Chapter03

3 - 1©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder

Learning Objective 6Learning Objective 6

Explain how materiality affectsExplain how materiality affects

audit reporting decisions.audit reporting decisions.


MaterialityMateriality

Materiality is an essential consideration in Materiality is an essential consideration in determining the appropriate type of report determining the appropriate type of report for a given set of circumstances. for a given set of circumstances.

A misstatement in the financial statementsA misstatement in the financial statementscan be considered material if knowledge ofcan be considered material if knowledge ofthe misstatement would affect a decisionthe misstatement would affect a decisionof a reasonable user of the statements.of a reasonable user of the statements.


Levels of MaterialityLevels of Materiality

Amounts are immaterial.Amounts are immaterial.

Amounts are material but do not overshadowAmounts are material but do not overshadowthe financial statements as a whole.the financial statements as a whole.

Amounts are so material or so pervasive thatAmounts are so material or so pervasive thatoverall fairness of the statements is in question.overall fairness of the statements is in question.

There are three level of materiality are used There are three level of materiality are used

for determining the type of opinion to issue:for determining the type of opinion to issue:


Levels of MaterialityLevels of Materiality Amounts are immaterialAmounts are immaterial When a misstatement in the financial When a misstatement in the financial

statements exists but is unlikely to affect the statements exists but is unlikely to affect the

decisions of a reasonable user, it is decisions of a reasonable user, it is

considered to be immaterial. An unqualified considered to be immaterial. An unqualified

opinion is therefore appropriate. opinion is therefore appropriate.

Amounts are material but do not Amounts are material but do not overshadow the financial statements overshadow the financial statements as a wholeas a whole

The second level of materiality exists when a The second level of materiality exists when a

misstatement in the financial statements misstatement in the financial statements

would affect a user’s decision, but the overall would affect a user’s decision, but the overall

statements are still fairly stated and statements are still fairly stated and

therefore useful. therefore useful.


Levels of MaterialityLevels of Materiality Amounts are so material or so Amounts are so material or so

pervasive that overall fairness of the pervasive that overall fairness of the statements is in questionstatements is in question

The highest level of materiality exists when The highest level of materiality exists when

users are likely to make incorrect decisions if users are likely to make incorrect decisions if

they rely on the overall financial statements.they rely on the overall financial statements.

When the highest level of materiality exists, When the highest level of materiality exists,

the auditor must issue either a disclaimer of the auditor must issue either a disclaimer of

opinion or an adverse opinion, depending on opinion or an adverse opinion, depending on

which conditions exist. which conditions exist.

When determining whether an exception is When determining whether an exception is

highly material, the extent to which the highly material, the extent to which the

exception affects different parts of the financial exception affects different parts of the financial

statements must be considered. statements must be considered. This is called This is called

Pervasiveness.Pervasiveness.


Relationship of Materiality toRelationship of Materiality toType of OpinionType of Opinion

MaterialityMaterialityLevelLevel

Significance in Terms ofSignificance in Terms ofReasonable Users’ DecisionsReasonable Users’ Decisions

Type ofType ofOpinionOpinion

Users’ decisions are unlikelyUsers’ decisions are unlikelyto be affected.to be affected.ImmaterialImmaterial UnqualifiedUnqualified

Users’ decisions are likelyUsers’ decisions are likelyto be affected.to be affected.MaterialMaterial QualifiedQualified

Users’ decisions are likelyUsers’ decisions are likelyto be significantly affected.to be significantly affected.

HighlyHighlymaterialmaterial

DisclaimerDisclaimeror adverseor adverse


Materiality DecisionsMateriality Decisions

Failure toFailure tofollow GAAPfollow GAAP

Audit reportAudit report

UnqualifiedUnqualified QualifiedQualifiedopinion onlyopinion only AdverseAdverse


Materiality DecisionsMateriality DecisionsWhen a client has failed to follow GAAP, the When a client has failed to follow GAAP, the

audit report will be audit report will be unqualifiedunqualified, , qualified qualified

opinion onlyopinion only, , or adverseor adverse, depending on the , depending on the

materiality of the departure. materiality of the departure.

Several aspects of materiality must be Several aspects of materiality must be

considered.considered.Dollar amount compared with a baseDollar amount compared with a base

MeasurabilityMeasurability

Nature of the itemNature of the item


Dollar amount compared with a baseDollar amount compared with a base

The primary concern in measuring The primary concern in measuring

materiality when a client has failed to materiality when a client has failed to

follow GAAP is usually the total dollar follow GAAP is usually the total dollar

misstatement in the accounts involved, misstatement in the accounts involved,

compared with some base. compared with some base.

