Lect 14

Auditing: Auditing: Concept of MaterialityConcept of Materiality

The materiality concept is the principle that The materiality concept is the principle that trivial / insignificant matters are to be trivial / insignificant matters are to be disregarded in accounting, and all important disregarded in accounting, and all important matters are to be disclosed. Items that are matters are to be disclosed. Items that are large enough to matter are material items.large enough to matter are material items.

The materiality concept is an established, The materiality concept is an established, recognized accounting convention.recognized accounting convention.

Materiality Materiality

• Applying the materiality concept may call for more subjective judgment. Moreover, the subjective judgments of senior management, accountants, auditors, board of directors, stockholders, and potential business partners, can differ, especially when competing interests are involved.

Why materiality concept is Why materiality concept is important?important?

• Why is the materiality concept important and necessary in financial

accounting?

• Please follow that some of the reasons explained in the following slides shows

that materiality is necessary and inevitable in business case analysis, as well.


• What is Material? What is Not?

• The materiality concept addresses omissions and misstatements in accounting reports and in business case analysis. The central question is: Do They matter?


Some omissions are inevitable and desirable in both cases.

• An income statement, for instance, is meant to help stockholders, management, and boards of directors make judgments—judgments about investing, managing, and evaluating management performance.

components of Internal Controlcomponents of Internal Control

A statement with too much detail could

Obscure/unclear the "larger picture," could be

difficult to prepare, and difficult to read

and use.

• Similarly, a business case analysis is a tool for decision support and planning. Non material details are can be simply distracting and pointless.

components of Internal Controlcomponents of Internal Control

On the other hand, omission or misstatement of material items would work against the purpose in either case. In the US, the predominant approach to deciding what is material and what is not, is the view written in the GAAP (Generally Accepted Accounting principles) that items are material if they could individually or collectively influence the economic decisions of users, taken on the basis of financial statements.


This definition is consistent with a more formal statement from the board responsible for GAAP, the United States Financial Accounting Standards Board (FASB).


• Materiality refers to ... "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

Materiality :Materiality :

• Here the auditors responsibility is to determine whether the financial information / statements are materially misstated .

Materiality : Auditor What to doMateriality : Auditor What to do

• If the auditor determines that there is a material misstatement , he or she will bring it to the client’s attention so that correction could be made.

Materiality : Facts Materiality : Facts

• Facts– Accounting and auditing are business

functions relating to the proper recording and reporting of financial information. Accounting is the specific function of taking a company's financial information and presenting to internal and external users for business and investment decisions. Auditing is the process of reviewing the information prepared by company accountants and ensuring it is in accord with GAAP, the leading accounting authority in the United States.

Materiality : facts Materiality : facts

– According to GAAP, accountants are to use professional judgment when assessing material errors and how these errors might influence economic decisions made by users of the financial statements.

Materiality : Types Materiality : Types

• Types– While GAAP is silent on specifically

determining the materiality of financial errors or misstatements, a few common standards have developed in the accounting industry and public accounting practice.

• Types:– These professional judgments include errors

or misstatements equal to 5 percent of pre-tax net income or gross profit, 33 percent of total company assets, 50 percent of total revenues in an accounting period, 1 percent of total equity or a blend of consistent errors and misstatements in the company's financial statements.

Materiality : Effects Materiality : Effects

• Effects– Material errors or findings usually mean

companies must go back and correct any previous accounting or financial statements that may be affected. These corrections may have devastating effects on companies, particularly on public companies.

Materiality: Effects Materiality: Effects

• Effects

• Corrected financial statements for previous accounting periods may lead investors to sell the company's stock or investment analysts to negatively rate the company's stock. This leads the company to lose equity financing, limiting its ability to grow and expand in the marketplace.

Materiality: Prevention & Solution Materiality: Prevention & Solution

• Prevention/Solution

• Implementing proper accounting policies or internal controls can help companies avoid material misstatements in its financial statements. Employing educated or professionally licensed accountants can also help companies improve their overall accounting process.

Materiality : Prevention/Solution Materiality : Prevention/Solution

• Prevention / Solution

• Although these preventive measures can be time-consuming and expensive to develop and implement, they usually pay for themselves by limiting the number of errors or misstatements found during the audit process

Materiality: Expert Insight Materiality: Expert Insight

• Expert Insight– Using a public accounting firm to develop

accounting policies and internal controls helps companies understand current accounting practices. The accounting industry is well versed in technical accounting rules and the changing business environment.

Materiality: Expert InsightMateriality: Expert Insight

– Accounting professionals may also be able to advise companies on the highest risk areas of their operations and explain the importance of accounting policies or internal controls for these operations.

Materiality: In SummaryMateriality: In Summary

• Materiality is a concept or convention within auditing and accounting relating to the importance/significance of an amount, transaction, or discrepancy. The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in conformity with an identified financial reporting framework such as Generally Accepted Accounting Principles (GAAP). The assessment of what is material is a matter of professional judgment.

Materiality : Summary Materiality : Summary

• "Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful."

