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In a company having turnover of Rs. 50 Lakhs P.A. and a profit of Rs. 2 Lakhs P.A. The damages paid of Rs. 1 Lakh may be material and therefore may require separate
disclosure because of its relative size. However, the same information may not be material for a company having turnover of Rs. 100 Crore P.A. and profit of Rs. 15
Crore P.A. Violation of Law even of a very small amount will be considered as material.
The auditor’s determination of materiality is a matter of professional judgement and is effected by auditor’s perception of financial information needs of the users
of the financial statements.
AS 1 Disclosure of Accounting Policy Relationship between materiality and audit risk: There is an inverse
relationship between materiality & Audit Risk
Sometimes, the concept of materiality is also discussed in financial reporting framework but it is discussed in the context of
preparation and presentation of financial statements, not from the point of view of auditing but the bases which are used in
FRF can also be used for determining the level of materiality in auditing. FRF generally considers the following things for
determining materiality
• Items which could reasonably be expected to influence the economic decision of the user of the financial
statements.
• Surrounding circumstances & auditor’ perception of the financial information needs of the user of the financial
statements.
• Common financial information needs of the users or a particular group
Question
Materiality and audit risk – Short Note (Imp.)
Answer
Materiality and Audit Risk: SA 320 on 'Materiality in Planning and Performing an Audit' requires that the auditor should
consider materiality and its relationship with audit risk when conducting an audit.
o Materiality depends on the size and the nature of the items judged in the particular set of circumstances..
o The audit should be planned so that audit risk is kept at an acceptably low level.
o There is an inverse relationship between Materiality and the degree of audit risk.
o Accordingly, if we have high risk in an organisation we should keep our materiality level low.
o Higher the materiality levels the lower the audit risk and vice-versa.
o Audit Risk has three components – Inherent risk (IR), Control Risk (CR) & Detection Risk.
o If a company is having low IR & CR then the chances are material misstatement are also low.
o Auditor will keep his materiality level high. So if Risk is less Materiality levels will be high.
o If Risk is high auditor will keep his materiality level low so that he can detect greater number of misstatements.
NOTE
Auditor’s preliminary assessment of materiality helps the auditor to decide the question as to what items to
examine and whether to use sampling in audit procedure. By this exercise he will reduce the audit risk to an
appropriately low level.
Performance Materiality
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✓ For purposes of the SAs,
✓ Performance materiality means
✓ the amount or amounts set by the auditor
✓ at less than materiality
✓ for the financial statements as a whole
✓ to reduce to an appropriately low level
✓ the probability
✓ that the aggregate of misstatements exceeds materiality for the financial statements as a whole.
Benchmarking
1. Meaning: Benchmarking is one recognized method through which an Auditor determines the
materiality level. Under this method, a percentage is often applied to a chosen benchmark, as
a starting point in determining materiality for the Financial Statements as a whole.
2. Factors: Factors that may affect the identification of an appropriate benchmark include –
(a) Elements of the Financial Statement (e.g., Assets, Liabilities, Equity, Revenue,
Expenses)
(b) Whether there are items on which the attention of the users of the particulars Entity’s
Financial Statement tends to be focused (e.g., profit, revenue or net assets)
(c) Nature of the Entity, where the Entity is at in its life cycle, and the industry and
economic environment in which the Entity operates
(d) Ownership Structure and Financial Pattern (e.g., if an entity is financed more by Debt
rather than Equity, users may put more emphasis on Assets, and claims on them, than on the
Entity’s Earning) and
Selection of Appropriate Benchmarks: Examples of benchmark that may be appropriate, include categories of
reported income such as PBT, Total Revenue, Gross Profit and Total Expenses, Total Equity or Net Asset Value.
(a) Profit Before Tax from continuing operations is often used for profit-oriented entities.
In this regard if Profit Before Tax from continuing operations is volatile, other
benchmark may be more appropriate.
(b) In an audit of the entities doing public utility programs/projects, Total Cost or
Net Cost (Expenses less Revenues) may be appropriate benchmarks for that particular
program/project activity.
(c) Where an entity has custody of the assets, assets may be an appropriate
benchmark.
Few Transacations,
Large number of transaaction
and balances
Few Transacations :
Identical items High Amount , related parties,
unusual nature, Foreign Exchange
What precautions should be taken by an auditor while applying test check techniques?
Test Check Technique: While adopting test check technique, an auditor should take following precautions:
-
(iv) PLANNING
Preparation of test check plan with clear audit objective understood by the audit staff.
(v) Un-biased selection of the transactions with reference to the random number tables or other
statistical methods.