Misstatements must be compared with Misstatements must be compared with

some measurement base before a some measurement base before a

decision can be made about the decision can be made about the

materiality of the failure to follow GAAP. materiality of the failure to follow GAAP.

Common bases include net income, total Common bases include net income, total

assets, current assets, and working assets, current assets, and working

capital. capital.


Dollar amount compared with a baseDollar amount compared with a base

To evaluate overall materiality, the To evaluate overall materiality, the

auditor must also combine all unadjusted auditor must also combine all unadjusted

misstatements and judge whether there misstatements and judge whether there

may be individually immaterial may be individually immaterial

misstatements that, when combined, misstatements that, when combined,

significantly affect the statements. significantly affect the statements.

When comparing potential misstatements When comparing potential misstatements

with base, the auditor must carefully with base, the auditor must carefully

consider all accounts affected by a consider all accounts affected by a

misstatements (pervasiveness).misstatements (pervasiveness).


The dollar amount of some misstatements The dollar amount of some misstatements

cannot be accurately measured. cannot be accurately measured.

For example, a client’s unwillingness to For example, a client’s unwillingness to

disclose an existing lawsuit or the disclose an existing lawsuit or the

acquisition of a new company subsequent acquisition of a new company subsequent

to the balance sheet date is difficult if not to the balance sheet date is difficult if not

impossible to measure in terms of dollar impossible to measure in terms of dollar

amounts. amounts.

The materiality question the auditor must The materiality question the auditor must

evaluate in such situations is the effect on evaluate in such situations is the effect on

statement users of the failure to make the statement users of the failure to make the

disclosure.disclosure.

MeasurabilityMeasurability


The decision of a user may also be affected by The decision of a user may also be affected by

the kind of misstatement. The following may the kind of misstatement. The following may

affect a user’s decision and therefore the affect a user’s decision and therefore the

auditor’s opinion in a different way than most auditor’s opinion in a different way than most

misstatements. misstatements.

— Transactions are illegal or fraudulent.Transactions are illegal or fraudulent.

— An item may materially affect some future period, An item may materially affect some future period,

even though it is immaterial for the current period even though it is immaterial for the current period

only. only.

— An item has a “psychic” effect (for example, the An item has a “psychic” effect (for example, the

item changes a small loss to a small profit, item changes a small loss to a small profit,

maintains a trend of increasing earnings, or allows maintains a trend of increasing earnings, or allows

earnings to exceed analysts’ expectations)earnings to exceed analysts’ expectations)

— An item may be important in terms of possible An item may be important in terms of possible

consequences arising from contractual obligations.consequences arising from contractual obligations.

Nature of the itemNature of the item


Materiality DecisionsMateriality Decisions

ScopeScopelimitationlimitation

Audit reportAudit report

UnqualifiedUnqualified Qualified scopeQualified scopeand opinionand opinion DisclaimerDisclaimer


When there is a scope limitation in an audit, the When there is a scope limitation in an audit, the

audit report will be unqualified, qualified scope audit report will be unqualified, qualified scope

and opinion, or disclaimer, depending on the and opinion, or disclaimer, depending on the

materiality of the scope limitation. materiality of the scope limitation.

The auditor will consider the same The auditor will consider the same three factorsthree factors

included in the previous discussion about included in the previous discussion about

materiality decisions for failure to follow GAAP, materiality decisions for failure to follow GAAP,

but they will be considered differently. but they will be considered differently.

The size of potential misstatements, rather The size of potential misstatements, rather

than known misstatements, is important in than known misstatements, is important in

determining whether an unqualified report, a determining whether an unqualified report, a

qualified report, or a disclaimer of opinion is qualified report, or a disclaimer of opinion is

appropriate for a scope limitation. appropriate for a scope limitation.

Materiality Decision – Scope LimitationMateriality Decision – Scope Limitation


For example, a recorded accounts payable of For example, a recorded accounts payable of

$400,000 was not audited, the auditor must $400,000 was not audited, the auditor must

evaluate the potential misstatements in accounts evaluate the potential misstatements in accounts

payable and decide how materially the financial payable and decide how materially the financial

statements could be affected. The pervasiveness statements could be affected. The pervasiveness

of these potential misstatements must also be of these potential misstatements must also be

considered.considered.

It is typically more difficult to evaluate the It is typically more difficult to evaluate the

materiality of potential misstatements resulting materiality of potential misstatements resulting

from a scope limitation than for failure to follow from a scope limitation than for failure to follow

GAAP. Misstatements resulting from failure to GAAP. Misstatements resulting from failure to

follow GAAP are known. follow GAAP are known.

