price for company with high price/earnings multiple

 Accuracy and reliability of accounting system

 Imminent acquisition/merger/sale

 Threat of litigation or other external review of the auditors’ work such as monitoring by government agency or entity

 Imminent public stock offering

 The risk that there may be undetected misstatements

 Detection of fraud or fraud indicators in prior period

Planning materiality is concerned with whether a misstatement, or an aggregation of misstatements, in an underlying financial statement item, account balance or class of transaction, is likely to result in a material misstatement in the financial statements as a whole. Auditors use planning materiality to determine which financial statement items, account balances and transactions to test and which to not test.

Materiality at Financial Statement Level

A misstatement of a financial statement item is material when the misstatement, aggregated with misstatements of other financial statement items, is likely to equal or exceed the level of reporting materiality.

Materiality at Account Balances & Class of Transactions Level

A misstatement of an account balance underlying a financial statement item is material when the misstatement, aggregated with misstatements in other account balances underlying the financial statement item, is likely to result in a material misstatement of the financial statement item.

A misstatement of a transaction underlying an account balance is material when the misstatement, aggregated with misstatements in other transactions underlying the account balance, is likely to result in the material misstatement of the account balance.

Performance Materiality

To plan the audit of various accounts, auditors need to assign part of the planning materiality to each account or class of transactions. If planning materiality is Rs. 1 million and procedures for each account or class of transactions are designed to allow a Rs. 1 million misstatement to go undetected, the total misstatement could obviously be more than acceptable. Therefore, auditors use performance materiality (an amount less than materiality for the financial statements as a whole) to make sure that the aggregate of uncorrected and undetected immaterial misstatements does not exceed materiality for the financial statements as a whole. For example, auditors may use different amounts (smaller than overall financial statement materiality) when auditing particular classes of transactions, account balances, or disclosures. The audit team cannot look at every transaction, so the concept of performance materiality takes this risk into account. When auditors use sampling, performance materiality is referred to as tolerable misstatement.

Computing Materiality

A number of quantitative approaches may be used by the auditor depending on his professional judgment; however, two common methods employed are discussed here: Single Rule Approach

This approach is based on “rule of thumb” and use a single financial variable for computing materiality. Typically, as a matter of policy, an audit firm would provide three or four such rules and allow the auditor in an individual audit to choose the most appropriate rule. Depending on his/her assessment of qualitative factors, an auditor would select the single rule that was judged to be the most appropriate way to compute materiality for a specific client. Examples of possible common single rules are:

 5% of pre-tax income  1/2 % of total assets  1% of equity

 ½% of total revenues

Where an entity's results are expected to be "normal", materiality is based on pre-tax income amounts. However, where the entity incurs losses, has potential going concern problems or the results are in other ways unusual, materiality may be based on one or more of the other factors referred to above. For example, if the entity is incurring losses, both before and after tax, the auditor may use total assets or total revenue, whichever is the greater. The final assessment of reporting materiality is subjective and depends on the auditor's perception of, for example, what information is relevant, who the users of the financial statements are, what decisions the users may make and what would influence those decisions.

Blend or Average Method

This method typically takes four or five individual rules of thumb and then either weight each rule according to some proportion or average them (an equal weighing). Presumably, the blending or averaging process provides an indirect way of considering

qualitative factors. An example of the averaging method would be to take the previously listed four single rules and average them (give each of them a 25% weight).

Hypothetical Case Illustration

In order to illustrate the previous materiality methods, let us assume the following summary financial statements for ABC Company:

Balance Sheet Assets Rs. 30,000,000 Liabilities Rs. 20,000,000 Owners' Equity Rs. 10,000,000 Rs. 30,000,000 Income Statement Total Revenues Rs. 90,000,000 Cost of Merchandise Rs. 50,000,000 Gross Profit Rs. 40 000,000

Selling & Other Expenses Rs. 32,000,000

Net Income Before Tax Rs. 8,000,000

Income Tax Rs. 3,000,000

Net Income After Tax Rs. 5,000,000

The single rule method would involve the auditor selecting one of the four following materiality amounts:

Single Rule Computation Materiality Amount

5% of pre-tax income 5% x Rs. 8,000,000 Rs. 400,000

½% of total assets 1/2% x Rs 30,000,000 Rs. 150,000

1% of equity 1 % x Rs. 10,000,000 Rs. 100,000

1/2% of total revenues 1/2% x Rs. 90,000,000 Rs. 450,000

The average or blending method using the single rules previously given would involve the following computation:

Average Method

(5% of pre-tax income + 1/2% of total assets + 1 % of equity + 1/2% of total revenues) /4

Computation

(Rs.400,000 + Rs.150,000 +Rs.100,000 +Rs.450,000) /4 = Rs. 275,000.

Determining Performance Materiality

Performance materiality is generally based on overall planning materiality. The extent to which performance materiality is based on the overall materiality is a matter of

professional judgment. As discussed earlier, the auditor would use an amount/rate lower than that arrived at for the overall financial statement level for account balances, class of transactions and disclosures.

Furthermore, the rate of performance materiality may also differ in each of the above case depending upon their significance to the financial statements as a whole. Instead of a blanket rate a range of different rates may be arrived at keeping in view the qualitative aspects of each area.