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Materiality Notes

Materiality in financial statements is defined by the potential influence of misstatements on users' decisions, requiring auditors to understand user contexts and apply professional judgment. Common benchmarks include normalized profit before tax from continuing operations, with a typical threshold of 5% for determining materiality. The planning phase involves setting materiality levels to guide audit procedures, while the end of the audit compares established materiality against identified and projected misstatements to assess the need for report modifications.

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15 views5 pages

Materiality Notes

Materiality in financial statements is defined by the potential influence of misstatements on users' decisions, requiring auditors to understand user contexts and apply professional judgment. Common benchmarks include normalized profit before tax from continuing operations, with a typical threshold of 5% for determining materiality. The planning phase involves setting materiality levels to guide audit procedures, while the end of the audit compares established materiality against identified and projected misstatements to assess the need for report modifications.

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tcatt080
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Determining Materiality

Materiality defined:
A misstatement in the financial statements is considered material if, in light of
surrounding circumstances , it is probable, that the decision of a person who is relying
on the financial statements , and who has a reasonable knowledge of business and
economic activities ( the user) would be changed or influenced by the misstatement.

Materiality is defined in relation to the users and the decisions that the users will make.

The auditor must have a knowledge of the users and their decisions to determine
materiality.
Materiality involves the exercise of professional judgement.

A percentage is often applied to a benchmark.


Factors that may affect the identification of an appropriate benchmark include the
following:
1. The elements of the financial statements. (assets, liabilities, equity, revenue and
expenses)
2. Whether there are items on which the attention of the users of the particular entity’s
financial statements tends to be focused.
3. The nature of the entity, where it is in its life cycle , and the industry and economic
environment.
4. The entity’s ownership structure and the way it is financed.
5. The relative volatility of the benchmark.
Normalized Profit Before Tax from Continuing Operations

Commonly used for profit-oriented entities.

Before tax is used to eliminate the difference in profits caused by different tax rates. For
example the small business rate versus the normal corporate rate. Tax is set by tax law.
Users are interested in the performance of the company.

Discontinued operations are excluded because users are predicting future profit and the
discontinued operations are not relevant to predicting future profits.

Normalized profit before tax from continuing operations


- Circumstances that give rise to an exceptional decrease or increase in profit should
be eliminated in calculating materiality ( One time revenue or expense that is
material should be eliminated from profit before calculating materiality)
- Large gain from settlement of a law suit. Large inventory write down or impairment
loss.
- 5% of normalized profit before tax from continuing operations is commonly used.
Materiality at the planning phase:
The auditor will determine the planning materiality at the beginning of the audit.

Planning materiality – the combined amount of misstatements in the financial


statements that would be considered material

The purpose of setting materiality in the planning phase is to help determine the
appropriate evidence to be gathered, determine the nature, timing and extent of risk
assessment procedures and determine what will be considered a material
misstatement.
A low materiality results in more evidence being gathered.

CAS 320 Performance Materiality - requires that performance materiality also


be determined.
- Set to reduce to an appropriately low level the probability that the aggregate of
uncorrected and undetected misstatements (maximum possible misstatement) in
the financial statements exceeds materiality for the financial statements as a whole.
- It is determined for purposes of the extent of the audit testing.
- Lower the performance materiality the greater amount of audit testing performed.
- Lower the performance materiality the lower the probability of undetected error.

CAS 320 Materiality for classes of transactions, account balances and disclosures
- If an error in a certain account or class of transactions might influence users
decisions more than other accounts or transactions a lower materiality may be set
for that account or class of transactions. Example: if a company was being
purchased and a multiple of earnings was being used to set the purchase price, a
lower materiality might be set for sales and other income statement accounts.
Materiality at the end of the audit:
The materiality (planning) established is compared to the “maximum possible
misstatement” determined during the audit to determine if the auditor’s report should
be modified. (a qualified opinion.)

Maximum Possible Misstatement

Identified Misstatements – the actual misstatements discovered in the sample tested that have
not been corrected

+
Likely or projected misstatement – the projection of the actual misstatements in the sample to
the population

=
Likely aggregate misstatement

+
Further possible misstatements - misstatements over and above the likely aggregate
misstatements that result from the imprecision in the sampling process, ( competence of staff
in sampling, in examining and interpreting audit evidence) (undetected misstatements)

=
Maximum possible misstatement

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