CPA P1 Auditing
TOPIC 16 MATERIALITY
ISA 320 Materiality in Planning and Performing an Audit provides guidance to auditors in this area and states the objective of the auditor is to apply the concept of materiality appropriately in planning and performing the audit.
Overview
An error/omission is material if its existence affects how users of the FS react
Hence, auditors will examine all material areas of the FS, and… …will examine areas which appear immaterial but could be materially understated!!!
Items are material both by SIZE and by NATURE Materiality must be considered both on an individual basis and on an aggregate basis MATERIAL BY SIZE (QUANTITATIVE) The audit team needs to know what size errors are important when they are doing their audit work. To achieve this, firms typically have a standard method for calculating a baseline materiality figure as part of the planning process. Common measures are:
½ - 1% of turnover
5 - 10% of profits
1 - 2% of total assets 1
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However, these are up to the judgment of the auditor. As a result, different firms use different measures. Any calculation done is very flexible, and may have to be reassessed during the audit (if for example many large errors are found).
Whilst this calculation is helpful, it has problems as several small immaterial errors could add up to an overall material error !!
Performance Materiality is the amount set by the auditor at less than materiality for the FS as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the FS as a whole
Example: student took an admission in an auditing course. Course contains 60 lectures in total. In order to qualify for exam entrance, students have to fulfil attendance criteria i.e. student can be absent from 10 lectures as a whole but not more than 1 lecture in a week. Now the above attendance policy has two levels of restrictions. First that students cannot leave more than 10 lectures unattended during the whole course. Whereas, the second level is that maximum of one lecture can be left unattended in a particular week. This second restriction is probably there to ensure that no student fall short of 50 lectures in total and must attend at least 50 lectures. In simple words this second layer, which is more stringent then the first, is ensuring that first level of restriction is not breached. Same goes in auditing. Performance materiality (materiality established for a particular component inside financial statement for example an assertion level) i.e. materiality established while performing audit procedures on certain account balances and/or transactions etc. is deliberately settled lower than the materiality level for the financial statements as a whole so that overall 2 © Cenit Online 2015
CPA P1 Auditing misstatements are kept under the materiality level for the financial statement as a whole (materiality level established for the whole financial statement for example financial statement level).
TOLERABLE MISSTATEMENT/RATE OF DEVIAITON
Tolerable Misstatement is a monetary amount set by the auditor and is the maximum misstatement that the auditors are willing to tolerate in an account balance or class of transactions and still conclude that the balance being audited is true and fair.
If the auditor is performing tests of control, then he is testing whether a control procedure has been followed, not that a balance is correct. Tolerable Error will therefore be the maximum number of control failures that the auditor is prepared to accept, whilst still believing that the control can be relied on overall. This is the tolerable rate of deviation.
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CPA P1 Auditing MATERIAL BY NATURE (QUALITATIVE)
All transactions with directors are likely to be material by nature
An item of a non recurring or exceptional nature or arising from unusual circumstances is likely to be of more significance than an item arising out of the ordinary activities of the business o A fine imposed by a regulatory authority (non recurring) o Bad Debts or inventory losses of an abnormally high amount
Statutory disclosure items: Certain items are required to be accounted for or disclosed in a certain manner, by Company Law. Any misstatement of these is material and as such 100% precision is required. o Directors remuneration and loans o Interest Payable/Receivable including maturity analysis of related liabilities o Share Capital/Share Premium o Auditors Remuneration o Depreciation in so far as amounts disclosed are concerned
Nature of the Account Balance: A misstatement in a transaction that affects only the Statement of Financial Position classification (e.g. cut-off of receipts from receivables) is less likely to be material than a misstatement that affects the determination of profits (e.g. Irrecoverable debts)
Critical Turning Points: An item which would otherwise be regarded as immaterial of insignificant might, if corrected or disclosed have a critical impact on the overall view.
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A minor adjustment that would turn a small profit into a small loss or vice versa
o If directors bonuses kick in at a certain level, and the company is close to this, any adjustments that change the profit level may be material, however small o Same is true if company has committed to maintaining certain ratios (e.g. as a loan covenant, they may have committed to a minimum current ratio) o Milestone Items which are otherwise immaterial – such as revenue or profit before tax going from say €998,662 to say €1,003,098 or say €9,897,000 to say €10,028,000. We can also apply the same thinking to Net Assets.
All transactions with directors are likely to be material by nature
Related Party Transactions (RPT’s): Per IAS 24 (Related Party Disclosures) , financial statements must disclose fully any material transactions undertaken with a related party by the reporting entity, regardless of any price charged. We must look at these from the point of view of both the company and the related party – the danger with RPT’s is the risk of transactions not being conducted at arms length and transactions may occur which are intended to obscure/hide financial problems. In addition RPT’s must be fully disclosed in the notes to the financial statements.
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CPA P1 Auditing QUESTION: MATERIALITY
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CPA P1 Auditing
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