What is materiality?

University Degree Business and Administrative studies

Materiality refers to quantitative and qualitative omissions or misstatements that make it probable the judgement of a reasonable person would have been changed or influenced.

These omissions or misstatements can be individually or in the aggregate material.

Accountants and auditors are concerned about this. Remember what will be in your reports:

Review report: "Based on my review, I am not aware of any material modifications that should be made...."
Audit report: "In my opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ....."

Materiality needs to be considered at two times, in

planning the audit and designing audit procedures.
evaluating whether financial statements taken as a whole are presented fairly, in all material respects, is accordance with GAAP.

Materiality and Planning the Audit

Financial Statement Level - The planning starts here!

Begin by making a preliminary estimate about materiality levels for balance sheet and income statement. See pages 226 - 227 for some rules of thumb.
Select the smallest estimate for purposes of developing your audit plan. If

$100,000 would materially misstate income, and
$200,000 would materially misstate total assets

Your audit plan should be designed to detect omissions or misstatements, that individually or in the aggregate, equal $100,000.

Account Balance Level - Allocate materiality to each account.

Remember that financial statement audits are done on an account by account basis. Therefore, you need to estimate how much error you can tolerate in each account before you conclude that the account is materially misstated.

Two ways to allocate materiality. See page 229.

In proportion to the account's balance. This is the more mechanical approach.
In proportion to how difficult it is to audit the account. This is a more judgemental approach.

Materiality and Evaluation of Audit Findings

The auditor aggregates errors the client has not corrected. These include

known misstatements - errors that you actually found.
likely misstatements - errors that a sampling program indicates have a high probability of exisiting.

The auditor determines if these errors materially misstate any

account balance,
financial statement subtotal, or
financial statement total.

Audit Risk

Audit risk is the risk that an auditor will fail to modify his or her opinion when the financial statements contain a material misstatement.

For each line in the financial statements, auditors want audit risk to be low for each assertion.

How to get low audit risk.

Auditor's must evaluate the three components of audit risk. The combination of these three components determines whether or not there is low audit risk.

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The auditor determines if these errors materially misstate any

account balance,
financial statement subtotal, or
financial statement total.

Audit Risk

Audit risk is the risk that an auditor will fail to modify his or her opinion when the financial statements contain a material misstatement.

For each line in the financial statements, auditors want audit risk to be low for each assertion.

How to get low audit risk.

Auditor's must evaluate the three components of audit risk. The combination of these three components determines whether or not there is low audit risk.

Inherent risk - How susceptiable is an assertion to a material misstatement, assuming no controls?

High inherent risk if account is prone to misstatement.
Low inherent risk if account is not likely to contain a misstatement.
Inherent risk is based on factors

peculiar to a specific assertion. EG, Accounts receivable must be shown a realizable value. This is an accounting estimate. Valuation is very difficult for A/R.
that affect many accounts. EG, the company is having financial problems. They may try to overstate sales (occurrence) and understate expenses (completeness).

Control Risk - How likely is it that a material misstatement will not be detected and corrected by controls relevant to an assertion?

High Control Risk if

Controls for a particular assertion are not operating effectively, or
The auditors decides that it would not be efficient to test the controls.

Low Control Risk if tests of controls show the controls to be effective.

Detection Risk - How likely is it that the auditor will not detect a material misstatement in an assertion?

High detection risk - It is very likely that the auditor will fail to detect a material error. In other words, the auditor reduces substantive testing.
Low detection risk - There is very little chance that the auditor will fail to detect a material error. In other words, you do extensive substantive testing.

AR = IR * CR * DR

The auditor knows that audit risk must be low for each assertion.
Next, the auditor evaluates the assertion's inherent risk.

Hi if prone to misstatement.
Lo if not prone.

Third, the auditor evaluates control risk.

Hi if controls are poor or you decide not to test controls.
Lo if your testing indicates that controls are OK.

Finally, the auditor sets detection risk.

Hi when assertion not likely to be materially misstated or controls are good. This means reduced substantive testing.
Lo when assertion is likely to be misstated and you are not relying on controls. This means extensive substantive testing.

Since detection risk is the last item to be figured out, the audit risk equation can be re-written as:

DR = AR .

