ISA 240.26 - risk of revenue recognition

Materiality in a financial statement audit

Introduction

After reading this article, one should be able to: 1. define the concept of materiality used in auditing, and 2. state how the auditor arrives at judgements about materiality at the financial statement level and in relation to individual account balances 3. describe the relationship between materiality and audit evidence and 4. Document audit materiality

Materiality underlies the application of International Standards on Auditing. Materiality thus has a pervasive effect in a financial statement audit. In conducting an audit, the auditor should consider materiality in planning the audit and in evaluating the fair presentation of the financial statements in accordance with an identified financial reporting framework.

The determination of materiality is a matter of professional judgment. In determining the materiality of an item, the auditor considers not only the item’s nature and amount relative to the financial statements, but also the needs of financial statement users.

Materiality has to be considered before a detailed audit program can be prepared. In the initial planning, however, an auditor cannot anticipate all of the factors that will ultimately influence the materiality judgment in the evaluation of audit results at the completion of the audit. Therefore, these factors must be considered as they arise, and materiality must be evaluated throughout the audit.

Materiality has significant implications for audit efficiency. To be efficient, an auditor should not spend time examining balances where there is no chance of a material error. Sometimes, in an audit of a small entity, there is a temptation to audit everything because it does not seem as though it will take much time when individual items are considered. The unnecessary time can, however, add up to a significant amount overall.

The concept of materiality

Material information means information that matters, is important or essential. In terms of accounting, it pertains to information that is to be recognised, measured or disclosed in accordance with the requirements of an Accounting Standard. In measuring or disclosing accounting information, emphasis is on the needs of known or perceived users. In auditing materiality pertains to the largest number (threshold) of uncorrected errors, misstatements, or erroneous disclosures or omissions that exist in the financial statements and yet are not misleading. The auditor plans and executes an audit with a reasonable expectation of detecting material misstatements. The assessment of what is material is a matter of the auditor's professional judgement of the needs of the reasonable person relying on the information.

Preliminary judgements about materiality

The auditor makes preliminary judgements about materiality levels in planning the audit. This assessment, often referred to as planning materiality, may ultimately differ from the materiality levels used at the conclusion of the audit in evaluating the audit findings, because the surrounding circumstances may change and additional information about the entity will have been obtained during the course of the audit. For example, the client may have obtained the financing needed to continue as a going concern, which was in doubt when the audit was planned, and the audit may affirm that the company's short-term solvency has significantly improved during the year. In such cases, the materiality level used in evaluating the audit findings might be higher than planning materiality.

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

1.       The financial statement level, because the auditor's opinion on fairness extends to the financial statements taken as a whole, and

2.       The account balances and class of transactions level, because the auditor verifies account balances in reaching an overall conclusion on the fairness of the financial statements.

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. 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.

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

In audit planning, the auditor should recognise that there may be more than one level of materiality relating to the financial statement. Each statement, in fact, 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.

In making a preliminary judgement about materiality, the auditor initially determines the aggregate level of materiality for each financial statement balance. For example, it may be estimated that errors totaling R100 000 for the income statement and R200 000 for the statement of financial position would be material.

It would be inappropriate in this case for the auditor to use statement of financial position materiality in planning the audit because if statement of financial position misstatements amounting to R200 000 also affect the income statement, the income statement would be materially misstated. For planning purposes, the auditor should use the smallest aggregate level of misstatement considered to be material to any one of the financial statements. This decision rule is appropriate because the financial statements are interrelated and many audit procedures pertain to more than one statement. For instance, the audit procedure to determine whether year-end credit sales are recorded in the proper period provides evidence about both accounts receivable (statement of financial position) and sales (income statement).

Quantitative guidelines

In assessing the quantitative importance of a misstatement, it is necessary to relate the rand amount of the error to the financial statement under examination. In planning the examination, the auditor generally is concerned only with misstatements that are quantitatively material. In evaluating audit evidence, the auditor considers both quantitative and qualitative misstatements.

There is no universally agreed upon guideline on quantitative measures of materiality. In the absence of evidence, or convincing argument to the contrary, Discussion Paper 6 – Audit Risk and Materiality (Issued July 1984) is an acceptable source to establish on quantitative measures of materiality.

To illustrate the use of quantitative measures of materiality the following logic must be applied:

1.       An amount which is equal to or greater than 10 per cent of an appropriate base amount is presumed to be material.

2.       An amount which is equal to or less than 5 per cent of an appropriate base amount may be presumed not to be material.

3.       To determine whether an amount between 5 per cent and 10 per cent is material is a matter of judgement.

Materiality judgements relating to profit and loss should ordinarily exclude the effect of unusual items or abnormal fluctuations, exceptional events or transactions and discontinued operations. Therefore, in relation to profit and loss, an amount as referred to above should be an amount after allowing for any income tax effect where the base amount has been determined after allowing for any income tax effect.

