In Part 1 of the article on AU-C 320, requirements of the standard, definitions and types of error were discussed. This Part will focus on the practical application of the standard.
Preliminary Estimate of Materiality for the Financial Statements as a Whole (Planning Materiality)
Simply put, the preliminary estimate of materiality at the financial statement level is the maximum amount by which the auditors believe the statements could be misstated, by known or unknown error or fraud, and still not affect the decisions of reasonable financial statement users. Clarified Auditing Standards require quantification of materiality levels, which are estimates of the perceptions of likely users of financial statements. These estimates guide auditors’ decision-making and design of auditing procedures. Again, these estimates are only guides and are not specific determinations of what is, and is not, material in an audit. The nature of engagement risks, the needs of financial statement users, and audit objectives provide information for the ultimate determination of materiality.
Usually, a single base such as the higher of total revenues or total assets is selected for the financial statements taken as a whole. Once the base is determined, the dollar amount of the base is normally multiplied by a percentage factor, sometimes determined by the volume of the base, to determine the allowance for known and unknown error and fraud in the financial statements taken as a whole. Next, a percentage factor based on risk at the financial statement level is multiplied times planning materiality to determine tolerable misstatement, or performance materiality, which is the maximum amount of known and likely error (uncorrected error) an auditor can accept in the financial statements without adjustment.
A Practical Framework for Materiality Calculations
A general range of 50% to 75 % of planning materiality, based on moderate risk at the financial statement level, is commonly used to calculate tolerable misstatement (performance materiality) at the financial statement level. Extremely low risk could enable an auditor to calculate performance materiality at an even higher level, say 80% to 90%. Lower risk at the financial statement level will result in fewer individually significant items.
When risk is high at the financial statement level, a lower level of tolerable misstatement can result by using a factor of 10% to 30%. This will result in a lower, lower limit for individually significant items and gathering more evidence from auditing smaller account balances, general journal entries, unusual transactions, etc.
All the percentage factors illustrative above are based on an auditors’ professional judgment resulting from the assessed level of risk at the financial statement level. None of the factors are specified in the auditing standards.
Performance materiality (tolerable misstatement) is the base for determining the lower limit for individually significant items in the financial statements taken as a whole, ranging from 10% to 100% of performance materiality, depending on high risk or low risk respectively. For engagements with higher risk of material misstatement at the financial statement level, individually significant items will generally be those account balances, transactions or general journal entries in excess of 10% to 30% of performance materiality. When risk of material misstatement at the financial statement level is lower, a percentage of up to 100% may be used for determining individually significant items. When risk is low at the financial statement level, the lower limit may be commonly calculated at 80% to 90% of performance materiality; moderate risk calculations may be 50% to 60% of tolerable misstatement and high risk 20% to 30%. The determinations of appropriate percentages are matters of professional judgment based on the facts and circumstances of each engagement.
Clarified Auditing Standards clearly indicate that performance materiality (tolerable misstatement) is affected by risk. Risk of material misstatement is often different for each financial statement classification. Because the lower limit for individually significant items is calculated based on performance materiality, and because performance materiality must be determined separately for each material financial statement classification, the lower limit for individually significant items will also vary by financial statement classification. Performance materiality at the assertion or account classification level can range from 10% to 100% of performance materiality at the financial statement level. The same general rule of 10% to 100%, based on high or low risk, may be followed for calculating individually significant items at the assertion or account classification levels.
Some auditors have used 100% of tolerable misstatement at the financial statement level to determine the lower limit for individually significant items and sample sizes at the assertion level. To reach this level of tolerable misstatement at the assertion level for sampling or non-sampling purposes, the risk assessment procedures must provide sufficient evidence to reduce the assessed level of risk of material misstatement to a very low level. Risk of material misstatement at account classification (assertion) levels for smaller entities ordinarily will be slightly less than high to moderate resulting in tolerable misstatement calculated at 30% to 60% of financial statement tolerable misstatement.
Part 3 of this materiality article will contain a discussion of how to perform good error analysis, which is the end of the risk assessment process. A later article will discuss the Clarified Auditing Standard, Audit Sampling.
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