Materiality in Accounting and Auditing

Structure of Presentation
1. Introduction
2. The concept of Materiality
3. Why materiality is relevant
4. Quantitative and Qualitative Aspects of Materiality
5. Materiality in Audit
6. Materiality and Audit Risks
7. Type of misstatements

1. Introduction

The auditor expresses opinion on whether the FS are prepared in all material respects, in accordance
with the applicable financial reporting framework.

The principle of 'de minimize lex non curat est' (materiality), suggests that trivial (small) things that do
not make a difference in the overall view of the FS need not be given the strictest accounting treatment.
In other words, accounting standards can be ignored if the net impact of doing so is so small that the
user of the financial statement will not be misled. Hence misstatements, including omissions, are
considered material if individually or in aggregate they are reasonably expected to influence economic
decisions of users, based on the FS. The objective of audit is to enable the auditor express opinion on
whether FS are prepared in all material (significant) respects in accordance to financial reporting
framework.

The concept of materiality is loo naked with the concept of True and Fair view which requires that FS
show financial position and results in as fair and accurate a way ac possible, but not necessarily correct
and exact. The FS should be as much as possible be factual and confirm with reality.

2. The Concept of Materiality

The FS is not expected to be correct or accurate in every particular way but in all significant respects.
Hence, non-compliance with applicable reporting framework can be ignored if the net impact of doing
so will not mislead users. Materiality, therefore, refers to what influences a reasonable, informed but
not necessarily a sophisticated user. Information is considered material if it's omission, misstatement
(errors and inaccuracies) individually and in aggregate could influence the decision of users, taken on
the basis of FS. The phrase "in all material respects" refer to the degree of confidence or precision. The
concept is important because FS contain accounting estimates about uncertain and unresolved
transactions. The goal is to ensure that overall view of FS is true and Fair. After all, the audit report is not
a guarantee, neither is it a certificate nor an assurance of efficiency and effectiveness of management.
Instead, it is a judgement based on evidence but which adds credibility to the FS. It is uneconomical to
allow immaterial items to cluster and complicate the auditing process, divert user's attention from
significant matters and increase the cost, and time for audit assignment.

A matter is material if it's non-disclosure, misstatement, or omission would make possible a distraction
of the view given by FS or financial information. It suggests that a level of misstatement can be tolerated
provided the overall truth and fairness is not distorted.

There are two forms of Materiality: Materiality by value(size) and Materiality by nature.

3. Why Materiality is Important

Materiality needs to be considered:

 If it helps reduce cost and time of audit assignment.

 If it enables audit to use sampling and rely on analytical techniques and statics.
 If 100% accuracy is possible in all.
 Before deciding whether a matter requires disclosure in FS.
 Whether or not errors need to be corrected (restated).
 Whether an item should be separately disclosed or aggregated with other items in FS.
 The extent of audit work appropriate under a particular circumstance.
 Whether a non standard audit opinion be issued.

Setting Materiality Threshold

The materiality of the matter may be judged by the size or nature of the error or both. Hence,
materiality has both quantitative and qualitative aspects. No single factor determines whether an item
material. It's determined by the answer to the question "if this item is allowed to stand, is it likely to
mislead users of the FS in any way.

Quantitative materiality or materiality by value: A figure might be material because of its size, relative to
other figures, often in terms of percentage errors. E.g

5-10% profit

10% turnover

5% Net assets

These are not prescriptive but reference figures, subject to auditor's professional judgement. The impact
of the amount needs to be considered. To decide whether an item is material;
  Compare the magnitude with overall view of the account.
 Compare the magnitude with prior year FS of the same item.
 Compare magnitude with the total, of which it is a ___.
 Note that special items like director's remunerations are always material.

Qualitative Aspect of Materiality:

This relates to the nature of errors and misstatements, regardless of the value or amount. Examples
include:

 Omissions of disclosures required by law.

 Misstating short term loan for long term loan.
 An omitted item that might affect accounts. Eg court case, contingent liability etc.
 Covenant violations (agreements).
 Inaccurate description of accounting - state 50yrs in not but use 5yrs.
 Related 3rd party transactions.

Generally, materiality levels are influenced by

a) Nature of an item.
b) Statutory requirements.
c) Purpose of FS.
d) Amount involved.

Materiality in Audit Procedure

Materiality is not a single figure or set of criteria that is used at some point during audit and then
discarded. It is fundamental concept to all the stages of an audit; at all times. It should be taken into
account while considering the nature, timing and extent of audit procedures. Materiality judgement
influence planning, testing, account analysis, evaluation and reporting.

Materiality should be taken into account at planning stage and reconsidered if outcome of tests,
inquiries or examination differ from expectation. To perform effective and efficient audit, the auditor
must repeatedly reevaluate whether scope of procedures planned for various accounts are adequatw or
excessive.

At the completion stage, before deciding on the truth and fairness view of the FS, the auditor must
assess the materiality of aggregate uncorrected errors. To keep track of the errors, the auditor must
maintain summary of potential audit adjustments. Individually immaterial misstatements may aggregate
to a material amount . Some misstatements can also offset others.
In summary, materiality is practical reality in accounting and Auditing. Materiality assessment and audit
planning should be viewed as a dynamic, rather than static concept. New facts and circumstances can
change the materiality threshold set at planning stage.

Materiality and Audit Risks

What could make FS materially misstated should be considered at audit planning stage. When
this is taken to specific account balances and classes of transactions, it helps in deciding the extent of
examination of items and whether sampling and analytical procedures are to be used. Also, it assists in
the selection of the combination of procedures that may reduce audit risks to acceptable level.

Materiality and level of audit risk are inversely related to lower the materiality, the higher the risk
and vice versa. Where materiality is low and audit risk is high; the auditor may compensate for the risk
by either:

i. Carrying out extended or additional tests of control to reduce control risk.

ii. Modify the nature, timing an extent of planning substantive procedures to reduce detection risk.

Type of Materiality

1. Identified Misstatement (IM) from representative sample or other representative sample.

2. Likely Misstatement - extrapolated or projected effect of identified Misstatement.
3. Likely Aggregate Misstatements - sum of misstatements, specific misstatements identified and
extrapolated ND vest estimate of misstatements that cannot be specifically identified.
4. Further Possible Misstatements: the further misstatement as a result of sampling and non-
sampling errors.

Problem with Materiality

- not prescriptive

1. A matter of judgement, a prescriptive rule may lead to overlooking material misstatements.

2. Percentage guideline may be used with care, bearing in mind the focus of the entity.
3. In owner managed business, the key figure may move from profit to other item like profit before
director's salaries and benefits.
4. Materiality decision need to keep in mind the nature of business and the need or the
anticipated use.