Materiality: Materiality: quantitative guidelinesquantitative guidelines

• The Financial Accounting Standards Board (FASB) has refrained from giving quantitative guidelines for determining materiality. This has resulted in confusion in the use of Auditing Standards No 47, "Audit Risk and Materiality in Conducting the Audit". Several common rules that have appeared in practice and academia to quantify materiality include:

Materiality: Quantitative Materiality: Quantitative guidelinesguidelines

• Percentage of pre-tax income or net income (i.e., 5% of average pre-tax income (using a 3-year average));

• Percentage of gross profit; • Percentage of total assets; (i.e.,1/3% of total

assets); • Percentage of total revenue; (1/2% of total

revenues); • Percentage of equity; (i.e.,1% of total equity);

Materiality: Quantitative Materiality: Quantitative guidelinesguidelines

• Blended methods involving some or all of these definitions (e.g., use a mix of the above and to find an average);

• "Sliding scale" methods which vary with the size of the entity. (i.e., 5% of gross profit if between $0 and $20,000; 2% if between $20,000 and $1,000,000; 1% if between $1,000,000 and $100,000,000; 1/2% if over $100,000,000)

Materiality:Materiality:

What Constitutes Abuse of the What Constitutes Abuse of the Materiality Concept?Materiality Concept?

• Abuses of the materiality concept are more likely to have serious legal consequences in accounting, than in business case analysis.

• For accountants, GAAP and FASB have resisted putting precise quantitative value on the size of misstatement or omission that qualifies as an error in materiality. Nevertheless, in reaching judgment on specific cases, auditors and courts have utilized several "rules of thumb."

Materiality : Abuse Materiality : Abuse

1. On an income statement, an omission or error greater than 5% of Profit (before tax), or greater than 0.5% of sales revenues is more likely to be considered "large enough to matter."

2. On a balance sheet, a questionable entry more than 0.3 to 0.5% of total assets or more than 1% of total equity, is more likely to be viewed suspiciously.


• The final judgment on a suspected materiality abuse, however, will also consider factors besides the magnitude of the error. Auditors and courts will also consider

• Please go to next page

Materiality : Abuse Materiality : Abuse

1. Motivation and intent behind the error

If the intent is to keep stock prices inappropriately high, inflate reported earnings, or inappropriately influence merger / acquisition decisions, for instance, an abuse judgment is more likely.

Materiality: Abuse Materiality: Abuse

• 2. The likely effect on user perceptions and judgment.

• An accounting statement with large indirect manufacturing labor& expenses misclassified as direct manufacturing labor might not be seen as materiality abuse, since both kinds of labor contribute to cost of goods sold and the gross profit / gross margin result is the same regardless of which category has the labor in question.

Materiality: AbuseMateriality: Abuse

Steps of applying MaterialitySteps of applying Materiality

• There are 5-steps in applying materiality

Step-1. Set preliminary judgment about materiality :

Step-2. Allocate preliminary judgment about materiality to segments

Steps of applying Materiality Steps of applying Materiality

• Step-3. Estimate total misstatement in segments

• Step-4. Estimate combined misstatement in segments

• Step-5. Compare combined estimate with preliminary or revised judgement about materiality


Step-1. Set preliminary judgment about materiality : Ideally an Auditor decides early in the audit the combined

amount of misstatement in the financial statements that would be considered material. SAS 47 defines the amount as the preliminary judgment about materiality. This judgment need not be quantified but often is. It is called preliminary judgment about materiality because it is a professional judgment and may change during the engagement if circumstance changes.


• The reason for setting a preliminary judgment about materiality is to help

the auditor plan the appropriate evidence to accumulate. If an Auditors sets a low dollar amount , more evidence is required than high amount. (Please follow the example of the text - Page 252)


Audit Risk Audit Risk

• Audit risk (also referred to as residual risk) refers to acceptable audit risk, i.e. it indicates the auditor's willingness to accept that the financial statements may be materially misstated after the audit is completed and an unqualified (clean) opinion was issued. If the auditor decides to lower audit risk, it means that he wants to be more certain that the financial statements are not materially misstated.

Audit RiskAudit Risk

• In Formula, Audit Risk can be explained • As follows:

• AR = CR*IR*DR• where... IR is inherent risk, CR is control

risk and DR , detection risk is the conditional probability that the auditor does not detect a material misstatement in the F/S, given that one exists.

Audit Risk ModelAudit Risk Model

• The audit risk model expresses the relationships among the audit risk components as follows:

• AR = IR x CR x DR

• To illustrate the use of the model , assume that an auditor has made the following risk assesment for a particular assertion , such as the completeness assertion for investors :

• go to next page

Audit Risk Audit Risk

• AR + 5% , IR = 75% , CR = 50%• Detection Risk ( DR) can be determined as follows:• AR .05• DR = ---------------------- = 13%• IR (.75) x CR (.50)

• A 13% detection Risk means the auditor needs to plan sustentative test in such a way that there is an acceptable risk that they will have approximately a 13% of failing to detect material misstatement. This level of risk is acceptable if the auditor has assurance from other sources to support inherent and control risk assesment.

Documents

Lect 14