S.C. Vasudeva & Co.2 Scope Objective Definitions Materiality in context of an Audit Requirements Determining Materiality & Performance Materiality Revision of Materiality Documentation
SA 320 deals with the auditor’s responsibility to apply the concept of materiality in planning and performing an audit of financial statements. Objective The objective of the auditor is to apply the concept of materiality appropriately in planning and performing the audit. 3S.C. Vasudeva & Co.
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 as a whole 4S.C. Vasudeva & Co.
Financial Reporting Framework Financial reporting frameworks normally discuss “materiality” in context of preparation & presentation of financial statements:- Misstatements are material if in aggregate /individually may influence economic decision of users of financial statements. Judgments on materiality made in light of surrounding circumstances and are affected by the size or nature of a misstatement or a combination of both, and Judgments about matters that are material to users of the financial statements are based on a consideration of the common financial information needs of users as a group. Contd.. 5S.C. Vasudeva & Co.
Concept of Materiality Concept of materiality in context of audit according to “Guidance note on accrual basis of accounting issued by ICAI”- The aspects of materiality is a vital factor as to nature & extent of audit coverage required in conducting an audit that is framing of audit programe with keeping in mind materiality a)As per AS-1 “ Disclosure of Accounting Policies” “Financial Statements should disclose all “material” items i.e items the knowledge of which might influence the decisions of the users of the financial statements” b) Concept of “True & Fair” also recognizes that the concept of materiality must be given due importance in the preparation and presentation of financial statements 6S.C. Vasudeva & Co.
Concept of Materiality c) Guidance Note on accrual basis of accounting issued by ICAI provides concept of materiality in the context of an Audit as follows: The aspects of materiality is vital factor as to the nature and extent of audit coverage required in conducting of an audit i.e. the question of materiality has a direct bearing in shaping an audit programme aiming to conduct an audit effectively. d) Materiality Concepts as per RBI Guidelines based on N.D. Gupta Committee “ In his approach to audit the auditor should keep in mind the concept of ‘materiality’. Items that do not materially affect the views presented by the financial statements may be ignored. In case of some banks, Head Office circular indicates the quantum of materiality to be considered by the branch auditor. The concept of materiality is fundamental to the reporting of information. Materiality depends on the size, nature and circumstances. Hence, the branch auditor has to decide on the materiality taking into account the amount involved and the impact of the financial statement. If there is a basic mistake in the accounting principle, then such transaction may be reported through Memorandum of Changes even if the amount involved is not material. 7S.C. Vasudeva & Co.
Materiality in the context of Financial Reporting Framework Disclosure for items of income and expenditure which exceeds 1% of revenue from operations or Rs 100,000 whichever is higher. Revised Schedule VI Disclosure for items of expenditure which exceeds 1% of total revenue or Rs 5,000 whichever is higher. Old Schedule VI 8
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. In this context the auditor assumes that users : 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; Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates; Understand that financial statements are prepared, presented and audited to levels of materiality; and Make reasonable economic decisions on the basis of the information in the financial statements. 9S.C. Vasudeva & Co.
Illustrative Factors for Consideration of Materiality: Factors for considerationIllustration Materiality to users is based on common financial need of users of group and thus possible effect of misstatement on specified individual user whose need may vary widely need not be considered, Paragraph 10 of the “Framework for the Preparation and Presentation of Financial Statements,” issued by ICAI in July 2000, indicates for a profit oriented entity that “as provides of risk capital to the enterprise, investor need more comprehensive information than other users. The provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy”. 10S.C. Vasudeva & Co.
