1. Materiality Considerations in an Audit
Dr. Donald K. McConnell Jr.
11/30/2018

2. Materiality: a Difficult Concept for Inexperienced Auditors to Grasp
It’s not your fault! We educate you with the wrong mindset!
Materiality should be viewed in relation to audit client’s size; not your personal finances
11/30/2018

3. Why Must We Develop Materiality Criteria in an Audit?
Adequate planning requires preliminary judgments about materiality levels for audit purposes (Au )
The audit report says the financial statements present fairly in all material respects
Once established, materiality defines:
Levels for audit AJE’s
Scopes for audit testing
11/30/2018

4. FASB Tried to Define Materiality
Issued an extensive Discussion Memorandum (DM) years ago
Charge: to develop materiality criteria the profession could use
Conclusion: no consensus could be reached!
Materiality is a matter of auditor’s judgment
11/30/2018

5. FASB Concepts Statement No. 2 Defines Materiality Qualitatively
“… the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”
11/30/2018

6. Materiality Has Two Dimensions
Qualitative aspects
Quantitative aspects
11/30/2018

7. CPA Firms Tend to Want to Use Quantitative Measurements
Inexperienced audit seniors can readily plug numbers from financial statements into a formula
Intrafirm consistency in defining materiality is desirable!
11/30/2018

8. One Major CPA Firm’s Pre-Au 312 Response to Lack of Authoritative Guidance
Quantitative materiality defined (a black box approach):
The greater of total assets or revenues
Times 1.6
Quantity raised to the two-thirds power!
M=[Greater of TA or Rev x 1.6]^2/3
Au later said should be “lower of”
11/30/2018

9. How Do We Develop Quantitative Materiality in the Planning Phases?
The problem: materiality must be defined three to four months before year end
The underlying theory of analytical procedures is relevant
Data relationships may reasonably be expected to exist and continue in the absence of known contrary conditions (Au )
Therefore last year’s audited figures should be a good starting point
11/30/2018

10. A Quantitative Approach to Calculating Materiality
[Arens text (figure 9-2) and course packet]
11/30/2018

11. Qualitative Aspects of Materiality
Sometimes more important than quantitative guidelines
The interaction of quantitative and qualitative considerations can cause relatively small misstatements to have a material effect on the financial statements (Au )
Examples:
The CEO claims a few hundred dollars improperly on an expense report
A quantitatively immaterial reduction in working capital violates a bond indenture restriction
11/30/2018

12. The SEC Recently Admonished Auditors to Pay More Attention to Qualitative Aspects [SAB 101]
11/30/2018

13. Qualitative Materiality Cases
BarChrisCorp. sold bonds to the general public under an S-1 registration. Financial position and earnings were found subsequently to be materially misstated. The judge ruled that earnings per share being overstated by 15.3% was immaterial, while current ratio being overstated 15.6% was material!
The judge reasoned that prospective bondholders would be much more concerned by an overstatement of a company’s key liquidity measures than by an overstatement of earnings, especially in light of the Company’s history of liquidity problems and significant working capital needs.
11/30/2018

14. Qualitative Materiality Cases [con.]
The SEC ruled (in an AAER) that an otherwise immaterial loss accrual the auditors had not required W.R. Grace Company to book was material, because this affected a trend in earnings.
Though quantitatively small to the audit materiality gauge, failure to book the accrual had continued an upward earnings trend which would have not occurred, had the accrual been booked.
11/30/2018