Materiality in Auditing and Business Size

Audit Practice and Procedures II - Materiality and Risk

• This week's topic is materiality and risk in audit procedures.
• A misstatement in financial statements is considered material if the knowledge of the misstatement affects a reasonable user's decision regarding the statements.
• Materiality levels are categorized as immaterial, material, and highly material, which relate to the significance of the misstatement in terms of reasonable user decisions.
• For immaterial misstatements, user decisions are unlikely to be affected.
• Material misstatements affect user decisions only if the information is important to the specific decisions being made, and the overall financial statements are presented fairly.
• Highly material misstatements significantly affect most or all users' decisions based on the financial statements.
• Auditors are responsible for identifying whether financial statements are materially misstated.
• If a material misstatement is found, auditors must bring it to the client's attention for correction.
• If the client refuses to correct the misstatement, the auditor issues a qualified or adverse opinion based on the materiality of the issue.
• Auditors rely on a thorough understanding of materiality.
• The phrase "obtain reasonable assurance" in audit reports informs users that auditors do not guarantee the fair presentation of financial statements.
• The phrase "free of material misstatement" informs users that the auditor's responsibility is limited to material financial information.
• Materiality is crucial because auditors cannot provide assurances on immaterial amounts.
• Materiality and risk are fundamental to audit planning and approach design.
• Determining materiality involves professional judgment and five related steps.
• These steps involve setting materiality for financial statements as a whole, determining performance materiality, estimating total misstatement in segments, estimating combined misstatement, and comparing the combined estimate with a preliminary or revised materiality judgment.
• The auditor first sets materiality for the financial statements as a whole and then determines performance materiality for segments.
• Step 3 involves estimating the total misstatement in certain segments throughout the audit.
• Steps 4 and 5 involve estimating the combined misstatement and comparing this with the initial/revised judgment for materiality respectively, which occurs during engagement completion.

Recap of Last Class

• Audit Evidence
• Types of Audit Evidence
• Audit Plan
• Audit Documentation

Materiality Definitions

• 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.
• Auditors are responsible for determining material misstatements to bring to the client's attention.

Materiality for Financial Statements as a Whole

• Auditing standards require auditors to decide on the combined amount of misstatements in financial statements that they would consider material early in the audit.
• This is referred to as the preliminary judgment about materiality.
• The preliminary judgment about materiality for financial statements as a whole is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users.
• This is conceptually an amount that is $1 less than materiality as defined, for convenience.
• Auditors set a preliminary judgment about materiality to help plan the appropriate evidence to accumulate.

Factors Affecting Preliminary Materiality Judgment

• Materiality is a relative rather than an absolute concept.

• Benchmarks are needed to evaluate materiality; for example, net income before taxes is often the primary benchmark for determining materiality for profit-oriented businesses, while other benchmarks, such as net sales, gross profit, or total or net assets, may be used.

• Qualitative factors also affect materiality, including the importance of fraud, contractual obligations, and financial trends.

Performance Materiality

• Performance materiality is defined as the amount(s) set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.
• Auditors must accumulate evidence by segments rather than the financial statements as a whole.
• Performance materiality helps auditors decide the appropriate audit evidence to accumulate.
• Performance materiality is inversely related to the amount of evidence an auditor will accumulate.

Factors Affecting Acceptable Audit Risk

• The degree to which external users rely on the statements.
• The likelihood that a client will have financial difficulties after the audit report is issued.
• The auditor's evaluation of management's integrity.

Factors Affecting Inherent Risk

• Nature of the client's business.
• Results of previous audits.
• Initial versus repeat engagement.
• Related parties.
• Complex or nonroutine transactions.
• Judgment required to correctly record account balances and transactions.
• Makeup of the population.
• Factors related to fraudulent financial reporting.
• Factors related to misappropriation of assets.
• Methods used to assess acceptable audit risk.

Financial Statement Assertions

• International auditing standards and AICPA standards classify assertions into three categories: - Assertions about classes of transactions and events for the period under audit. - Assertions about account balances at period end. - Assertions about presentation and disclosure.

Management Assertions

• Occurrence: Events or transactions recorded actually occurred.
• Completeness: All transactions and events that should be in the records are included.
• Accuracy: Transactions and events were recorded appropriately.
• Classification: Transactions and events are recorded in the proper accounts.
• Cutoff: Transactions and events were recorded in the correct accounting period.
• Rights and obligations: The entity holds rights to the assets it’s claimed and has obligations related to liabilities.
• Existence: Assets, liabilities, and equity interests exist at a certain balance sheet date.
• Completeness: All assets, liabilities, and equity interests that should have been recorded are recorded.
• Valuation and allocation: Assets, liabilities and equity interests are included in financial statements at appropriate amounts.
• Occurrence and rights and obligations of disclosed events or transactions.
• Completeness of all disclosures.
• Accuracy and valuation of financial and other disclosures.
• Classification and understandability of disclosures.

General Transaction-Related Audit Objectives

• Occurrence: Recorded transactions actually occurred.
• Completeness: All transactions that should be recorded have been recorded.
• Accuracy: Transactions were recorded at the correct amounts.
• Cutoff: Transactions or events were recorded in the correct accounting period.
• Classification: Transactions are recorded in the appropriate accounts.
• Timing: Transactions are recorded on the correct dates.

Balance-Related Audit Objectives

• Includes general and specific balance-related audit objectives.

Interim Audit

• Examination of books of accounts to check recording of transactions, done before the official conduct of a statutory audit.
• Purpose is early identification of threats, taking corrective measures.
• Objectives: Determine period profit; determine whether company can pay interim dividend; identify and early detect fraud, and improve employee efficiency.
• Characteristics: Conducted between two periods; In-depth analysis of transactions over defined period; Sometimes used to determine book value; Considered more reliable than audits without interim audits.
• Procedure: Analyze organization levels; gather information from internal/external sources; conduct the audit as per guidelines; document working papers; consider effects of material misstatement on the organization.

Benefits of Interim Audit

• Improved efficiency and effectiveness; less expensive than statutory audits; facilitates easy finalization of final accounts; employees are more thorough in their work; companies easily borrow funds; fraud risk decreased.

Limitations of Interim Audit

• Late corrections for errors; accounts may be delayed; audit reports are submitted late; low moral checks; planned frauds are undetected; past data; incomplete checking and planning for future.

Final Audit

• Performed after financial year-end.
• Also known as a periodic audit.
• Commences after year-end books of account are closed.

Advantages of Final Audit

• Economical, efficient.
• Staff duties separation.
• Convenient for management (single session or same-day process).
• Minimum time required.
• Planned work, Work continuity.
• No change in figures, small businesses.
• Relationships, full information/decision making.
• Thorough checking, legal requirements.
• Performance improvements.

Disadvantages of Final Audit

• Late corrections.
• Accounts delayed.
• Audit reports delayed.
• Low moral check.
• Planned frauds undetected.
• Past data, no concern with current situation.
• Incomplete thorough checking.
• Planning for future is problematic.
• Easy and quick detection of errors not possible.
• Accounts not presented quickly.

This quiz explores the concept of materiality in the context of auditing and how it relates to the size of a company. It delves into benchmarks for evaluating materiality, the significance of different types of misstatements, and the advantages of final audits. Test your understanding of these key auditing concepts and their implications for businesses.