The auditor uses the idea of Materiality to assess the risks of material misstatement and determine the nature, timing, and scope of risk assessment methods. This approach is crucial to the audit process as a whole.
Thus, Materiality is an essential aspect of auditing.
This article will cover everything about the materiality concept in audit, its types, why it is necessary, and what factors are responsible for affecting Materiality.
What is Audit Materiality?
Choosing a benchmark that has been utilized to effectively ensure that if the auditor does not discover any accounting error, it won’t materially mislead the clients of the financial statements is known as “audit materiality.
International Financial Reporting Standards (IFRS) asserts that any transaction can be regarded as substantial if its exclusion or misstatement from the financial statements can potentially affect the decision of the various stakeholders.
Materiality in audit refers to quantitative and non-quantitative disclosures and amounts in financial statements. For instance, the user of financial information may be influenced economically by the lack of or insufficient exposure to accounting policy for a significant portion of the financial statement.
Factors Affecting Materiality
Following the firm’s guidelines or a general rule of thumb is not sufficient for calculating Materiality.
For reference, a team of engagement experts determines Materiality as 10% of adjusted earnings before tax after eliminating extraordinary items. The choice of Materiality would still need a great deal of professional judgment, even if the firm had materiality standards restricting the engagement team’s selections.
How did the engagement team determine, for instance, that 10% was suitable and that net income was a convenient base?
To Ascertain the overall Materiality:
- The auditor’s decisions are influenced by the degree, nature, or combination of the misstatement and the company’s circumstances.
- The general financial data needs for users as a group, rather than the particular requirements of each user, are considered when making decisions about items that are material to users of the financial statements.
How to Determine the Audit Materiality?
There is no concrete structure for determining the audit materiality of any transaction within the financial statements, as was already indicated above. However, auditors frequently depend on their professional judgment or specific rules (described under “Audit Materiality guidelines).
Since the concept of Materiality is relative and greatly influenced by size and external factors, the auditor must have a solid understanding of how to apply it. The degree and kind of error are considered when determining whether it is substantial.
Example of Audit Materiality
Let’s take the case of the company Aayush Bhaskar Pvt Ltd. as an example, which requested a ₹5,00,000 loan from the bank. The bank provided the loan, but only under the condition that the business’s current ratio does not drop below 1.0.
The business accepted this, and a contract with the bank was created. The company’s auditor learned about this arrangement while carrying out the audit.
The company’s current ratio is only a little bit higher than 1.0. For the company’s auditor, a slight error of ₹12000 can now be significant. It can result in a breach of the contract between the business and the bank.
The company’s current ratio would drop below 1.0 with the ₹12,000 error added on. As a result, given that it may result in an agreement violation, this would be considered material to the audit. It may legitimately affect how the users of the company’s financial statements make economic decisions.
Why Is Audit Materiality Important?
- The crucial idea of audit materiality considers both quantitative and qualitative factors. Both factors affect how the company’s financial statement users make financial decisions.
- Their economic decisions are greatly influenced by qualitative factors, including the company’s sufficient disclosure of contingent liabilities, related party transactions, changes in accounting rules, etc.
- It serves as the foundation for the auditor’s view of the company since it gives the auditor the assurance needed to determine whether or not the company’s financial statements are free of serious misstatements.
Relevance of Audit Materiality
The financial statements as a whole, including their content and type of testing, must be considered by the auditor when determining the Materiality level. The auditor’s conclusion is based on their assessment of the amount, nature, context, and effect on users of the financial statements due to the misrepresentation.
Limitations of Audit Materiality
- The objective of the Materiality may be hampered if the auditor cannot set it at the appropriate level.
- The company’s auditor may miss the misrepresentation that impacts the company’s compliance with regulatory standards.
- Comparatively to the quantitative technique, the qualitative approach is typically fairly challenging to measure.
Types of Materiality
Materiality meaning in audit, can be divided into four types. All four types are mentioned below:
Overall Materiality
The auditor establishes Materiality for the entire financial statements while designing the overall audit plan. Above that point, the financial statements would be significantly misstated. This is considered overall Materiality or “materiality for the financial statements as a whole.”
Performance Materiality
As a “safety net,” performance in audit materiality is set below overall Materiality to reduce the possibility that all unrepaired and undiscovered misstatements will have a material impact on the financial statements.
Performance materiality permits the auditor to react to specific risk evaluation (without affecting overall Materiality) and to bring the possibility that the total of unrepaired and undiscovered misstatements surpasses overall Materiality to an adequately low level.
Specific Materiality
The materiality level chosen to identify potential errors is known as specific Materiality. These could exist across several departments within an organization for specific types of transactions and for account balances that could influence the users of the company’s financial statements’ economic choices.
Specific performance materiality
Performance materiality and specific performance materiality are identical concepts; however, specific performance materiality is measured based on specific Materiality rather than overall Materiality.
Some Important Points
- In the context of audit materiality, both the quantitative and qualitative factors are taken into account.
The quantitative factors include putting up a preliminary judgment for the Materiality, evaluating the performance materiality, calculating the number of misstatements in a cycle, accounting, etc.
The qualitative factors include making enough disclosures about the company’s contingent liabilities, making the appropriate disclosures about dealings with the company’s connected parties, making the disclosure regarding any changes in the company’s accounting policy, etc.
- Recognized Misrepresentations, Probable Misstatements, Apparent Aggregate Misstatements, Additional Possible Misstatements, and Maximum Allowable Misstatements are only a few of the forms of misstatements that an auditor must take into account while dealing with significant misstatements.
- There are three categories of audit materiality: overall, performance, and specific. The auditor uses these in various business scenarios.
Conclusion
The opportunity is provided by audit materiality to the company, auditor, and viewer of the financial statement. The materiality level is set at the point where it is conceivably possible for users of the company’s financial information to be influenced economically.
As a result, the principle of audit materiality is essential because it serves as the foundation for the audit’s task scope. In the end, the shareholders and other end users of the financial statements find the final judgment of the auditor in the financial statements to be the most influential economic decision-making instrument.
References
- Materiality in audits – Audit Committee Guide – Publications – ASSURANCE & AUDIT – PwC Australia
- Materiality Threshold in Audits – Overview and Methods (corporatefinanceinstitute.com)
- https://us.aicpa.org/content/dam/aicpa/research/standards/auditattest/downloadabledocuments/au-c-00320.pdf
- Audit Materiality: How to Understand – CPA Hall Talk
- Materiality Threshold in Accounting Overview & Examples | What is Materiality in Accounting? – Video & Lesson Transcript | Study.com
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