FASB 2 defines materiality as:
The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable user relying on the information would have been changed or influenced by the omission or misstatement.
A careful reading of the FASB definition reveals the difficulty that the auditors have in applying materiality in practice. While the definition emphasizes reasonable users who rely on the statements to make decisions, auditors must have knowledge of the likely users of the client statements and the decisions that are being made.
In applying this definition, three levels of materiality are used in determining types of opinion to issue
Amounts are material
When a misstatement in the financial statements exists but is unlikely to affect the decision of a reasonable user, it is considered to be immaterial an unqualified opinion is therefore appropriate.
Amounts are material but don't overshadow the financial statements as a whole
The second level of materiality exists when a misstatement in the financial statements would affect a user's decision, but the overall statements are fairly stated and therefore useful.
Amounts are so material or so pervasive that the overall fairness of the financial statements is in question
The highest level of materiality exists when users are unlikely to make correct decisions if they rely on the overall financial statements.
Auditors should follow the five closely related steps in applying materiality
Step1 Set preliminary judgment about materiality
Step2 Allocate preliminary judgment about materiality to segments
Step3 Estimate total misstatement in segment
Step4 Estimate the combined misstatement
Step5 Compare combined estimate with preliminary or revised judgment about materiality .
Step1 Set preliminary judgment about materiality
It is called preliminary judgment about materiality because although it is a professional opinion it may change during the engagement. This judgment should be documented in the audit files.
The preliminary judgment is the maximum amount by which the auditor believes that the statement could be misstated and still not affect the decision of a reasonable user of financial statements.
Auditors make preliminary judgment about materiality to help plan the appropriate evidence to accumulate. The lower the dollar amount of the preliminary judgment the more evidence is required.
During the audit, auditors often change the preliminary judgment about materiality. We refer to this as the revised judgment about materiality.
Auditors are likely to make the revision because of the change in one of the factors that are used to determine the preliminary judgment, the preliminary judgment may be revalued after current financial statements are available, or client circumstances may have changed due to qualitative events.
Factors affecting preliminary judgment about materiality for a given set of financial statements
Materiality is a relative rather than an absolute concept
A misstatement of a given magnitude may be material for a small company and may be immaterial for a large Company even if they are the same dollar amount. This makes impossible to establish dollar dollar-value guideline for a preliminary judgment about materiality that may be applicable to all audit clients
Bases are needed for evaluating materiality
Because materiality is relative, it is necessary to have bases for establishing whether misstatement is material or not.
The Financial Accounting Standards Board (FASB) has refrained from giving quantitative guidelines for determining materiality. This has resulted in confusion in the use of Auditing Standards No 47, "Audit Risk and Materiality in Conducting the Audit". Several common rules that have appeared in practice and academia to quantify materiality include:
Percentage of pre-tax income or net income (i.e., 5% of average pre-tax income (using a 3-year average));
Percentage of gross profit;
Percentage of total assets; (i.e.,1/3% of total assets);
Percentage of total revenue; (1/2% of total revenues);
Percentage of equity; (i.e.,1% of total equity);
Blended methods involving some or all of these definitions (e.g., use a mix of the above and to find an average);
"Sliding scale" methods which vary with the size of the entity. (i.e., 5% of gross profit if between $0 and $20,000; 2% if between $20,000 and $1,000,000; 1% if between $1,000,000 and $100,000,000; 1/2% if over $100,000,000)
Qualitative factors also affect materiality
Certain types of misstatement are likely to be more important than others to users, even if the dollar amounts are the same.
Step2 Allocate preliminary judgment about materiality to segments( Tolerable misstatement)
The allocation of preliminary judgment about materiality to segments is necessary because auditors accumulate evidence by segments rather than for the financial statement as a whole.
If auditors allocate preliminary judgment about materiality to segments, this helps them decide the appropriate audit evidence to accumulate.
Most practitioners allocate materiality to balance sheet accounts rather than income statement ones , because most income statement misstatement has an equal effect on the balance sheet because of double entry book-keeping system. It is inappropriate to allocate preliminary judgment to both income statement and balance sheet accounts because doing so will result in double counting which in turn will result in smaller tolerable misstatement than that is desired. When auditors allocate preliminary judgment about materiality to account balances, the materiality allocated to any given account balance is called tolerable misstatement.
In practice, it is often difficult to predict in advance which accounts are most likely to be misstated and whether misstatement are likely to be overstatement or understatement.
Similarly, the relative costs of auditing different account balances often cannot be determined. It is therefore a difficult professional judgment to allocate preliminary judgment about materiality to accounts. Accordingly many accounting firms have developed rigorous guidelines and sophisticated statistical methods for doing so. These guidelines also help ensure that auditor appropriately documents in the audit files, as required by SAS 107(AU 312), the tolerable misstatement amounts are the related basis used to determine those amounts.
To summarize, the purpose of allocating the preliminary judgment about materiality to balance sheet accounts is to help auditor decide the appropriate evidence to accumulate for each account on both the balance sheet and income statement. An aim of the allo9cation is to minimize audit costs without sacrificing audit quality regardless of how the allocation is done. When the audit is completed the auditor must be confident that the amount of combined misstatements in all accounts are less than or equal to the preliminary judgment or revised one about materiality.
Step3 Estimate total misstatement in segment,Step4 Estimate the combined misstatement ,And Step5 Compare combined estimate with preliminary or revised judgment about materiality
When auditors perform audit procedures for each segment of the audit, they keep a worksheet of all misstatements found. Misstatements in an account can be of two types: Known Misstatement and likely misstatement.
Known Misstatement
Are those where the auditor can determine the amount of misstatement in the account.
Likely misstatement
They are two types the first are the misstatement arises from the differences between management's and auditor's judgment about estimates of account balances, The second are projections of misstatements based on the auditor's tests for a sample from a population.
The auditor makes a direct projection of the known misstatements from the sample to the population and adds estimates for sample error.
This estimate for the sample error results because the auditor has sampled only a portion of the population and there is a risk that the sample doesn't accurately represent the population.
The relationship between materiality and types of audit reports issued by the auditors
In concept, the effect of materiality on the type of opinion to issue is straight forward. In application, deciding on actual materiality in a given situation is difficult judgment. There are no simple, well-defined guidelines that enable auditors to decide when something is immaterial, material or highly material.
Materiality decisions -Non GAAP conditions
When a client has failed to follow GAAP , the audit report will be unqualified ,Qualified or adverse depending on the materiality of the departure.
Materiality decisions -Scope limitations conditions
When the auditor faced scope limitation in an audit, the audit report should be unqualified, qualified scope and opinion, or disclaimer, depending on the materiality of the scope limitation.
Summary:
Materiality is one of the basic and major concepts of auditing. "Audit Materiality", states that the concept of materiality recognizes that some matters, either individually or in the aggregate, are relatively important for true and fair presentation of the financial information in conformity with recognized accounting policies and practices. There are no sets of rules or prescriptions that may be applied consistently to determine materiality in all circumstances. Materiality is a relative terms.
What may be material in one circumstance may not be material in another. The assessment of what is material is a matter of professional judgment and experience of the auditor.