In determining whether an amount or aggregate of an item is material, the item should be compared with the more appropriate of the base amounts described below (Source DP 6 P106):

Based Used	Possible Range
Gross revenue	½ - 1%
Total assets	1 – 2%
Gross profit	1 – 2%
Shareholder’s equity	2 – 5%
Net profit	5 – 10%

In practice, auditors may develop their own guidelines. Sometimes auditors use the blended method. This method blends the five thresholds listed above with equal weights, and computes an average of the sum.

Qualitative considerations

The emphasis in planning materiality is on quantitative considerations. Since the errors are not yet known, their qualitative effect can be considered only during the testing phase of the audit as evidence becomes available. Qualitative considerations relate to the causes of misstatements. A misstatement that is quantitatively immaterial may be qualitatively material. This may occur, for instance, when the misstatement is attributable to an irregularity or an illegal act by the client. Discovery of either occurrence might cause the auditor to conclude there is a significant risk of additional similar misstatements. Other examples of qualitative misstatements are:

An inadequate or improper description of an accounting policy when it is likely that the users of the financial information are misled by the description.

A change in accounting method which is likely to affect materially the results of subsequent financial years.

A related party transaction or event requiring disclosure.

A probability of a breach of a financial covenant; for example, a loan agreement may require the entity to maintain a specified minimum current ratio as at the statement of financial position date. The company may be tempted to overstate current assets or understate current liabilities. This might persuade the auditors to use a lower materiality threshold for current assets and current liabilities.

Although it is suggested that the auditor should be alert for misstatements that could be qualitatively material, it ordinarily is not practical to design procedures to detect them.

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 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 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 realised that accounts with seemingly immaterial balances may contain understatements that exceed materiality.

In making judgements 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.

Allocating financial report materiality to accounts

When the auditor's preliminary judgements about financial report materiality are quantified, a preliminary estimate of materiality for each account may be obtained by allocating financial report materiality to the individual accounts. The allocation may be made to both the statement of financial position and income statement accounts. However, because most income statement misstatements also affect the statement of financial position and because there are fewer statement of financial position accounts, many auditors make the allocation on the basis of the statement of financial position accounts.

In making the allocation, the auditor should consider the likelihood of misstatements in the account and the probable cost of verifying the account. For example, misstatements are more likely to exist in inventories than in plant assets and it is usually more costly to audit inventories than plant assets.

To illustrate the allocation, assume that the total assets of Nkonki Company consist of the following:

Account Balance	Rand	%age Balance
Cash	500,000	5
Accounts receivable	1,500,000	15
Inventories	3,000,000	30
Plant assets	5,000,000	50
Total	10,000,000	100

The auditor anticipates few misstatements in cash and plant assets and some misstatements in accounts receivable and inventories. Based on prior experience with the client, the auditor expects the accounts with few misstatements will be significantly less costly to audit than the other accounts. Assuming the preliminary estimate of financial report materiality is 1 per cent of total assets, or R100,000, consider the following alternative allocation plans:

Materiality Allocation:

Account	Plan A	Percent	Plan B	Percent
Cash	5,000	5	2,000	2
Accounts receivable	15,000	15	18,000	18
Inventories	30,000	30	50,000	50
Plant assets	50,000	50	30,000	30
Total	100,000	100	100,000	100

In Plan A, materiality has been allocated proportionately to each account without regard to expected monetary misstatements or audit costs. It is based on the subjective judgement of the auditor as to the inherent risk relative to size, and the probability of misstatements. It is a conservative approach and is inefficient in terms of audit effort. In Plan B, larger materiality allocations are made to accounts receivable and inventories, for which more misstatements are expected and the costs of detection are higher. Thus, the amount of evidence needed on these accounts is reduced compared with that for Plan A because of the inverse relationship between account balance materiality and evidence. In effect, the auditor is simply allowing for a greater proportion of the total allowable misstatements to remain in those accounts where it would be most expensive to detect the misstatements. Although the smaller materiality allocations for cash and plant assets increase the amount of evidence needed for those accounts, the fact that they are less costly to audit should result in an overall savings.

The allocation of the preliminary estimate of materiality may be revised as the audit progresses. For example, under Plan B, if, after auditing accounts receivable, the maximum misstatement in that account is estimated to be R8,000, the R10,000 unused portion of materiality for this account can be reallocated to inventories. Although the foregoing example suggests a certain degree of precision in allocating overall materiality to accounts, in the final analysis the process is heavily dependent on the subjective judgement of the auditor.

Relationship between materiality and audit evidence

Materiality is one of the factors that affects the auditor's judgement about the sufficiency of audit evidence. In making generalisations 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 misstatement in the recorded inventory balance does not exceed R100,000 than it does to be assured the misstatement does not exceed R200,000. 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 per cent of total assets than when it represents 10 per cent.

Documentation

The normal practice is that all misstatements of possible significance encountered during an audit are documented in the file. Some of them are adjusted by the client. Others are not. Most auditors accumulate the unadjusted misstatements discovered during the course of the audit in the schedule of unadjusted errors, or what some auditors refer to as the “over and under” schedule. The schedule can then be used to make decisions as to whether the cumulative effects of the unadjusted misstatements are material. Some auditors of small entities prefer to see that all identified errors are adjusted, which means they have no need for such a schedule.