AUDIT MATERIALITY (1SA 320)

DEFINITION:

FASB (Financial Accounting Standards Board) Concept Statement 2 defines materiality as:

The magnitude of an omission or misstatement (error) of accounting information

that, in light of surrounding circumstances, makes it (probable) that the judgement
of a reasonable person relying on the information would have been changed or
influenced by the omission or misstatement.

As auditors are responsible for determining whether financial statements are

materially misstated or not, upon discovering a material misstatement, they must
bring to the client’s attention so that a correction can be made. If the client refuses
to correct the financial statements, the auditor should issue a qualified or an adverse
opinion depending on the materiality of the misstatement.

INTERRELATIONSHIP BETWEEN MATERIALITY & AUDIT RISK

The auditor should consider materiality and its relationship with the audit risk namely:

1) The higher the audit risk, the smaller the amount of materiality will be set to
compensate for this.

2) The lower the audit risk, the higher the amount of materiality could be set,
because the chances are few that material misstatements could occur and go
undetected.

PLANNING MATERIALITY

Planning materiality is a provisional judgement of materiality and is normally quantified to

help the auditor in determining the nature, timing and extent of the audit procedures to be
performed. Planning materiality is set in the planning phase of the audit and percentages
are often applied to a chosen benchmark as a starting point for the calculation.

The following indicators are generally used in practice to base materiality on:

Turnover ½% - 1%

Gross profit 1% - 2%

Net income 5% - 10%

Total assets 1% - 2%

Equity 2% - 5%

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The auditor needs to base materiality upon the most appropriate criteria for the entity that
will provide a stable basis. It can be a single indicator (i.e. using either a Statement of
Financial Position or Income Statement) or a combination of indicators (i.e. using both the
Statement of Financial Position and the Income Statement)

Because planning materiality gets determined before the final financial statements have
been compiled, the calculations are normally based on:

 Estimates or provisional information

 Budgets or forecasts

 Interim financial information

 Information from prior periods

 Current-year unaudited information e.g. management accounts.

EXAMPLE OF A POSSIBLE MATERIALITY CALCULATION

$`000 The following calculations are required:

Turnover 10 000 Gross profit = Turnover – Sales cost

Sales costs 2 500 ($10 000000- $2 500 000 = $7 500 000)

General & 5 000 Net profit = Gross profit-General &

administration costs administrative costs ($7 500 000-$5 000 000 =
$2 500 000)

Total assets 6 548

Equity 3 500

Net income 2 500

Once the data is in the correct format, using the materiality indicators as a guide, the
following calculations need to be done:

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PRELIMINARY MATERIALITY CALCULATIONS MADE FROM FIGURES GIVEN ABOVE

$ % $ $

Turnover 10 000 000 ½% - 1% 50 000 100 000

Gross profit 7 500 000 1% - 2% 75 000 150 000

Net income 2 500 000 5% - 10% 125 000 250 000

Total assets 6 548 000 1% - 2% 65 480 130 960

Equity 3 500 000 2% - 5% 70 000 175 000

After the calculations have been done, the auditor must consider the following:

 Audit Risk: Impact of the audit risk on the materiality figure ( the higher the
audit risk, the lower the materiality figure, and vice versa). This is thus an
indication whether the auditor will be settling on a materiality figure from the
higher range or lower range of the calculated figures.

 Stability Of Indicators: If an indicator is not stable, the auditor would not

consider using that indicator.

 Single Or Combination Of Indicators: The auditor can consider either using

either both the statement of financial position (balance sheet) and the
statement of comprehensive income (income statement) as indicators, or only
the statement of financial position, or only the comprehensive income. Some
authors discourage the use of combination of indicators as they argue that their
use lead to duplication of figures as some of the figures in the income statement
might also be found in the statement of financial position (e.g. closing
inventory).

FINAL MATERIALITY

Final materiality is established at the end of the audit and is used to evaluate identified
misstatements against, in order to determine the effect on the financial statements.

The auditor will need to reassess the amount of planning (preliminary) materiality,
given the knowledge gained during the audit, and the audit evidence obtained. This will
enable the auditor to assess whether the amount of planning materiality is still
appropriate, or whether it needs to be adjusted to measure audit differences and other
misstatements against. The final materiality figures would most likely be calculated on

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the actual audited figures of the current year.

DEFINITION OF AN AUDIT APPROACH:

An audit approach is the strategy or method to obtain audit evidence against which to
measure fair presentation of the financial statements. It contains the nature, timing and
extent of the audit procedures, namely tests of controls and substantive procedures.
Basically there are two audit approaches, namely the combined approach (using both
the tests of control & substantive procedures and the substantive approaches.

a) Combined Approach:-where the auditor intends to rely on internal controls for

a class of transaction or account balance, he will test the internal controls that
exist for that class of transaction or account balance. The result of the tests of
controls will affect the nature, timing and extent of the substantive procedures
to be performed for the assertions of the class of transaction or account
balance.

Testing the controls will have the benefits of:

 Adding value to the client

 Enabling the auditor to limit the substantive procedures

 Enabling the auditor to perform early verification procedures.

b) Substantive Approach:-where the auditor decides not to test the internal

controls but with the view that the audit evidence and audit assurance for the
assertions of a class of transaction or account balance will be obtained entirely
through substantive procedures. This is called a substantive approach.

The above may be the case where:

 No internal controls exist or they are not functioning effectively.

 It is not cost effective (i.e. to test internal controls)

 The nature of the accounts is such that substantive procedures are more
appropriate.

Meaning Of Nature, Timing, Extent Of Audit Procedures (Tests Of Controls &

Substantive Procedures

a) Nature: this relates to how the procedures will be performed i.e. either by tests
of controls or substantive tests

Tests of controls:- consist of inspection, observation, inquiry reconciliation re-

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 performance.

Substantive tests:-detail testing consisting of inspection, observation, inquiry,

recalculation, re-performance, confirmation and analytical review.

b) Timing

This relates to when the procedures are performed.

Test of controls:-these should be performed to cover the whole period of

reliance. The auditor should obtain audit evidence on the effective operation of
the controls for the entire period of reliance.

Substantive procedures:-these are performed to verify year-end balances. As a

result ,substantive procedures will be performed mainly at or after year-end.

c) Extent

This relates to how many items should be tested, namely the size of the sample.
Normally, the bigger the sample used, the more the reliance which is placed on
the test performed.

Test of controls:-the test of controls should be such to obtain sufficient

appropriate audit evidence that the controls operated effectively throughout
the period of reliance. The extent of test of controls will rely on;

 The frequency of the control procedure;

 The length of time of audit reliance on the control

 The expected deviation of the control

 The extent of the intended reliance.

Substantive procedures:-a sufficient number of substantive tests should be performed

(big enough samples) to substantiate the auditor’s opinion and to limit the detection
risk.

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