Those resulting from scope limitations must Those resulting from scope limitations must

usually be subjectively measured in terms of usually be subjectively measured in terms of

potential or likely misstatements. potential or likely misstatements.



For client-imposed restriction, the auditor For client-imposed restriction, the auditor

should be concerned about the possibility should be concerned about the possibility

that management is trying to prevent that management is trying to prevent

discovery of misstated information.discovery of misstated information.

In such cases, auditing standards In such cases, auditing standards

encourage a encourage a declaimer of opiniondeclaimer of opinion when when

materiality is in question.materiality is in question.

When restriction resulted from conditions When restriction resulted from conditions

beyond the client’s control, beyond the client’s control, a qualification a qualification

of scope and opinionof scope and opinion is more likely. is more likely.



1.1. Evaluate the existence of the MisstatementsEvaluate the existence of the Misstatements

2.2. Evaluate the dollar amount of misstatements Evaluate the dollar amount of misstatements which effect of the financial statements.which effect of the financial statements.

3.3. Combine all unadjusted misstatements Combine all unadjusted misstatements

4.4. Carefully consider all accounts affected by a Carefully consider all accounts affected by a misstatements (evaluate the pervasiveness of misstatements (evaluate the pervasiveness of the misstatements) the misstatements)

5.5. Compare the amount of the misstatements Compare the amount of the misstatements with some base.with some base.

6.6. Evaluate the nature of misstatementsEvaluate the nature of misstatements

7.7. Judge whether the misstatements are material Judge whether the misstatements are material or immaterial.or immaterial.

Summery of Materiality DecisionSummery of Materiality Decision



Draft appropriately modifiedDraft appropriately modified

audit reports under a varietyaudit reports under a variety

of circumstances.of circumstances.


Discussion of ConditionsDiscussion of ConditionsRequiring DepartureRequiring Departure

Auditor’s scope has been restricted.Auditor’s scope has been restricted.

Statements are not in conformity with GAAP.Statements are not in conformity with GAAP.

Auditor is not independent.Auditor is not independent.


Scope Restricted by ClientScope Restricted by Clientor Other Conditionsor Other Conditions

ImmaterialImmaterial MaterialMaterial

Level of MaterialityLevel of Materiality

ExtremelyExtremelyMaterialMaterial

UnqualifiedUnqualifiedreportreport

Qualified scope, additionalQualified scope, additionalparagraph, and qualifiedparagraph, and qualified

opinion (except for)opinion (except for)

DisclaimerDisclaimerof opinionof opinion


Statements Not Prepared in Statements Not Prepared in Accordance With GAAPAccordance With GAAP




UnqualifiedUnqualifiedreportreport

Additional paragraphAdditional paragraphand qualified opinionand qualified opinion

(except for)(except for)

AdverseAdverseopinionopinion


The Auditor Is Not IndependentThe Auditor Is Not Independent




Disclaimer of opinionDisclaimer of opinion(regardless of materiality)(regardless of materiality)



Determine the appropriate auditDetermine the appropriate audit

report for a given audit situation.report for a given audit situation.


Auditor’s Decision ProcessAuditor’s Decision Process

Determine whether any condition existsDetermine whether any condition existsrequiring a departure from a standardrequiring a departure from a standardunqualified report.unqualified report.

Decide the materiality for each condition.Decide the materiality for each condition.

Decide the appropriate type of report.Decide the appropriate type of report.

Write the audit report.Write the audit report.


Number of ParagraphsNumber of Paragraphsin the Reportin the Report

Standard unqualifiedStandard unqualified 33Unqualified with explanatory paragraphUnqualified with explanatory paragraph 44Unqualified shared report with other auditorsUnqualified shared report with other auditors 33Qualified – opinion onlyQualified – opinion only 44Qualified – scope and opinionQualified – scope and opinion 44Disclaimer – scope limitationDisclaimer – scope limitation 33AdverseAdverse 44

Type of ReportType of Report



Discuss the impact of e-commerceDiscuss the impact of e-commerce

on audit reporting.on audit reporting.


Impact of E-Commerce onImpact of E-Commerce onAudit ReportingAudit Reporting

Auditors are not required to read informationAuditors are not required to read informationcontained in electronic sites.contained in electronic sites.

Most public companies provide access to financialMost public companies provide access to financialinformation through their home Web page.information through their home Web page.

Auditing standards note that electronic sitesAuditing standards note that electronic sitesare not considered “documents.”are not considered “documents.”


End of Chapter 3End of Chapter 3

Technology

Chapter03