You have been asked the partners of your firm materiality which will provide guidance to members accounts of limited companies.
to prepare a draft memorandum on of staff in conducting the audit of the
a) Define materiality. (4 marks)
b) Explain the importance of this concept to the auditor. (6 marks)
c) Suggest some criteria for determining cut-off point in order to assess the materiality of an error. (10 marks)
(Total: 20 marks)
The auditor should consider materiality when conducting his audit. Materiality is defined as follows. ―Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements‖. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement.
Thus materiality provides a threshold or cut off point rather than being a primary qualitative characteristic which information must have if it is to be useful. The concept of materiality is key to the auditor when he is concluding whether financial statements show a true and fair view. The auditor can only report that the financial statements do not show a true and fair view on issues that are material. In designing the audit plan, the auditor establishes an acceptable materiality level so as to detect quantitatively material misstatements. However, both the amount (quantity) and nature (quality) of misstatements need to be considered. Examples of qualitative misstatements would be inadequate or improper description of an accounting policy when it is likely that a user of the financial statements would be misled the description and failure to disclose the breach of regulatory requirements when it is likely that the consequent imposition of regulatory restrictions will significantly impair operating capability.
The auditor should consider materiality at both the overall financial statements level and in relation to individual account balances, classes of transactions and disclosures
b) Materiality is important to an auditor because: –
Auditors should consider materiality and its relationship with audit risk when conducting an audit. The auditors responsibility is to plan and perform an audit to provide reasonable assurance that the financial statements are free of material
misstatement and give a true and fair view. Thus anything that would distort the view given the financial statements must lead to a qualification but only if its material.
Auditors should consider materiality when determining the nature, timing and extent of audit procedures.
Materiality assessments during planning assists in the determination of an efficient and effective audit approach. It helps the auditor decide on matters such as what items to examine and whether to use sampling techniques.
In evaluating whether the financial statement give a true and fair view, auditors should assess the materiality of the aggregate of uncorrected misstatements.
If the auditor believes that the aggregate of uncorrected misstatements may be material, he should extend his audit procedures to obtain more audit evidence in the relevant area or request management to adjust the financial statements.
If management refuses any adjustments the auditor should consider the implications for his audit report.
Therefore materiality provides a reference point in making decisions on the effects of misstatements on the financial statements.
c) Materiality guidelines can be derived answering the following questions:-
Who are the relevant users of the financial information?
What are their decision making needs?
For a given item, what is the appropriate context for assessing its materiality?
In what range of values do items become critical in terms of materiality?
How should particular items in these critical ranges be decided and reported?
The auditor should also consider:-
Is the item so fundamental that the accounts can no longer be said to give a true and fair view?
Materiality is a relative factor and the item must be considered in relation to the accounts as a whole, the total of which it would form part and the corresponding amount in the previous years.
Some items are capable of exact calculations others like depreciation are merely estimated and providing the estimate is reasonable, should be acceptable.
However, it is generally accepted that:-
a) Errors over 10% are material
b) Errors between 5 – 10% may be material
c) Errors under 5% may not be material.