Audit Materiality

What is Audit Materiality?

Audit materiality is one of the most important concepts for auditors. MisstatementsTop Accounting ScandalsThe last two decades saw some of the worst accounting scandals in history. Billions of dollars were lost as a result of these financial disasters. In this article, we look at the 10 biggest accounting scandals in recent times. Many of these scandals were a result of the excessive greed of the, including omissions, are considered to be material if, individually or in the aggregate, they are reasonably expected to influence the economic decisions of users of the financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are intricately linked to each other and this guide will explain how they all fit together. By following the steps below you'll be able to connect the three statements on your own.. Materiality in audit comprises both quantitative and qualitative aspects.

Quantitative Considerations

When dealing with materiality in quantitative aspects, we must consider the following five steps:

• Set a preliminary judgment of materiality
  1. This is usually done at the planning stage of an audit
  2. The general rule of thumb is either 1) 5-10% of normalized net income (normalized excludes one-time gains/losses and discontinued operationsChapter 11Chapter 11 is a legal process that involves reorganization of a debtor’s debts and assets. It is available to individuals, sole proprietorships, partnerships, and corporations. It is most commonly used by corporations. The reorganization allows the business to continue operations but under supervision) or 2) 0.5-2% of total assets
• Consider performance materiality
  1. Materiality more on a line item basis, i.e., accounts receivable, inventory, etc.
• Estimate the misstatement in a cycle or account
• Estimate the total aggregate misstatements
• Compare this total with the criteria for judgment of materiality to determine if, overall, the financial statements are materially misstated

Qualitative Considerations

There are numerous qualitative factors to consider in an audit as well. For example, if a company does not provide adequate disclosures regarding contingent liabilitiesContingent LiabilityA contingent liability is a potential liability that may or may not occur. The relevance of a contingent liability depends on the probability of the contingency becoming an actual liability, its timing, and the accuracy with which the amount associated with it can be estimated. or related party transactions, this may be considered to be material. In addition, an inaccurate description of an accounting policy may also be material. For example, assume a company chooses to use 50 years to amortize an asset  – but in the note disclosures, it’s useful life is stated to be only five years.

Small errors in financial statements can also lead to severe covenant violations. For example, if the company enters into a covenant with their local bank to maintain a current ratio of 1.0, a minute $2,000 misstatement can change the ratio sufficiently to make it appear the company is in compliance when, in fact, it is in violation of the covenant.

Types of Misstatements

When dealing with material misstatements, there are several types of misstatements that auditors must consider. If auditors choose to stratify (i.e., pick out high-value or key items in a balance), these misstatements are known as IMOs. That is, they are Identified Misstatements Other than those derived from representative samples. When auditors follow ordinary sampling to examine data, misstatements in this group are known as IMRs – Identified Misstatements (obtained from) Representative samples. Take a look at the table below.

Example

Let’s say that in this example, inventory is audited using sampling. The identified misstatement in the sample is $1,200 (an overstatement) and the likely misstatement in the entire population (obtained by extrapolating from the misstatement in the sample) is $2,000. Accounts payable is then audited with no sampling and $25,000 of understatements are identified. Further Possible Misstatements (FPMs) are estimated at $2,000.

The materiality level has been set at $30,000, after tax.

In these situations, the easiest way to approach it is to assemble an adjustments schedule. An adjustment refers to what changes should be made to account for the misstatements. Take a look at the following schedule and note that credit balances are put in parenthesis.

Comparing the $30,000 materiality threshold to the $27,000 in identified misstatements, we can conclude that the financial statements are not materially misstated. However, we must note that sampling was used when auditing inventory and so there is the potential for further possible misstatements. After adding the FPM value of $2,000, we see that $29,000 is still below the threshold and, thus, we can still reach the same conclusion.

Related Readings

We hope you’ve enjoyed reading CFI’s explanation of audit materiality. To learn more, see the following CFI resources:

• Auditor’s ReportAuditor's ReportAn independent Auditor’s Report is an official opinion issued by an external or internal auditor as to the quality and accuracy of the financial statements prepared by a company. The report is a primary source of communication between the auditor and users of financial statements. The users include equity holders, lenders, creditors
• Forensic Audit GuideForensic Audit GuideA Forensic Audit is a detailed audit of a company's records to be used in a court of law in a legal proceeding. Accountants, lawyers, and finance professionals are all involved. In such an audit, they will be looking for corruption, conflicts of interest, bribery, extortion, asset misappropriation, financial fraud
• Audited Financial StatementsAudited Financial StatementsPublic companies are obligated by law to ensure that their financial statements are audited by a registered CPA. The purpose of the independent audit is to provide assurance that the management has presented financial statements that are free from material error.  Audited financial statements help decision makers
• Audit Legal ImplicationsAudit Legal ImplicationsInaccurate or erroneous financial information cause audit legal implications. Auditors are responsible for making sure that all line items on financial statements are presented fairly. The audit reports ultimately affect business decisions of banks, government, investors, and other business-related entities.