Materiality consideration is an integral part of auditing process as it helps in guiding the evidence to be obtained in order to decide whether financial statements give a true and fair view.
The auditor does not guarantee accuracy of financial statements. He provides reasonable assurance that financial statements are free from material misstatement.
For example, the entity reported a net profit of Rs. 2 million. The electricity bill for December 31, 20 x 7 was not received till the accounts were finalized. The client made a provision of Rs. 50,000, for December on the basis of past experience. Actual bill was received just before the finalization of audit. Actual charge was Rs. 50,250. If the tax rate is 40%, the tax liability is also affected by Rs. 100. Obviously if the client does not amend the accounts, the auditor will not qualify his report as the misstatement of profit will not influence the judgment of the users of the financial statements.
On the other hand, if for example, property taxes were estimated at Rs. 300,000 and actual charge was Rs. 450,000, the accounts need be adjusted on the grounds of materiality.
In short, materiality is a fact that if it had been correctly stated, or disclosed would have influenced the average prudent investor in his decision whether to purchase, hold or sell the shares in the entity.
The objective of assessing materiality is to determine the extent to which financial statements may contain errors without impairing true and fair view. Such assessment is a matter of auditor’s judgment in each case.
Adequate guidance is not generally available in the accounting and auditing literature regarding definitive quantitative measures of determining materiality. Ordinarily, materiality levels may be established separately for profit and loss statement and balance sheet accounts.
However, since any misstatement in profit and loss account affects the balance sheet, the materiality levels are also considered at overall financial statement level.
Examples of some of the measures of materiality are:
INVERSE RELATIONSHIP BETWEEN MATERIALITY AND AUDIT RISK.
There is an inverse relationship between materiality and the level of audit risk. Assume that in a client the audit risk is high (because combined level of inherent and control risk is high), the auditor will have to reduce materiality level. The materiality level will have to be reduced so that extended substantive tests will be carried out in order to reduce detection risk and overall audit risk.
ISA – 320 states “there is an inverse relationship between materiality level and the level of audit is, that is the higher the materiality level, the lower the audit risk and vice versa” does not mean that if audit risk is high, the materiality level
will be low. The inverse relationship means that if the audit risk is high, the acceptable materiality level needs to be low. That is, if the combined level of inherent and control risk is high, the acceptable detection risks should be low, to restrict the audit risk to acceptably low level. In order to reduce detection risk a larger sample size will need be selected.
In other words, if in a client the acceptable materiality level is low, the risk that inappropriate report is more than in a client where acceptable materiality level is high.
Put it differently, if acceptable materiality level is lower, the audit risk is increased. An auditor plans a materiality level of say Rs. 10,000 and the audit risk is X. If he concludes that even Rs. 2,000 will make the financial statements misleading, what the auditor to do?
Either reduce detection risk by extending sample size or reduce assessed level of control risk.
The audit risk will then again be x %.
Note that like inherent risk, actual control risk cannot be reduced. However, the assessed level of control risk may be reduced by performing additional tests of controls.
In the audit risk model, the CR at planning stage represents planned control risk. After performing test of control, CR represents assessed level of control risk.
The inverse relationship can also be expressed like this:
If the auditor considers even relatively small amounts to be material, he would perform excessive audit work to express an opinion, in order to reduce audit risk.
For example, if the auditor considers that Rs. 50,000 is material, the would probably check X number of items. However if the lowers it down to Rs. 10,000, he will have to check X plus items to reduce excessive audit risk.
The auditor should compare aggregate of uncorrected misstatements with materiality level.
Aggregate amounts of uncorrected error is computed like this:
• Errors found in sample (less anomalous error)
• Add projected error based on sample, based on above
• Add anomalous error
• Less sample error corrected.
• Add uncorrected errors of previous years affecting current year’s financial statements.
If aggregate uncorrected errors exceed materiality level the auditor should either:
(a) Reduce detection risk by testing additional items or,
(b) Require the management to correct errors.
If the auditor concludes that the test of additional items has not reduced aggregate errors below materiality level and the management does not amend the accounts, the auditor’s report will have to be modified.
If the total amount of aggregate uncorrected errors is less than but close to materiality level, the auditor should obtain additional audit evidence or ask management to correct errors.
Performance of additional tests may either provide further evidence that auditor’s assessment of misstatement is appropriate, or may reveal that the aggregate uncorrected errors exceed the materiality level.