In planning the audit, the auditor makes judgments about misstatements that will be considered material. 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 users taken on the basis of the financial statements. Generally, auditors place focus on quantitative materiality considerations and tend to forget qualitative disclosures that could also be indicative of a misstatement being material by nature. It is important to consider and document all relevant aspects when determining the materiality levels and material qualitative disclosures relevant to the audit. Only when this is properly considered and determined, can appropriate conclusions be drawn.
Determining the overall 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. A common mistake by auditors is to justify their selection of the overall materiality level based on their assessment of risk. Overall materiality should be based on the level of overall materiality that could be expected to influence the economic decisions of users taken on the basis of the financial statements.
Apart from determining a quantitative materiality threshold, the auditor also needs to apply their mind to identifying the qualitative characteristics that could influence the decisions made by the users of the financial statements. For example, instances of non-compliance and fraud may be qualitatively material, irrespective of the amount of the misstatement involved. When considering whether misstatements in qualitative disclosures could be material, the auditor may identify relevant factors such as:
- The circumstances of the entity for the period, for example, the entity may have undertaken a significant business combination during the period
- The applicable financial reporting framework, including changes made, for example, a new financial reporting standard may require new qualitative disclosures that are significant to the entity
- Qualitative disclosures that are important to users of the financial statements because of the nature of an entity, for example, liquidity risk disclosures may be important to users of the financial statements for a financial institution.
After determining the appropriate overall materiality level and qualitative materiality factors, the auditor determines the performance materiality level and trivial threshold. This is not a simple mechanical calculation and involves the exercise of professional judgment. It is affected by the auditor’s understanding of the entity, updated during the performance of the risk assessment procedures, and the nature and extent of misstatements identified in previous audits, and thereby, the auditor’s expectations in relation to misstatements in the current period. Therefore, this is where the auditor’s assessment of risk comes into the equation, which may be used as part of the justification for the level of performance materiality and trivial threshold determined.
It is important for auditors to clearly document their considerations in support of their judgments made for overall materiality, performance materiality and the trivial threshold.
Separate materiality figures
In certain industries, it may be appropriate to determine separate materiality figures in instances where there is one or more class of transactions, account balance or disclosure that distorts the financial statements, or in some areas, where misstatements of lesser amounts than materiality for the financial statements, as a whole, could reasonably be expected to affect the economic decisions taken by users of the financial statements.
For example, a typical investment management entity does not have high- value assets or large expenses, but these items may still influence the users of the financial statements. Also, agencies and businesses selling products for other businesses at low margins or commissions tend to distort the balance between revenue and the other sections of the financial statements. Materiality based on revenue will be distorted when compared to other sections of the financial statements, causing the other sections to receive too little audit attention, compared to their influence on the users of the financial statements. Therefore, separate materiality figures for other sections may be appropriate.
Auditors must document their considerations in support of their judgments made in this regard.
Revision of materiality
During the audit, the auditor may become aware of information that would have caused the auditor to determine a different amount initially, if it was known during planning. Changes in circumstances may occur, new information may come to light, or the auditor’s understanding of the entity and its operations may change because of him having performed further audit procedures. For example, if, during the audit, it appears that actual financial results are likely to be substantially different from the anticipated period-end results that were used to determine materiality, the auditor should revise materiality accordingly.
If overall materiality (and separate materiality figures) is revised to a lower level, it is critical to consider and document whether it is necessary to revise performance materiality, and whether the nature, timing and extent of the further audit procedures remain appropriate.
Materiality drives many important decisions during an audit and a significant amount of professional judgment is involved in setting the appropriate materiality levels for an audit. Appropriate levels can only be determined based on a sound understanding of the entity, its industry and circumstances, and need to be properly justified on file.
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1. IAASB, ISA 320: Materiality in planning and performing an audit