Audit & Assurance Audit Materiality Mwamba Ally Jingu: FCPA; PhD

Audit Materiality
International Standard on Auditing (ISA) 320 Materiality in Planning and Performing an
Audit
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

The International Standards on Auditing (ISA) 200 makes clear that the purpose of an audit
of the financial statements is to enable the auditor to express an opinion on whether the
financial statements are prepared, in all material respects, in accordance with the International
Financial Reporting Standards (IFRS). The financial statements prepared under IFRS enables
the auditor to obtain reasonable assurance that the financial statements as a whole are free
from material misstatement, whether due to fraud or error. The question is what are material
misstatements?

ISA 200 explains that in general, misstatements, including omissions, are considered to be
material if, individually or in the aggregate, they could reasonably be expected to influence
the economic decisions of users of the financial statements. Judgements about materiality are
made in the light of surrounding circumstances. They are affected by auditors’ perceptions of
the financial information needs of users of the financial statements. The concept of
materiality is therefore fundamental to the audit. It is applied by auditors at the planning
stage, and when performing the audit and evaluating the effect of identified misstatements on
the audit and of uncorrected misstatements, if any, on the financial statements.

While materiality is first determined at the planning stage, auditors need to be mindful that
circumstances may change during the audit or some of the audit findings may mean that the
initial assessments have to be reassessed. The ISA does, however, highlight some key words
and phrases in relation to materiality in the context of an audit which include:
• Misstatements (including omissions) which could influence decisions of users of the
financial statements;
• Judgement (i.e., there is not a single right answer) based on surrounding circumstances
including the size and nature of the misstatement; and
• Decisions on materiality are based on the users’ common needs as a group.

Choosing a benchmark

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Audit & Assurance Audit Materiality Mwamba Ally Jingu: FCPA; PhD

ISA 320 includes a number of factors to consider when choosing a benchmark. These include
the nature of the entity and the industry in which it operates and whether users focus on
particular items in the financial statements. Also important is the relative volatility of the
benchmark, so some reference to previous periods is common. The benchmark chosen should
therefore link to what the users are most concerned about in the financial statements.

Appropriate benchmarks
ISA 320 gives a number of examples of benchmarks that can be used. These include:

gross profit, total equity, net assets.

Calculating materiality
There are a number of benchmarks which can be selected to calculate materiality and a range
of materiality percentages that could be used when calculating materiality. ISA 320 doesn’t
specifically mention the ranges of percentages that can be used. Thus this is left to the
auditor’s judgment, however, common percentages used are:

Revenue (0.5% to 1%)

Total Assets (1% to 2%)
Net assets (2% to 5%)
Profit after tax (5% to10%)

Ideally the one selected by the auditor should be the benchmark that most represents the
needs of the users of the financial statements. From the above, it should now be clear the
extent of judgment required by the auditors when calculating materiality at the planning
stage. This article has only looked at calculating materiality for the financial statements as a
whole.

Example - Size

A default by a customer who owes only TShs 100,000 to a company having net assets of
worth TShs 500, 000,000 is immaterial to the financial statements of the company. However,
if the amount of default was, say, Shs 2,000,000 the information would have been material to
the financial statements omission of which could cause users to make incorrect business
decisions.

Audit Materiality is defined from the perspectives (views) of the users of the financial
statements

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Audit & Assurance Audit Materiality Mwamba Ally Jingu: FCPA; PhD

THE 5% RULE
For many years accountants have used quantitative estimates to help them identify
potentially material transactions and events. Working materiality levels or quantitative
estimates of materiality generally are based on the 5% rule, which holds that reasonable
investors would not be influenced in their investment decisions by a fluctuation in net
income of 5% or less. Nor would the investor be swayed by a fluctuation or series of
fluctuations of less than 5% in income statement line items, as long as the net change was
less than 5%. This theory has been and remains the fundamental concept behind working
materiality estimates today

Materiality should be considered by auditors when planning and evaluating the results of an
audit. No authoritative guidance is provided on factors that should be considered when
establishing materiality for planning or evaluation purposes. During the planning phase of an
audit, auditors establish materiality to determine the nature, timing, and extent of audit
procedures to perform. Auditors commonly establish a quantitative amount for materiality
during the planning phase. This quantitative amount will be referred to as "planning
materiality" as it can change if audit circumstances change. Factors to consider when
establishing planning materiality include:
 Users of the financial statements (i.e., creditors, stockholders, suppliers, employees,
customers, regulators),
 Size of financial statement elements (i.e., Current Assets, Current Liabilities, Total
Assets, Total Revenues, Net Income),
 Trends (i.e., Earnings, Revenues, Cash Flows).

Though not cited as an example in the ISA, gross assets (as well as net assets) might be
appropriate for an entity with significantly higher values in the balance sheet compared to its
income statement For profits it is reasonable to use an average of the benchmark (e.g., the
average adjusted profit before tax over 3–5 years) which can smooth out the volatility. Of
course, it is always a matter of professional judgement and auditors need to be clear why they
have chosen a particular route. While profit is deemed to be an important benchmark in a
profit-making business. However, this can raise a number of questions:
• What if the profits are very volatile from one year to the next?

• What if the entity has made a loss in the year?

• What if the entity has broken even in the year?

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Audit & Assurance Audit Materiality Mwamba Ally Jingu: FCPA; PhD

It doesn’t seem unreasonable to argue that an item that turns a profit into a loss or vice versa
must be material. But if that is taken to its logical conclusion, sooner or later auditors of a
multi-billion TZS business are going to be faced with a very low materiality. Clearly it seems
reasonable to include items that are defined as exceptional in the accounting framework
because users generally focus on the underlying performance of the business. But often
auditors will also include things like the remuneration paid to owner managers (ISA 320.A9 )

Materiality Fraudulent financial Reporting.

The other perspective on working materiality is financial fraud. Fraud generally is not limited
by amount but rather by intent. In other words, if the intent was to defraud someone by TZS
1000 or by TZS 50,000,000 it’s still fraud. It’s not the amount that makes it fraud. A material
misrepresentation is not tied to the amount of the misrepresentation but rather occurs
whenever there was intent to misrepresent the financial statements. Therefore, if somebody
makes a TZS10,000 entry giving a company the one cent it needs to meet its earnings target
and the entry was not based on IFRS but rather on management’s need to meet this target, the
entry was a material misrepresentation. This explains why management’s intent always
should be to fairly present in all material respects the results of operations and condition of
assets when recording any accounting entries into the company’s books and records.

Materiality = quantity and quality

Both the amount (quantity) and nature (quality) of misstatements are relevant to deciding
what material is. Quantitative The materiality level is often determined by applying a
percentage to a chosen benchmark. There is no definitive figure for this percentage, such as
more than 10 per cent is material, because of the number of variables which could apply.
Examples of benchmarks are categories of reported income such as, total revenue, gross or
net asset value.
Using the percentage a numerical threshold may provide the basis for a preliminary
assumption that a deviation of less than that percentage is unlikely to be material.
However, quantifying the size of a misstatement in percentage terms is only the start, and
cannot be used as a substitute for a full analysis of all relevant considerations. Qualitative
Materiality also relates to the nature of the item in the context of the particular
circumstances of its misstatement. Examples of qualitative misstatements
• The inadequate or improper description of an accounting policy.
• Failure to disclose a breach of regulatory requirements when the imposition of regulatory
restrictions will significantly impair operating