Auditing Theory
Materiality, Misstatements, Determining Material Accounts and Disclosure,
and Audit Risk
-Harries Francisco Andaya, CPA
Lucio
Concept of Materiality
The auditor is expected to design and conduct an audit that provides
reasonable assurance that material misstatements will, whether due to fraud
or error, be detected.
The auditor is required to determine materiality for the financial statements
as a whole when establishing the overall audit strategy, which is part of
planning an audit.
In financial reporting, materiality is any information that may influence user’s
economic decisions. On the other hand, materiality in audit is considered in
terms of the smallest aggregate level of misstatements that could comprise the
financial statements.
For any given client, materiality is not simply a function of specific amounts in
the financial statements. An auditor must understand who the potential users
are and the type of judgments made by those users when relying on financial
statements.
Application of Materiality
Materiality is applied both in planning, performing and concluding on
the audit. In particular, when:
▪ Identifying material classes of transactions, account balances and
disclosures
▪ Determining the nature, timing and extent of risk assessment
procedures
▪ Identifying and assessing the risk of material misstatement
▪ Determining the nature, timing and extent of further audit
procedures
▪ Evaluating the effect of uncorrected misstatements, if any, on the
financial statements and in forming the opinion in our audit report.
Materiality Levels
The auditor establishes the following levels of materiality in an audit of
financial statements:
a) Materiality for the financial statements as a whole
b) Materiality for particular classes of transactions, account balances,
or disclosures, if necessary
c) Performance materiality for (a) and (b) above
d) Clearly trivial materiality
Materiality for the Financial Statements as
a whole (a.k.a. Preliminary/Planning
Materiality)
The auditor’s determination of materiality is a matter of professional
judgment, and is affected by the auditor’s perception of the financial
information needs of users of the financial statements. The
determination of materiality is not a mechanical exercise, in fact, there
is no specific methodologies prescribed in the standard.
Materiality for the Financial Statements as
a whole (a.k.a. Preliminary/Planning
Materiality)
Benchmarks
Factors may affect the identification of an appropriate benchmark
include:
▪ The elements of the financial statements (e.g., assets, liabilities,
equity, revenue, expenses)
▪ Whether there are items on which the attention of the users of the
particular entity’s FSs tends to be focused.
▪ The nature of the entity, where the entity is 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
Materiality for Particular Classes of
Transactions, Account Balances, or
Disclosures
For certain entities, there may be 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.
Materiality for Particular Classes of
Transactions, Account Balances, or
Disclosures
Factors that may indicate such classes of transactions, account balances, or
disclosures exist include the following:
▪ Whether law, regulation or the applicable financial reporting framework
affect users’ expectations regarding the measurement or disclosure of
certain items (e.g., related party transactions, and the remuneration of
management and those charged with governance)
▪ The key disclosures in relation to the industry in which the entity operates
(e.g., research and development costs for a pharmaceutical company)
▪ Whether attention is focused on a particular aspect of the entity‘s business
that is separately disclosed in the financial statements (e.g., a newly
acquired business)
Performance Materiality (a.k.a.
Tolerable Misstatement)
Performance materiality is the amount or amounts set by the auditor to
less than materiality for the FSs as a whole to reduce to an
appropriately low level the probability that the aggregate of
uncorrected and undetected misstatement exceeds materiality for the
FSs as a whole, i.e., to provide a cushion, so that if misstatements are
detected, the auditor may nevertheless be able to conclude with
reasonable assurance that the total misstatement in the FSs does not
exceed materiality.
Performance Materiality (a.k.a.
Tolerable Misstatement)
The auditor is required to determine performance materiality for
purposes of:
▪ Assessing the risks of material misstatement; and
▪ Determining the nature, timing, and extent of further audit
procedures
If materiality level(s) have been set for particular classes of
transactions, account balances, or disclosures, performance materiality
also refers to amount(s) set at less than these levels
Clearly Trivial Materiality
Clearly trivial materiality is the amount below which misstatements
would be clearly trivial and would not need to be accumulated because
such amounts clearly would not have a material effect on the financial
statements.
Then there is any uncertainty about whether one or more items are
clearly trivial, the matter is considered not to be clearly trivial.
Revision of Materiality
Materiality levels are not cast in stone once determined. These may be
adjusted, upward or downward, as necessary as the audit progresses
for example due to the following reasons:
▪ Changes in entity’s circumstances
▪ New information
▪ Change in understanding of entity and its operations
Documentation of Materiality
The auditor shall document the following:
▪ Materiality for financial statements as a whole
▪ Materiality level(s) for particular items
▪ Revisions to the above as the audit progresses
Evaluation of Misstatements Identified
During the Audit
Closely related to the concept of materiality is misstatement.
Misstatement is a difference between the amount, classification,
presentation, or disclosure of a reported financial statement item and
the amount, classification, presentation, or disclosure that is required
for the item to be in accordance with the applicable financial reporting
framework. Misstatements can arise from error or fraud.
Evaluation of Misstatements Identified
During the Audit
Misstatements may be identified at any stage of the audit.
Misstatements may result from:
▪ An inaccuracy in gathering or processing data from which the FSs are
prepared.
▪ An omission of an amount or disclosure
▪ An incorrect accounting estimate arising from overlooking or clear
misinterpretation of facts
▪ Judgments of management concerning accounting estimates that
the auditor considers unreasonable or the selection and application
of accounting policies that the auditor considers inappropriate.
