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.

Group Audit: Practice Considerations

During preparation for Advanced Audit exam I have decided to update my knowledge about group audits (GA). I read two rather technical and a bit of boring articles in Student Accountant magazine by Lisa Weaver and Graham Fairclough. In real life the topic is very interesting and might require some imagination from people who have never been working in auditing, nevertheless participating in group (also referred as ‘multi-location audit’) audit to understand group auditing process.

In this article I would like to share my experience about several elements of multi-location audit.

Planning stage of group audit

In my subjective opinion planning stage plays more important role for GA than for audit of standalone financial statements. The reason is complexity of 2 elements of system:

·       Business relations within the audited company, inter-company relations, related party issues;

·        Accounting process accompanying these relations.

As a result of planning stage we will be able to identify the scope of audit, nature of procedures on final audit stage and resources needed accomplish our goal.

If the whole audit of group is undertaken by one audit firm, then all audit work would be split between consolidation audit team (i.e. ‘group auditor’ as referred in Fairclough’s article) and location audit team (component auditor if the auditor is other audit firm).

Participation in planning process of group audit gives strategic view on audit process. Understanding business is really essential at planning stage and the function of each company within the group need to be identified. For example, common type of gold mining holdings in Russia is as follows:

·        Mining entities themselves - the companies which extract gold;

·        Factories, gold processing plants (sometimes included within mining company);

·        Servicing catering companies: extraction of natural resources is often carried out in ‘hard-to-get’ places. The workers live there temporarily in camps and services like canteen, hotels, utilities need to be provided by mining company or outsourced;

·        Finance/holding companies. Their function in the group is to establish control and governance over the group, provide finance, management services.

·        Offshore companies, these companies often used to minimize taxes paid by company in country of operation. They are established in jurisdictions with soft tax regimes in countries like British Virginia Islands. It might be not legal so some companies play quite risky games with their tax authorities. Be aware about this auditing tax section.

Materiality

The planning materiality (PM) of group and each location is often discussed on focus audit team meetings and the decision of partners is communicated by consolidation team to local teams.  PM calculation has some specifics here, because it has to be allocated for each subsidiary depending on size of subsidiary/location. The size is usually measured based on subsidiary’s contribution to group assets, revenues or net incomes. I have presented below the table with possible size of subsidiary and assigned percentage of allocation:

Communication and interaction

The communications between consolidation and local audit team is critical during whole audit process. On the one hand, the consolidation team is able to emphasize only critical problems which help to concentrate local audit teams on risky areas, on the other hand, consolidation team can solve issues related with client, e.g. raise issue that one of subsidiary the local management is reluctant to give necessary information to local audit team.

Work in consolidation audit team is a bit of everything:

·       Administrative work: coordination of local audit teams, communications with client on corporate level, allocation of tasks and consolidation all essential information;

·        Audit work itself: consolidation team has to audit consolidation process and accounting issues related with consolidation/group accounting such as goodwill, inter-company eliminations, fair values allocations, non-controlling interests and etc.

·        Review of local audit team’s working papers and establish additional procedures to ensure that audit risk decreased;

·        Checking accuracy of final financial statements and reporting forms which have to be submitted to SEC (e.g.  10-K in US) in case client-company is listed.

In military language the consolidation audit team is army headquarters.

Participation in group audit

I was lucky that in the beginning of my audit career that I was able in to participate in big audit project of NYSE listed company. It was great experience to be part of the well elaborated and strategically well-considered audit process. The focus on planning stage gives very good understanding of both audit process itself and client as business and strict requirements to documentation might give you an idea how to formalize your understandings of complicated issues.

In summary, I would like to advise to anyone who is working in audit firm to try to take part in group audit, both as a member of consolidation and local audit team.  

References

Fairclough, G. (2011). Group Auditing. Student Accountant. April 2011, p. 1-6

Weaver, L. (2008). Objectives and Responsibilities. Student Accountant. March 2008, p. 72-75.