Basics of Audit :-Materiality

Audit Materiality explained – Misstatements, including omissions, are considered to be material if they, individually or in aggregate, could reasonably be expected to influence the economic decision of users taken on the basis of financial statements.

Various legal provisions and professional pronouncements contains reference to the concept of materiality. Clause 5,6,8 and 9 of part I of the Second Schedule to the Chartered Accountants Act, 1949, refer to material fact, material misstatement, material exceptions and to material departure from the generally accepted procedure of audit. Schedule III of the Companies Act, 2013 is designed to ensure that the Financial Statements disclose all material Information so as to give a true and fair view of the state of affairs and working results of a company. Similarly disclosure of all material accounting policies at one place and disclosure of all changes in polices is also due to materiality concept.

It is not possible to lay down precisely, either in terms of specific items or in terms of amounts, what could be considered material. Percentage comparison may be useful in determining the materiality of an item. Part II of Schedule III of the companies any item of income or expenditure which constitute 1% of revenue from operations or 100000 Rs has to be disclosed separately. The relative significance of an item has to be viewed from many angles while judging its materiality – One indicator of materiality will be its impact on the overall figures of profit or loss, another indicator would be impact on total of the category of the expenditure or income to which it pertains and there can be materiality adjudged by comparison with previous year figures.

Various stages of application of Materiality concept :

At Inception of Audit : In determination the nature, timing and extant of audit procedures

During Audit : In evaluating the effect of misstatements on the measurement and classification of accounts; and

While Reporting : In determining the appropriateness of presentation of financial information.

Types of Materiality :-

Overall Materiality (For Financial Report as a whole) : the highest amount of information that if omitted, misstated or not disclosed, then that information has the potential to affect the economic decision of users of the financial report or the discharge of accountability by management or charged with governance.

The determination of overall materiality should be made with the following questions in mind:

• Who are the major users of the financial report?
• What information is important to their economic decision making and discharging of their responsibilities?
• In addition to quantitative amounts, what qualitative factors might impact upon the users financial reporting requirements as they relate to materiality?

Overall Performance Materiality : The amount set by us as auditor at less than the Overall Materiality, to reduce to an appropriately low level, the probability that the aggregate of undetected misstatements exceeds

Overall Materiality. Overall Performance Materiality must be set at a % of the Overall Materiality so as to allow us a margin or buffer for the possible undetected misstatements that may occur during the engagement. We use a sliding scale of % based upon an estimate of the engagement risk associated with the client.

Specific Materiality (For Particular classes of transactions, account balances or disclosures): The misstatements or events that are used by the auditor to identify misstatements at lesser than the Overall Materiality. Specific Materiality could relate to sensitive areas such as particular note disclosures (that is, management remuneration or industry-specific data), compliance with legislation or certain terms in a contract, or transactions upon which bonuses are based. It could also relate to the nature of a potential misstatement such as an illegal act, non-compliance with loan covenants and statutory/regulatory reporting requirements.

Disclosure of the following transactions, balances or events would normally be subject to a Specific Materiality level lower than Overall Materiality:

• Related party transactions and balances
• Disclosure of items such as those related to financial instrument risk
• Significant management estimates or valuations including sensitivity analysis
• Director’s remuneration
• Director’s expense accounts
• Auditor’s remuneration, particularly non-audit services
• Significant accounting policies or changes in accounting policies
• Sensitive income and expense accounts such as management fees and commissions.

Determining materiality for the financial statements as a whole and performance materiality  Determining materiality involves the exercise of professional judgment.

• A percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial statements as a whole.
• Examples of benchmarks that may be appropriate, depending on the circumstances of the entity, include:
  • Profit before tax
  • total revenue
  • gross profit
  • total expenses
  • total equity or net asset value etc.

Factors that may affect the identification of an appropriate benchmark include the following:

• The elements of the financial statements
• Whether there are items on which the attention of the users of the particular entity’s financial
• statements tends to be focused
• The nature of the entity, where the entity is at in its life cycle, and the industry and economic environment in which the entity operates
• The entity’s ownership structure and the way it is financed
• The relative volatility of the benchmark