Evaluation of Misstatements Identified
During the Audit
Types of Misstatements
▪ Factual misstatement are misstatements about which there is no doubt
▪ Judgmental misstatements are differences arising from the judgments of
management concerning accounting estimates that the auditor considers
unreasonable, or the selection or application of accounting policies that the
auditor considers inappropriate
▪ Projected misstatements are the auditor’s best estimate of misstatements
in populations, involving the projection of misstatements identified in audit
samples to the entire population from which the samples were drawn
▪ Uncorrected misstatements
Evaluation of Misstatements Identified
During the Audit
Evaluation of misstatements normally involve the following
considerations:
1. Understanding the nature and cause of identified misstatements
2. Accumulation of misstatements identified
3. Evaluate overall scope of our audit
4. Evaluate the effect of uncorrected misstatements on the FSs
5. Communicate with management and TCWG.
Identifying Material Classes of
Transactions, Account Balances and
Disclosures
The auditor, after determining materiality and gaining sufficient
understanding of the entity and its environment including internal control,
identifies material classes of transactions, account balances and disclosures
from the entity’s trial balance, list of accounts and notes to FSs.
By identifying these items, the auditor focuses the audit only on what is
deemed material, thereby reduces its work on what is determined not to be
material
The auditor applies its professional judgment and should consider both the
account’s nature and amount, quantitatively and qualitatively, in deciding
whether an account is material or not. Quantitative consideration may involve
comparison on an account’s amount with materiality previously determined. If
an account’s amount exceeds materiality, this may be considered material.
However, there are accounts that may not be quantitatively material but may
deemed material qualitatively, such as those accounts involving accounting
estimates or suspicious account.
Types of Risk
The four critical components of risk that will affect the audit approach and
audit outcome are:
1. Business Risk – the risk that affects the operations and potential
outcomes of the entity’s organizational activities.
2. Financial Reporting Risk – the risk that relates to the recording of
transactions and the presentation of financial data in an entity’s financial
statements.
3. Audit Risk/Audit Engagement Risk – the risk that the audit may provide
an unqualified opinion on financial statements that are materially
misstated.
4. Other audit Engagement Risk – the risk auditors encounter by being
associated with a particular client: lost of reputation, inability of the client
to pay the auditor, or financial loss because management is not honest
and inhibits the audit process.
Audit Risk and The Audit Risk Model
Audit risk is the risk (likelihood) that the auditor gives an inappropriate audit
opinion when the FSs are materially misstated. Audit risk is a function of the
risk of material misstatement and detection risk [AR = ROMM x DR].
Risk of Material Misstatement (ROMM)
The ROMM refers to the likelihood that the financial statements are
materially misstated prior to the audit.
The ROMM may exist at two level:
▪ The overall financial statement level; and
▪ The assertion level for classes of transactions, account balances, and
disclosures.
Audit Risk and The Audit Risk Model
Inherent Risk
Inherent risk is the susceptibility of an assertion about a class of
transaction, account balance or disclosure to a misstatement that could
be material, either individually or when aggregated with other
misstatements, before consideration of any related controls.
Inherent risk is higher for some assertions and related classes of
transactions, account balances, and disclosures than for others.
Audit Risk and The Audit Risk Model
Control Risk
Control risk is the risk that a misstatement that could occur in an
assertion about a class of transaction, account balance or disclosure
and that could be material, either individually or when aggregated with
other misstatements, will not be prevented, or detected and corrected,
on a timely basis by the entity’s internal control.
Control risk is a function of the effectiveness of the design,
implementation and maintenance of internal control. However, internal
control, no matter how well designed and operated, can only reduce,
but not eliminate, risks of material misstatement in the financial
statements, because of the inherent limitations of internal control.
Accordingly, some control risk will always exists.
Audit Risk and The Audit Risk Model
Detection Risk
Detection risk is the risk that the procedures performed by the auditor
to reduce risk to an acceptably low level will not detect a misstatement
that exist and that could be material, either individually or when
aggregated with other misstatements.
For a given level of audit risk, the acceptable level of detection risk
bears an inverse relationship to the assessed risk of material
misstatement at the assertion level. The higher the assessed level of
risk of material misstatement, the lower the detection risk the auditor
sets, and vice versa.
Limitations of Audit Risk Model
The audit risk model has the following limitations:
▪ Inherent risk is difficult to formally assess.
▪ Audit risk is judgmentally determined.
▪ The model treats each risk component as separate and independent.
▪ Audit technology is not so precisely developed that each component
of the model can be accurately assessed.
Because of these limitations, many auditors use the audit risk model as
a functional one, rather than mathematical model.
Relationships among Materiality, Audit
Procedures, Audit Evidence and Audit Risk
Components
Materiality and Audit Procedures
The level of materiality has an inverse relationship on audit procedures.
The lower the materiality (performance materiality), the more
extensive the required audit procedures to be able to gain reasonable
assurance that the class of transactions, account balance, or disclosure
is not materially misstated.
Risk of Material Misstatements, Detection Risk and Audit Procedures
The higher the assessed level of risk of material misstatement, the
lower the detection risk, the more rigorous(nature, timing and extent)
the substantive audit procedures should be performed, and vice versa.
Relationships among Materiality, Audit
Procedures, Audit Evidence and Audit Risk
Components
In summary:
Substantive Audit Assessed level of Assessed level of
Procedures ROMM is high ROMM is low
Nature More effective Less effective
Timing At year end At interim dates
Extent More extensive Less extensive
Relationships among Materiality, Audit
Procedures, Audit Evidence and Audit Risk
Components
Audit Risk and Materiality
There is an inverse relationship between materiality and the level of
audit risk, i.e., the higher the materiality, the lower the audit risk, and
vice versa. The auditor takes the inverse relationship between
materiality and audit risk into account when determining the nature,
timing and extent of audit procedures.
Materiality and Audit Evidence
Materiality and audit evidence are inversely related. The lower the level
of materiality the auditor determines, the more audit evidence must be
obtained (and vice versa) in order to gain more confidence (assurance)
that the item is not materially misstated.