Illustrative Factors for Consideration of Materiality: Factors for considerationIllustration Apart from the size (or magnitude) of an item, its nature is also an important factor in determining whether or not it is material in the facts and circumstances of a case If the discovery of an illegal payment, even of a small amount could result in the closure of an enterprise, the item is material. Similarly, inadequate or improper description of an accounting policy would be material if it is likely to mislead the users of the financial statements. An item of information is material, if its omission or misstatement can influence the economic decisions of the users of the information. If fake sales of significant amounts are recorded in the books of account of a company, it would result in over- statement of sales and profit as shown by the financial statements. A potential investor may be induced by the figure of profit shown in the financial statements to invest in the shares of the company. 11S.C. Vasudeva & Co.
Illustrative Factors for Consideration of Materiality: Factors for considerationIllustration What is material depends upon the particular facts and circumstances of each case. For example, omission of sale invoice of Rs. 10000/- in an enterprise with turnover of say Rs. 1000/- crores, may not normally be material. However, the omission could become material if the turnover of the enterprise were say Rs. 5 lacs. 12S.C. Vasudeva & Co.
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 FS, the overall objectives of the auditor are to obtain reasonable assurance about whether the financial statements are as a whole free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion. Materiality & risk are considered throughout the audit, in particular, when: Identifying and assessing the risks of material misstatement ; Determining the nature, timing and extent of further audit procedures; and Evaluating the effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report. 13S.C. Vasudeva & Co.
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 circumstances related to some misstatements may cause the auditor to evaluate them as material even if they are below materiality. The auditor considers not only the size but also the nature of uncorrected misstatements, and the particular circumstances of their occurrence, when evaluating their effect on the financial statements 14S.C. Vasudeva & Co.
Determining Materiality and Performance Materiality when Planning the Audit When establishing the overall audit strategy,the auditor shall determine materiality for the financial statements as a whole and if, in the specific circumstances of the entity, there is one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than the 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, the auditor shall also determine the materiality level or levels to be applied to those particular classes of transactions, account balances or disclosures. 15S.C. Vasudeva & Co.
Determining Materiality and Performance Materiality when Planning the Audit Use of benchmarks in determining materiality for financial statements as a whole 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. Factors that may affect the identification of an appropriate benchmark include the following: 16S.C. Vasudeva & Co.
Determining Materiality and Performance Materiality when Planning the Audit Use of benchmarks in determining materiality for financial statements as a whole The elements of the financial statements (for example, assets, liabilities, equity, revenue, expenses); 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 and Whether there are items on which the attention of the users of the particular entity’s financial statements tends to be focused (for example, for the purpose of evaluating financial performance users may tend to focus on profit, revenue or net assets); 17S.C. Vasudeva & Co.
Determining Materiality and Performance Materiality when Planning the Audit Use of benchmarks in determining materiality for financial statements as a whole Consideration specific to small entities Where entity’s profit before tax from continuing operations is consistently nominal and owner takes much of PBT in the form of remuneration then relevant benchmark may be=Profit before remuneration. In the case of certain entities, such as, Central/State governments and related government entities (for example, agencies, boards, commissions) regulators are often primary users therefore the benchmark would be influenced by Legislative & Regulatory requirements 18S.C. Vasudeva & Co.
For other than not for profit making entity For Not for Profit making entity 1% of Total Income or 1% of Total Expenditure Whichever is lower. i) For a company having consistent pattern of profit 5% of profit before tax ii) For a company having business losses 1% of Gross turnover iii) In other case 0.25% - 1.5% of Gross Fixed Assets /Capital Work in Progress Computation of Materiality 19S.C. Vasudeva & Co.
Materiality Levels –Levels of particular class of transactions Factors that may indicate the existence of one or more particular transactions,account balances or disclosures for which misstatements of lesser amounts than materiality for the financial statements would affect the economic decisions of users-: Whether law, regulations or other applicable financial reporting framework affect users expectations regarding the measurement or disclosure of certain items (eg. Related Party Transactions- For example - remuneration of management and those charged with governance ). The key disclosures in relation to the industry in which the entity operates(eg. research and development costs for a pharmaceutical company) Whether attention is focussed on a particular aspect of the entity’s business that is separately disclosed in the FS(eg. A newly acquired business) 20S.C. Vasudeva & Co.
