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Audit Materiality: A clarification on its relevance in the audit process

A3In an effort by our firm to enlighten clients about the different aspects of the audit process we will be placing articles on a range of audit-related topics over the next few months, to help you better understand the terminology, options, cost-saving tools and, ultimately, the benefit of the audit for you and your business.

We commence by clarifying the term, Materiality, and the relevance thereof to the audit of your business.  As this term refers to much more than a mere numerical figure calculated for your entity during the audit, we believe that this article might address many questions you might still have when you hear your auditor refer to “materiality”.

First we must look at what the objective of an audit of a set of financial statements actually is.

The International Auditing Standard, ISA 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in accordance with the International Standards on Auditing, describes this objective as follows:

  • 11. In conducting an audit of financial statements, the overall objectives of the auditor are: (a) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatements, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and(b) To report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings. 

The reference in this objective to “material misstatement” reflects its relevance in the entire audit process.  Misstatements are considered to be material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.

From the above it will be apparent that misstatements can be considered to be material due to either their numerical value or, importantly, their nature.  The latter is usually the part that we find clients struggle to understand, where small value misstatements still have a big influence on our audit opinion and audit work.

In order to address the risk of numerical misstatements in the financial statements, we as auditors calculate, during the planning stage of the audit, a materiality figure, which represents the maximum numerical error that we would regard as not material to the financial statements. Due to the effect and importance of this figure for our entire audit process, it will only be in specific circumstances that the materiality figure for the audit will be disclosed to a client. You will, therefore, usually not know what the calculated materiality figure for your entity is.

This figure is client-specific and based upon, among other things, the following:

  1. The professional judgement of the auditor;
  2. Qualitative matters (for example new audit clients, the quality of accounting records, etc.), and knowledge of the clients;
  3. Certain firm-specific parameters and bases relevant to your business (for example a percentage of revenue or assets, etc.); and
  4. The needs of the users of the financial statements.

Audit procedures are then designed to address the risk of not detecting material misstatements in order to provide us with reasonable assurance that we will, in fact, detect all misstatements above this level. In essence the materiality figure will affect numerous areas throughout the entire audit process such as: risk assessment processes and the identification of risks for material misstatements, analytical review procedures, selection of areas and line items to be audited, sample sizes, etc.  The auditor might also choose to apply lower materiality figures to sections of the financial statements.

In applying materiality in the design of our assurance procedures our work will now focus on areas where we have identified specific risks from our risk assessment processes, and areas where the potential of material misstatements are considered to be the greatest.  In essence this will involve that we:

  1. Perform extensive audit procedures on line items in the financial statements exceeding this materiality figure (i.e. quantitatively material);
  2. Perform detailed procedures in areas considered to be material due to their nature (irrespective of the numerical value);
  3. Design specific audit procedures on line items for which we have identified specific risks for misstatements as part of our risk assessment processes; and
  4. Aim to do less work in non-material non-risk areas.

In short, we shall focus audit attention on those areas where risks are, in our opinion, considered to be the highest.

It is important to note that misstatements discovered during the audit, which in the auditor’s opinion are indicative of fraud, will always be considered to be material irrespective of their magnitude.

The materiality figure as set during the planning stage of the audit will, however, be reassessed:

  1. During the course of the audit, as circumstances might be identified that indicate to the auditor that the materiality figure, as initially calculated, might need to be amended (for instance, if the auditor detects fraud, a decrease in the initial materiality figure will be required); and
  2. At the finalisation stage, in order to evaluate whether misstatements identified during the audit are material to the financial statements.

As part of finalising the audit and the audit report, the auditor will then evaluate all misstatements discovered during the audit and documented on the schedule of audit differences, against their final materiality figure (as reassessed above), to conclude his/her audit opinion on the financial statements, indicating whether the financial statements are free from material misstatements, and thus concluding on the initial objective of the entire audit process.

If you need any further information about the auditing services that we offer, please contact your relationship director or Christa Swart at christas@asl.co.za, tel. 021 840 1600.