AAAP7 INT
Syllabus D. Audit of Historical Financial Information D1. Planning, materiality and risk

D1a. Materiality

Syllabus D1a)

Define materiality and performance materiality and demonstrate how it should be applied in financial reporting and auditing.

ISA 320 defines information as material if ‘its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.’

Material items could be large transactions or significant events.

Materiality is important to the auditor because if a material item is incorrect, the financial statements will not show a ‘true and fair view.’

Materiality Levels

  1. The auditor will decide materiality levels and design their audit procedures to ensure that the risk of material misstatements is reduced to an acceptable level.

    Generally, materiality will be set with reference to the financial statements such as:

    0.5 – 1% of turnover
    5 – 10% of profits reported
    1 – 2 % of gross assets

    Judgement will be used by the auditor in charge and will depend on the type of business and the risks it faces.

  2. Considerations

    • Quantity

      The relative size of the item

    • Quality

      This might be something that's low in value but could still affect users' decisions e.g.. Directors wages

Tolerable Error

  • This is when the auditor accepts the error

  • For example finding one error out of 100 tested, might be ignored

  • The tolerable level will be decided at planning stage

Performance Materiality

This is lower than normal materiality

The idea is that this will try to prevent all those small, undetected errors do not aggregate to become material

  • There are now 2 standards to consider..

    1. ISA 320 Audit Materiality

    2. ISA 450 Evaluation of Misstatements Identified During the Audit

  • As we know, materiality is calculated at the planning stage

    But it might not stay at that amount - oh no baby

    Things happen that make the auditor change the level

    Such things are often immaterial in quantity but material by their nature

  • Example

    The company you are auditing makes a $5,000 profit.

    The materiality is set at $10,000

    You notice that an invoice for $6,000 has been incorrectly placed into next year.

    This would be material as it changes the look of the whole accounts (changing a profit into loss)

  • The new standard recognises that there could well be instances where certain classes of transactions, account balances or disclosures might be affected by misstatements which are less than the materiality level for the financial statements as a whole, but which may well influence the decisions of the user of those financial statements regardless of the fact they are below materiality – this is where performance materiality is to be applied.

    Specifically, the clarified ISA 320 suggests performance materiality be applied to areas such as related party transactions and directors’ remuneration.