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06 Materiality
06 Materiality
Undergraduate audit courses teach the principles of materiality, but do not explain how materiality is
applied in an actual audit. Understanding how this is done clarifies the relationship between materiality
and risk.
There are two steps to calculating materiality. The first step is to determine reporting materiality. This
is the concept of materiality that most students are familiar with. A misstatement in excess of this
amount would result in the financial statements being materially misstated.
Reporting materiality is normally calculated as 5 percent of net income from continuing operations. If
the company has a tax minimization objective, then it is computed as 1 percent of revenues. The
materiality for a notforprofit entity is usually between ½ – 2 percent of total revenues or expenses.
The second step is to determine planning materiality or tolerable error. Tolerable error is normally
calculated as ½ of reporting materiality. Financial statement accounts greater than tolerable error are
considered significant because they might contain a material misstatement. Most of the audit work is
concentrated on significant accounts. Accounts less than tolerable error are considered insignificant
and involve relatively less audit work.
Tolerable error is set at ½ of reporting materiality to reflect the possibility of both overstatements and
understatements. For example, suppose reporting materiality is $1 million and the balance of accounts
receivable and accounts payable are both $750,000. Also suppose that accounts receivable is overstated
by $500,000 and accounts payable is understated by $500,000, producing a total misstatement of $1
million. If reporting materiality was used to identify significant accounts, both accounts would be
considered insignificant, and a material misstatement would be ignored. Therefore, the purpose of
tolerable error is to identify balances that are large enough to possibly contain a misstatement.
Note that, if most of the audit work is being after yearend, materiality and tolerable error are based on
the client's preliminary financial statements. However, because most audits involve significant interim
work (i.e. testing before yearend), these calculations are initially made based on proforma statements.
Proforma statements consist of actual yeartodate results plus projections for the remainder of the
year. After yearend, proforma materiality is revised to reflect actual results.
At this point, the materiality section of the file is complete. We will now explain the role of materiality
in the working paper stage of the file.
Tolerable error is also used to determine the threshold for substantive testing for a significant account.
Transactions above this threshold are referred to as key items, which the auditor tests. Nonkey items
are ignored as immaterial. In order to determine the threshold, the auditor incorporates the combined
risk assessment (CRA) of the significant account. Inherent and control risk assessments are made at
the end of the planning stage and IR x CR = CRA. However, regardless of the CRA, the auditor's goal
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is to reduce audit risk to an acceptably low level (i.e. 5%) Based on the equation IR x CR x DR = AR,
we know that the greater the CRA, the lower the level of detection risk required to achieve the
acceptable level of audit risk. The auditor can lower detection risk by doing more testing. This
involves lowering the testing threshold and increasing the number of key items selected for testing.
Therefore, the greater the CRA, the lower the percentage of tolerable error used as a testing threshold.
This is reflected in the following chart:
As an example, consider a company with ten customers. The first customer has a receivables balance
of $10,000, the second customer has a balance of $9,000, the third customer has a balance of $8,000
and onward. Suppose the auditor is trying to determine how many accounts to select for confirmation.
Tolerable error is $10,000 and the assessed level of inherent risk and control risk are high. In this case,
the auditor would confirm accounts greater than 25 percent of tolerable error, which is seven customers.
Now suppose the assessed level of inherent risk and control risk is low. In this case, the auditor would
confirm accounts greater than 75 percent of tolerable error, which is three accounts. In both cases it
was the auditor's objective to reduce audit risk to an appropriately low level. In the first case, this
involved lowering the detection risk by doing more substantive testing. In the second case, detection
risk could be higher because the assessed level of risk was lower.
In summary:
(1) It is always the auditor's objective to reduce audit risk to an appropriately low level. Audit
risk remains constant at 5%
(2) The higher the CRA, the lower the necessary level of detection risk to achieve the
appropriate audit risk.
(3) The auditor can lower detection risk by auditing to a lower percentage of tolerable
error used to select key items
As a final note, reporting materiality is also used to determine the nominal amount, which is usually 5
percent of reporting materiality. An error in excess of the nominal amount is recorded on the schedule
of audit differences, where it is aggregated with other errors. Errors less than the nominal amount are
ignored as immaterial or "small passed".
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