IR * CR

All substantive testing approach. - Auditor tests the assertion on or after the balance sheet date. Generally, IR and CR are Hi, while DR is low. For example,

Cash can be tested with 100% substantive testing by confirming the balance with the bank and reviewing the year-end bank reconciliation.
Depreciation expense can be tested with 100% substantive testing by recomputing depreciation for each asset.
Dividends paid can be tested with 100% substantive testing by multiplying dividend amount per share * times number of shares outstanding.

Rely on controls and reduce substantive testing approach. Generally, IR and CR are lo to moderate, and DR is moderate to hi. For example,

Confirm accounts receivable 2 months before balance sheet. Rely on controls over processing of accounts receivable to reduce risk that error will not occur during the final two months of the year. Rely on analytical procedures to detect unusual situations that might arise.
Confirm accounts receivable as of balance sheet date. However, auditor sends out fewer confirmations because internal controls over accounts receivable are good.

IR, inherent risk, is the risk that a material misstatement may occur in the client's unaudited financial statements, in the absence of internal control procedures.

CR, control risk, is the risk that a material misstatement in the client's unaudited financial statements will not be detected and corrected by the client's internal control procedures.

DR, detection risk, is the risk that a material misstatement in the client's unaudited financial statements will not be detected by the auditor.

Audit opinion

The audit opinion is that part of the auditor's report to the members of an entity in which the auditor expresses an opinion on the extent to which the financial statements are materially misstated. The fact that it is an opinion, and not a certification, is meant to indicate to financial statement users that the auditor is providing reasonable assurance, and not complete assurance, as to whether or not the financial statements are materially misstated.

Where the risk of material misstatement in the audited financial statements is considered acceptable, the auditor issues an unqualified, or "clean", audit opinion on the financial statements; where the risk is not acceptable, the auditor issues either, or a combination of, an exception opinion and/or an adverse opinion. Alternatively, if the auditor is unable to gather evidence of sufficient quantity or appropriate quality to form an opinion on the financial statements, the auditor may express his/her inability to form an opinion.

The Assertion of Accuracy

Accuracy is a and one of the three categories of . The assertion of accuracy may relate to:

financial statement item. A financial statement item is accurate when all account balances included in the financial statement item are accurate as to both (i) value and (ii) presentation and disclosure.

account balances . An account balance is accurate when all assets, liabilities, equities, revenues and expenses included in the account balance are accurate as to both (i) value and (ii) classification.

classes of transactions . A class of transaction is accurate when all economic event included in the class are accurate as to both (i) value and (ii) description.

On the other hand, a misstatement of accuracy occurs where the assertion of accuracy is not true. For example, when an account balance included in a financial statement item is not accurate as to either value or presentation and disclosure, the account balance, as well as the financial statement item and the financial statements as a whole, are misstated.

The Assertion of Completeness

Completeness is a and one of the three categories of . The assertion of completeness may relate to:

financial statement items . A financial statement item is complete when all valid account balances are included in the financial statement item.
account balances . An account balances is complete when all valid assets, liabilities, equities, revenues and expenses are included in the account balance.
classes of transactions . A class of transaction is complete when all valid economic events are included in the class of transaction.

On the other hand, a misstatement of completeness occurs where the assertion of completeness is not true. For example, when all valid account balances are not included in a financial statement item, the financial statement item is, and the related financial statements are, misstated.

The Assertion of Validity

Validity is a and one of the three categories of . The assertion of validity may relate to:

financial statement item. A financial statement item is valid when all account balances included in the financial statement item both (i) do exist and (ii) do pertain to the entity, as at balance date.
account balances . A balance sheet account balance is valid when all assets, liabilities and equities included in the account balance both (i) do exist and (ii) are owned/owed (or controlled) by the entity, as at balance date.

An income statement account balance is valid when all revenues and expenses included in the account balance both (i) have occurred and (ii) do pertain to the entity, during the relevant accounting period.

classes of transactions . A class of transaction is valid when all economic events included in the class both (i) have occurred and (ii) do pertain to the entity, during the relevant accounting period.

A misstatement of validity occurs where the assertion of validity is not true. For example, when an account balance included in the financial statements does not either exist or pertain to the entity, the account balance is, and the related financial statements are, misstated.