(vi) Identification of the areas where test check may not be done.
(viii) Setting up criteria to judge what constitute material or immaterial errors. Further investigation of
only material errors be carried out and all immaterial errors may be avoided.
Important Notes
1. Sample Size - Auditor shall determine a sample size sufficient to reduce sampling risk to an acceptably
low level.
2. Selection of items for testing - Samples should be selected in such a way that every item must have an
equal chance of selection.
3. Sample Design – While designing an audit sample auditor should consider the purpose of audit
procedure and characteristic of population from which the sample will be drawn
Sampling
Risk
Meaning In compliance
It arise from procedure In substantive
procedure
possibility that
Auditor's
conclusion based
upon sample, Risk of under reliance Risk of over reliance Risk of incorrect Risk of incorrect
Based upon sample, Based upon sample, Rejection Based upon Acceptance
May be different auditor concludes that auditor concludes that sample, auditor Based upon
from, I.C. system is not I.C. are very effective concludes that sample auditor
Conclusion that adequate, however & thus decides to rely transactions/ balances concludes that
would have been actually it is not so. on them, however it is are materially transactions/ balances
reached, not so in reality. misstated, whereas in are not materially
fact these are not. misstated while in fact
If same audit
these are misstated.
procedures were
applied on entire Auditor will have to do
population. more work however Auditor will have to do
audit report is not This may lead to more work however
It is always in errorneous errorenous opinion by audit report is not
This may lead to
sampling. Auditor errorenous opinion by
errorneous
Auditor
If acceptable sampling
risk is low, large
sample is needed.
It arises in both
compliance
procedures &
substantive
procedure.
Sampling Flow of
events
Investigate
SELECT SAMPLE
Nature Cause
In the extremely rare circumstances when the auditor considers a misstatement or deviation discovered in a sample to be an
anomaly, the auditor shall obtain a high degree of certainty that such misstatement or deviation is not representative of the
population. –
SURPRISE CHECKS
Is surprised checks desirable in audit, if so give important recommendations.
The need for and frequency of surprise checks is obviously a matter to be decided having regard to the
circumstances of each audit.
It would depend upon the extent to which the auditor considers the
• internal control system as adequate,
• the nature of the clients' transaction,
• the locations from which he operates and
• the relative importance of items like cash, investments, stores etc.
However, wherever feasible a surprise check should be made at least once in the course of an audit.
(3) The results of the surprise checks should be communicated to the management if they reveal any weakness in
the system of internal control or any fraud or error or deficiency in the maintenance of records.
(4) The auditor should satisfy himself that adequate action is taken by the management on the matters
communicated by him.
(5) It is not necessary in all cases for the results of the surprise checks to be included in the auditors'
report on the accounts. They should, however, be included if in the opinion of the auditor they are material
and affect a true and fair view of the accounts on which he is reporting.
If auditor expects
Maximum Error in
possibility of error in Studied Earlier
population that
population, larger
auditor is ready to
sample size is
accept for a given
required.
sample size.
If population is
expected to be free
If smaller tolerable misstatement smaller
error, big sample size sample size is needed
is needed.
In compliance
procedure Maximum
rate of deviation from
established procedure
of Internal Control
In substantive
procedureMaximum
monetary error.
♥ What is the meaning of Sampling? Also discuss the methods of Sampling. Explain in the light of the SA 530. (Most
Important)
Audit Sampling: "Audit Sampling" means the application of audit procedures to less than 100% of items within a population of
audit relevance such that all sampling units have a chance of selection in order to provide the auditor with a reasonable basis
on which to draw conclusions about the entire population.
The objective of the auditor when using audit sampling is to provide a reasonable basis for the auditor to draw conclusions
about the population from which the sample is selected.
There are many methods of selecting samples. The principal methods are as follows
The reasoning behind the stratified sampling is that for a highly diversified population, weights should be allocated to
reflect these differences. This is achieved by selecting different proportions from each strata. It can be seen that the
stratified sampling is simply an extension of simple random sampling.
(iii) Systematic selection, in which the number of sampling units in the population is divided by the sample size to give a
sampling interval, for example 50, and having determined a starting point within the first 50, each 50th sampling unit
thereafter is selected. Although the starting point may be determined haphazardly, the sample is more likely to be truly
random if it is determined by use of a computerized random number generator or random number tables. When using
systematic selection, the auditor would need to determine that sampling units within the population are not structured
in such a way that the sampling interval corresponds with a particular pattern in the population.
