Understanding SA 320 – MATERIALITY

SA 320 states that 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 the users taken on the basis of the financial statements.

The objective of the individual auditor is to obtain a reasonable assurance about whether the financial statements as a whole are free from material misstatements due to fraud and error thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material aspects, in accordance with the applicable reporting framework.

Materiality is not always a matter of relative size. For example a small amount lost by fraudulent practices of certain employees can indicate a serious flaw in the enterprise’s internal control system requiring immediate to avoid greater losses in future.

Materiality in planning and performing an audit

The concept of materiality applies on both planning and performing the audit, and in evaluating the effect of indentified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report. Financial reporting frameworks often discuss the concept of materiality in the context of the preparation and presentation of financial statements. Although financial reporting framework may discuss materiality in different terms, they generally explain that:

• Misstatement 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.
• Judgements about materiality are made in the light of surrounding circumstances and are affected by the size or nature of a misstatement or a combination of both.
• Judgement about matters that are material to users of the financial statements based on a consideration of the common financial information need of users as a group. The possible affect of misstatements on specific individual users, whose need may vary widely, is not considered.

In planning the audit, the auditor makes a judgement about the size of misstatements that will be considered material. These judgement provide a basis for :

1. Determining the nature, timing and extent of risk assessment procedure.
2. Identifying and assessing the risk of material misstatement and
3. Determining the nature, timing and extent of further audit procedure.

The materiality determined when planning the audit does not necessarily establish an amount below which uncorrected misstatements, individually or in aggregate, will always be evaluated as immaterial. The auditor has to apply professional judgement in determining materiality, choosing appropriate benchmark. Materiality forms the basis for determining of audit scope and the levels of testing the transactions.

Determining of materiality- a matter of professional judgement

the auditor’s determination of materiality is matter of professional judgement, and is affected by the auditor’s perception of the financial information needs of users of the financial statements. In this context it is reasonable for the auditor to assume that user:

1. Have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with reasonable diligence
2. Recognize the in certainties inherent in the measurement of amount based on the use of estimates, judgement and the consideration of future events and
3. Make a reasonable economics decisions on the basis of the information in the financial statements.
4. Understand that financial statements are prepared, presented and audited to levels of materiality.

PERMORMANCE MATERIALITY

Performance materiality means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements for the financial statements as a whole.

Performance materiality is set at a value lower than overall materiality. Its lower the risk the auditor will not be able to identify misstatements that are material when added together.

Determining materiality and performance materiality when planning the audit

When establishing the overall audit strategy, the auditor shall determine the materiality for the financial statement as a whole. If, in the specific circumstances of the entity, there is one or more particular classes of transaction, account balances or disclosures for which the misstatement of lesser amounts than the materiality for the financial statements as a whole could reasonable be expected to influence the economic decisions of the user taken on the basis of the financial statements, the auditor shall also determine the materiality level or levels to be applied to those particular classes of transactions, account balances or disclosures.

Materiality Level or Levels for Particular Classes of Transactions, Account Balances or Disclosures

Factors that may indicate the existence of one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements include the following:

1. Whether law, regulations or the applicable financial reporting framework affect users’ expectations regarding the measurement or disclosure of certain items like in case of related party transactions, and the remuneration of management and those charged with governance.
2. The key disclosures in relation to the industry in which the entity operates. For example, research and development costs for a pharmaceutical company.
3. Whether attention is focused on a particular aspect of the entity’s business that is separately disclosed in the financial statements like in case of newly acquired business. Revision in Materiality level as the Audit Progresses Materiality for the financial statements as a whole (and, if applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures) may need to be revised as a result of a change in circumstances that occurred during the audit (for example, a decision to dispose of a major part of the entity’s business), new information, or a change in the auditor’s understanding of the entity and its operations as a result of performing further audit procedures.

If during the audit it appears as though actual financial results are likely to be substantially different from the anticipated period end financial results that were used initially to determine materiality for the financial statements as a whole, the auditor revises that materiality.

If the auditor concludes that a lower materiality for the financial statements as a whole (and, if applicable, materiality level or levels for particular classes of transactions, account balances or disclosures) than that initially determined is appropriate, the auditor shall determine whether it is necessary to revise performance materiality, and whether the nature, timing and extent of the further audit procedures remain appropriate.

Documenting the Materiality

The audit documentation shall include the following amounts and the factors considered in their determination:

(a) Materiality for the financial statements as a whole

(b) If applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures

(c) Performance materiality and

(d) Any revision of (a)-(c) as the audit progressed

Materiality and Audit Risk

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report. In conducting an audit of financial statements, the overall objectives of the auditor are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and to report on the financial statements, and communicate as required by the SAs, in accordance with the auditor’s findings. The auditor obtains reasonable assurance by obtaining sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk. Materiality and Audit Risk are considered throughout the audit, in particular, when:

(a) Identifying and assessing the risks of material misstatement;

(b) Determining the nature, timing and extent of further audit procedures; and

(c) Evaluating the effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report.