AU-C 320 Requirements
The following requirements are excerpted from AU-C 320 (the
complete Section can be obtained from the AICPA at www.aicpa.org and should be obtained and read
for a thorough understanding of materiality concepts):
.10 When establishing the overall audit strategy, the auditor should determine
materiality for the financial statements as a whole. If, in the specific circumstances
of the entity, one or more particular classes of transactions, account
balances, or disclosures exist for which misstatements of lesser amounts than
materiality for the financial statements as a whole could reasonably be expected
to influence the economic decisions of users, then, taken on the basis of the
financial statements, the auditor also should determine the materiality level
or levels to be applied to those particular classes of transactions, account balances,
or disclosures. (Ref: par. .A3–.A13)
.11
The auditor should determine performance materiality for purposes of assessing
the risks of material misstatement and determining the nature, timing, and
extent of further audit procedures. (Ref: par. .A14)
Some Practical Issues
Definitions
Previously used terms such as planning materiality and
tolerable misstatement have been changed by this Section materiality and
performance materiality respectively.
Performance materiality applied to sampling applications is now termed
tolerable misstatement. While the
Section requires a distinction between performance materiality and tolerable
misstatement, practically it will be rare when there is an identifiable
difference. Following is a definition
paraphrased from this Section:
Materiality:
Materiality concepts generally are that misstatements are
considered to be material if they may be expected to influence the economic
decisions of users of the financial statements.
Judgments about materiality are made in light of risk
evaluations and the needs of financial statement users.
Materiality, similar in concept to the previously used term
“planning materiality,” may be practically defined as the maximum amount of
known and unknown error and auditor can accept in the financial statements
taken as a whole without adjustment. As you can see from the definition below,
this is also the definition of performance materiality.
Performance
materiality:
The amount or amounts determined by the auditor, based on
the assessed level of risk at the financial statement level, which is less than
materiality for the financial statements as a whole. The amount of performance
materiality is considered necessary to reduce to an appropriately low level the
probability that the aggregate of uncorrected and undetected misstatements is
greater than materiality. Performance materiality may also refer to the amount
or amounts set by the auditor at less than the materiality level or levels for particular
classes of transactions, account balances, or disclosures.
Tolerable
Misstatement:
Tolerable misstatement is essentially the maximum amount of
known and likely error an auditor can accept in a financial statement
classification without adjustment. As
one can see, it will be difficult to find circumstances when performance
materiality at the account class or transaction level is different from
tolerable misstatement.
Materiality Levels and Error
Definitions
Quantifying material levels based on assessed levels of
material misstatement, including calculating the lower limit for individually
significant items, enables the auditor to identify material unusual matters
(risks of material misstatement). As indicated in the excerpts from AU-C 320
above, these risks of material misstatement will precipitate changes in the
nature, extent and timing of further auditing procedures. Substantive evidence from these procedures
may identify errors. Known and likely error in financial statement
classifications is compared with the amount of performance materiality to
determine if an acceptable level of error remains in the financial statements
during the completion phase of an audit.
Known and likely error (uncorrected error) includes 1) known
but unadjusted error (passed adjustments) less than the lower limit for
individually significant items and greater than any “paper pass” limit, 2)
projected error from sampling applications and 3) estimated error from tests of
accounting estimates and other procedures such as predictive analytical
procedures that are designed to provide most of the substantive evidence for
certain financial statement classifications. The reversing effects of the prior
year’s errors must also be reflected in the current year’s aggregation of error,
at least by material financial statement classifications, to support the
in-charge accountant and engagement leader’s conclusions about an acceptable
level of error in the financial statements.
The next article will address the framework for calculating
materiality levels and the process of error analysis, including consideration
of both known and unknown error.
More Information
These eBook resources, without CPE credit, can be
obtained from my website, www.cpafirmsupport.com
:
- Small Audits Made Easy and Profitable
- Performing Auditing Tests of Balances Procedures
- Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
- Key Accounting Issues for Non-Profit Organizations
- A Practical Potpourri of Time Savings on Audits
- The Financial Reporting Framework for Small- and Medium-Sized Entities
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