(v) Haphazard selection, in which the auditor selects the sample without following a structured technique. Although no
structured technique is used, the auditor would nonetheless avoid any conscious bias or predictability (for example,
avoiding difficult to locate items, or always choosing or avoiding the first or last entries on a page) and thus attempt to
ensure that all items in the population have a chance of selection. Haphazard selection is not appropriate when using
statistical sampling.
(only example not be written in exam) Haphazard sampling is a sampling method that does not follow any systematic way
of selecting participants. An example of Haphazard Sampling would be standing on a busy corner during rush hour and
interviewing people who pass by.
Haphazard sampling gives little guarantee that your sample will be representative of the entire population. If you were to
use this method to conduct a survey to find out who people will vote for president, the results you get may not predict the
actual outcome of the election. This is because you would probably only be able to interview people who were probably
white-collar workers on their way to work, or those who were not in such a big hurry to get to where they're going, or those
who lived or worked near the area where you conducted your survey.
(vi) Block selection involves selection of a block(s) of contiguous (next or together in sequence) items from within the population.
Block selection cannot ordinarily be used in audit sampling because most populations are structured such that items
in a sequence can be expected to have similar characteristics to each other, but different characteristics from items
elsewhere in the population.
Although in some circumstances it may be an appropriate audit procedure to examine a block of items, it would rarely
be an appropriate sample selection technique when the auditor intends to draw valid inferences about the entire
population based on the sample.
(only example not be written in exam) In situations when the auditor uses block selection as a sampling technique, many
blocks should be selected to help minimise sampling risk. An example of block selection is where the auditor may examine
all the remittances from customers in the month of January. Similarly, the auditor may only examine remittance advices that
are numbered 300 to 340.
(i) The sample selection is more objective (Unbiased) and is based on mathematical law of probability.
(ii) It may provide a better description of large mass of data than a complete examination of all the data, since non-
sampling errors such as processing and clerical mistake are not large.
(iii) Result of sampling can be evaluated & projected in a better way
It implies examination of a few selected transactions from the beginning to the end through the entire flow of the
transaction, i.e., from initiation to the completion of the transaction.
This examination consists of studying the recording of transactions at the various stages through which they have passed.
it is also judged whether the person who has exercised the authority in relation to the transactions is fit (authorise) to do
so in terms of the prescribed procedure.
For example, if payment to a creditor is to be verified "in depth", it would be necessary to examine the following documents:
(i) The invoice and statement of account received from the supplier.
(ii) The entry in the stock record showing that the goods were received.
(iii) The Goods Received Note and Inspection Certificate showing that the goods on receipt were verified and
inspected.
(iv) The copy of the original order and authority showing that the goods in fact were ordered by an authority which
was competent to do so.
This enables the auditor to select audit procedures that, in combination, can be expected to support the audit opinion at
an acceptably low degree of audit risk. It may be noted that the auditor's assessment of materiality and audit risk may be
different at the time of initially planning of the audit as against at the time of evaluating the results of audit procedures.
♥ As per SA 530, meaning of audit sampling, sample design, sample size and selection of items for testing.
As per SA 530 on "Audit Sampling", the meaning of the term Audit Sampling is the application of audit procedures to less
than 100% of items within a population of audit relevance such that all sampling units have a chance of selection in order
to provide the auditor with a reasonable basis on which to draw conclusions about the entire population.
As per SA 530, Requirements relating to Sample design, sample size and selection of items for testing are explained below-
→ Sample design - When designing an audit sample, the auditor shall consider the purpose of the audit procedure
and the characteristics of the population from which the sample will be drawn.
→ Sample Size- The auditor shall determine a sample size sufficient to reduce sampling risk to an acceptably low
level.
→ Selection of Items for Testing- The auditor shall select items for the sample in such a way that each sampling unit
in the population has a chance of selection
♥ What precautions should be taken by an auditor while applying test check techniques?
♥ An assistant of X & Co, Chartered Accountants, detected an error of Rs. 5 per interest payment, which
recurred a number of times. The General Manager (Finance) of T Ltd advised him not to request passing
any adjustment entry as individually the errors were of very small amount. The Company had 2000
Deposit Accounts and interest was paid quarterly. State your views in this issue, with reasons.
Answer
Mis-statement, including omissions, are considered to be material if they, individually or in the aggregate, could
reasonably be expected to influence the economies decisions of users taken on the basis of the Financial Statement.
Analysis: In the instant case, an error of `5 in the interest computation, even if small individually, will have a material
effect due to the large number of transactions.
Hence, X & Co, need not pay any attention to the advise given by the General Manager (Finance) of T Ltd. The
necessary adjustment should be carried out in the accounts of the Company.