Is the amount set at less than materiality to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality. The auditor shall determine performance materiality for purposes of assessing the risks of material misstatement and determining the nature, timing and extent of further audit procedures Planning the audit solely to detect individually material misstatements overlooks the fact that the aggregate of individually immaterial misstatements may cause the FS to ne materially misstated and leaves no margin for possible undetected misstatements 21S.C. Vasudeva & Co.
The determination of performance materiality is not a simple mechanical calculation and involves the exercise of professional judgment. It is affected by issues such as: The auditor’s understanding of the entity; Experience in the prior year audits; nature and extent of misstatements identified in prior year audits; auditor’s expectations in the current year; the risk assessment. 22S.C. Vasudeva & Co.
Example 1: Materiality for entity A has been set at Rs.50,00,000 for current period audit and the engagement team is about to determine performance materiality. Entity is an IT Consulting Firm and there have been no significant changes in the entity’s business, internal control, risk of material misstatements or management. The Entity has been a client for 5 Years and the uncorrected misstatements have been in region of 20%-30% of materiality. Last Uncorrected misstatements are 10,34,280/-. What would you, as auditor of the entity fix as the performance materiality? 23S.C. Vasudeva & Co.
Example 2: For entity “A ” materiality has been set at Rs. 50,00,000 again, the uncorrected misstatements in the previous audit were 1,243,257.There have been no significant changes in entity’s business, internal control or risk of material misstatements but the entity has partly new management starting a few months into the current period. What would you, as auditor of the entity fix as the performance materiality? 24S.C. Vasudeva & Co.
Example 3:Materiality for Entity ‘B’ has been set for Rs 900,000 for the current period audit. Entity ‘B’ is an importer of fine Italian wine and food and has been audit client for 2 years. There have been no significant changes in the entity’ s business, internal control, risks of material misstatement or management.Last audit’s uncorrected misstatement amounted to Rs 421,853 with two of the misstatements carrying over and reversing in the current period to an amount of Rs 171,853. The engagement team’s best estimate of the current period’s uncorrected misstatements is to be similar to the prior period. What would you, as auditor of the entity fix as the performance materiality? 25S.C. Vasudeva & Co.
Example 4: A student took an admission in an auditing course. Course contains 60 lectures in total. In order to qualify for exam entrance, students have to fulfill attendance criteria i.e. student can be absent from 10 lectures as a whole but not more than 1 lecture in a week. What is the minimum number of lectures he needs to attend in a year? What does the second level of restriction imply? 26S.C. Vasudeva & Co.
Answer The aforesaid attendance policy has two levels of restrictions. First that students cannot leave more than 10 lectures unattended during the whole course. Whereas, the second level is that maximum of one lecture can be left unattended in a particular week. This second restriction is probably there to ensure that no student miss 10 lectures in a row. A similar concept is true in auditing. Performance materiality (materiality established for a particular component inside financial statement for example an assertion level) i.e. materiality established while performing audit procedures on certain account balances and/or transactions etc is deliberately set lower than the materiality level for the financial statements as a whole so that overall misstatements are kept under the materiality level set for the financial statement as a whole. 27S.C. Vasudeva & Co.
The auditor shall revise materiality for the financial statements as a whole in the event of becoming aware of information during the audit that would have caused the auditor to have determined a different amount initially. Necessary to re-perform the calculations may be on the basis of result of change in circumstances that occurred during the audit For Example –a decision to dispose of major part of entity’s business or if the actual financial results are likely to be substantially different from anticipated results,new information, or a change in the auditor’s understanding of the entity and its operations as a result of performing further audit procedures. 28S.C. Vasudeva & Co.
The audit documentation shall include the following amounts and the factors considered in their determination: Materiality for the financial statements as a whole; If applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures; Performance materiality, and Any revision of the above as the audit progressed. 29S.C. Vasudeva & Co.