Materiality and its relevance in audit

Ques. What is Materiality?

Ans. It is a Benchmark used to obtain reasonable assurance that an audit does not detect any material misstatement that can significantly impact the usability of financial statements.

Materiality is a relative rather than an absolute concept.

SA 320 "Materiality in Planning and Performing an Audit" explains materiality: Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.

Ques. Why it is relevant for audit/ What is the use of materiality in an audit?

Ans. The concept of materiality is fundamental to the entire audit process and is applied by the auditor:

• in determining the nature, timing, and extent of risk assessment procedures;
• in identifying and assessing the risks of material misstatement;
• in determining the nature, timing, and extent of audit procedures to gather sufficient appropriate audit evidence;
• in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements
• in forming the opinion in the auditor’s report on the financial statements

Ques. How is Materiality being calculated?

Ans. Calculating materiality is a matter of professional judgment. The standards allow for the use of benchmarks for the calculations. Benchmarks are standard percentages that are applied to the reporting entity's data to calculate materiality.

In practice, the calculation of materiality has the following steps:

1. Decide on the appropriate benchmark (also called measurement base).

Gross revenue, gross profit, operating income from continuing operations, net profit, shareholder's equity, and total assets are all benchmarks used by auditors.

For profit-orientated entities, operating income from continuing operations is the preferred benchmark, but when the entity suffered a loss or made a small profit, other benchmarks will be more appropriate.

2. Determining the percentage to use.

Firms usually have a range of percentages for each benchmark and the auditor in charge of the engagement should, after selecting the benchmark, determine the percentage to use for the engagement from this range based on the client's circumstances and internal control environment.

3. Document the judgments used to select the benchmark and the percentage.

The range of percentages can look like this:

Ques. What are the factors in assessing whether an amount is material?

Ans. (i) the potential impact of the misstatement on trends, especially trends in profitability;

(ii) a misstatement that changes a loss into profit or vice versa (for example recording a provision for doubtful trade receivables may result in marginal profit before tax turning into a loss);

(iii) the potential impact of the misstatement on the entity’s compliance with debt covenants (for example current ratio), other contractual agreements, and regulatory provisions;

(iv) the existence of statutory or regulatory reporting requirements (for example interest payable to parties covered under MSMED Act, 2006 and disclosures thereof);

(v) a misstatement that has the effect a variable pay or compensation of key management personnel (for example, by satisfying the requirements for targeted turnover or net profit before tax);

(vi) the sensitivity of the circumstances surrounding the misstatement (for example, consider whether the misstatements involve fraud or possible illegal acts);

(vii) the significance of the financial statement item affected by the misstatement;

(viii) the motivation of management with respect to the misstatement, for example:

(a) an intentional misstatement to ‘manage’ earnings; (b) an indication of a possible pattern of bias by management when developing and accumulating accounting estimates;

Ques. What are types of Materiality?

Ans.

1. Overall Materiality

When establishing the overall audit strategy, the auditor determines the materiality for the financial statements as a whole. It is a threshold, above which, the financial statements would be materially misstated. This is called "materiality for the financial statements as a whole" or simply overall materiality.

Overall materiality is based on the auditor’s professional judgment as to the maximum amount of misstatement(s) that if not corrected in the financial statements will not affect the economic decisions taken by a financial statement user. If the amount of uncorrected misstatements, either individually or in the aggregate, is higher than the overall materiality established for the audit, it implies that the financial statements are materially misstated.

2. Performance Materiality

Performance Materiality is set at an amount less than the overall materiality and acts like a "safety buffer" to lower the risk of aggregate uncorrected and undetected misstatements being material for the overall financial statements. Performance materiality enables the auditor to respond to specific risk assessments (without changing the overall materiality) and to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality.

3. Specific Materiality

Specific materiality is established for classes of transactions, account balances, or disclosures where misstatements of lesser amounts than overall materiality could reasonably be expected to influence the economic decisions of users, taken on the basis of the financial statements. (For example; potential investors may be interested in revenue)

4. Specific Performance Materiality

Specific performance materiality is the same concept as performance materiality, except that it is set in relation to specific materiality and not overall materiality.