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Sunday, November 1, 2015

Audit Planning: Materiality

Three major conceptual issues in planning an audit to detect material misstatements:

  1. Establishing materiality levels
  2. The different ways in which management assertions, as reflected in the financial statement items, may contain misstatements
  3. Information on the susceptibility of these assertions to misstatement and the effectiveness of the client’s internal control in preventing and detecting the misstatement, or the AUDIT RISK MODEL


The magnitude or an omission or misstatement of accounting information that, in the judgment of a reasonable person relying on the information, would have been changed or influenced by the omission or misstatement.

Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements.

Importance of materiality:

  1. Helps establish the extent of substantive tests
  2. Evaluate potential and actual misstatements
  3. Defines the threshold at which the auditor would require the client to make an adjustment to the financial statements.

When does the auditor consider materiality?

PLANNING STAGE: Determining the nature, timing, and extent of audit procedures

COMPLETION STAGE: Evaluating the effect of misstatements

Considerations in determining acceptable materiality levels:

  1. Elements of FS and FS measures
  2. Whether there are FS items where users attention tends to be focused
  3. Nature of the entity and industry in which it operates
  4. Size, nature of ownership, financing of the client

Materiality: Professional Judgment

Quantitative factors:

  • Total assets
  • Total revenues
  • Net income before taxes
  • Gross profit
  • Average of three years’ net income before taxes

Qualitative factors:

  • Probability of illegal payments
  • Probability of fraud
  • Small amounts that may violate covenants in contracts
  • Interruption in a trend in earnings

Using Materiality in an Audit

Step 1: Determine the overall materiality: FS level

  1. Material to the FS as a whole
  2. Consider that FS are interrelated
  3. Consider materiality at the SMALLEST aggregate level of misstatement that could distort any one of the FS.

Step 2: Determine tolerable misstatement: Account Balance Level

  1. Allocating overall materiality to the FS account balances.
  2. Allows auditor to determine audit procedures that will be applied to specific accounts.
  3. Allocated materiality is called the tolerable misstatement for that account.

Copyright @philcpareview

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