Audit Method: Materiality

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report. Information is material if it is likely to influence financial statements users’ decisions. The major reason for thinking about materiality is to try to fine tune the audit for effectiveness and efficiency.

Planning Materiality: Auditors use planning materiality at the planning stage to determine which financial statement items, account balances and transactions to test and which to not test. It affects the scope of both tests of controls and substantive tests.

Performance Materiality: To plan the audit of various accounts, auditors need to assign part of the planning materiality to each account or class of transactions. If planning materiality is 1million CU(Currency Unit) and procedures for each account or class of transactions are designed to allow a 1million CU misstatement to go undetected, the total misstatement could obviously be more than acceptable. Therefore, auditors use performance materiality (an amount less than materiality for the financial statements as a whole) to make sure that the aggregate of uncorrected and undetected immaterial misstatements does not exceed materiality for the financial statements as a whole.

Computing Materiality: A number of quantitative approaches may be used by the auditor depending on his professional judgment; two common methods employed are discussed here:

Single Variable Approach This approach uses a single financial variable for computing materiality. Depending on qualitative factors, an auditor would select the variable that was judged to be the most appropriate way to compute materiality for a specific client. Examples of possible common single variables are: 5% of pre-tax income, 1/2% of total assets, 1% of equity, 1/2% of total revenues.

Blend or Average Method This method typically takes four or five variables and then either weights each variable according to some proportion or averages them (an equal weighing). Presumably, the blending or averaging process provides an indirect way of considering qualitative factors. An example of the averaging method would be to take the previously listed four single variables and average them (give each of them a 25% weight).

Recommendation

My recommendation to audit seniors will be that consider the amount (quantity) and nature (quality) of misstatements as both are relevant in deciding what is material. Moreover consider the industry in which your audit client falls and then decide on which financial variable is most relevant to the particular industry. For example for retailers revenue or profit after tax would be more suitable, for business concerned with asset growth e.g. property development an asset based benchmark would be a better measure to use, a not for profit organization or a public sector body could use 0.5% to 1% of expenses since they are normally not concerned with revenue generation or profits.