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.
