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11 Materiaity http://www.youtube.com/watch?v=ST_wVEYki20&noredirect=1

SCRIPT

Materiality is another very important concept in the context of the audit because it identifies the amount or type of errorsthat may influence a user to change their decision using the financial information presented.

There are three important concepts embodied in materiality. First, a material misstatement is considered in the context of a knowledgeable users and its effect on the decision

making. Second, that materiality is relative to the circumstances. And thirdly, that the users are considered as a group, and not individually.

When the auditor identify a material misstatement, the path forward is either: To request of the client to make acorrection for the misstatement, or alternatively issue a modified opinion.

Lets walk through how materialit y is set and used throughout the audit.

The first step is to set planning materiality .Recognize that materiality is expressed as a dollar value number. This determines the amount of misstatement in thefinancial statements that would be considered material. Its called planning materiality, because it is not cast in stoneand can be updated as circumstances change throughout the course of the audit. The outcome of setting a lowermateriality is that more evidence is required. Think of it as the degree of precision in the auditor's opinion. If the auditorassesses materiality at $1 million, the unstated interpretation of the audit opinion is that the financial statements are fairlypresented within $1 million. So, if the auditor finds a $500,000 error , the client doesnt necessarily need to adjust thefinancial statements for that error, because $500,000 has been deemed immaterial.

Setting materiality requires a huge amount of professional judgement. Some rules of thumb are commonly applied to givethe auditor a range of values to select from. You can use 5-10% of normalized net income before taxes for steadyprofitable enterprises. or similarly you may use 0.5-5% of gross profit. You may need to look to the balance sheet for acompany with a volatile income stream, so you may use 0.5%-1% of total assets, or you may look at shareholders'equity and use 0.5- 5% shareholders equity. You may also look at a revenue based number if the income income is

inconsistent and 0.5-2% of revenue. This may be used by a NPO.

Auditors will mix and match to try and use the most appropriate rule of thumb to use when they assess materiality.Materiality also has qualitative considerations as well. Small amounts that involve fraud or illegal acts are typicallymaterial, even though the dollar amounts may be small. If a company is close to violating a lending covenant, or there isan agreement to sell the business that adjusts the price for any changes in the asset values, these would also bequalitative considerations that would impact the selection of materiality, often lowering it to the low end of the rangeswe just discussed.

The second step is to allocate materiality to various segments of the business This is done to determine the sample selection sizes and the extent of audit evidence required. Typically, materiality isallocated to balance sheet accounts, and less to income statement accounts, and the reason this is acceptable is simplybecause of the double entry nature of bookkeeping as we've discussed previously. Any misstatement of a balance sheetaccount would flow through the corresponding income statement account.

The third step is to estimate the total misstatements in each of the various segments after completing theaudit proceduresWhen a test of detail uncovers a misstatement, the error must be projected over the entire population unless it can beisolated. There are a number of ways to project the sampling error over the population to determine the maximumpossible misstatement, and this will be discussed in a later lesson.

The fourth step is to combine the estimated misstatements from all the segments.

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In the fifth step , it is the maximum possible misstatement which gets compared against materiality we set at theplanning stage, and if the misstatements are greater than materiality, then there is one of three possible outcomes:

1. The client will have to make an adjustment to lower the unrecorded misstatements.2. The auditor will have to perform more work to reduce the size of the maximum possible misstatement.3. The audit opinion may be modified.

For many audits, the third, fourth, and fifth steps are combined into one seamless evaluation.

Materiality and risk in auditing are closely related and inseparable. Think of materiality as a measure of magnitude of misstatement, and think of risk as a measure of uncertainty. So if you want to conceptually wrap your mind around whatan audit opinion is really saying, you could interpret the audit opinion to read that there is a 5% risk that we, as theauditor, failed to uncover a misstatement of $1 million or more. However, as closely as risk and materiality appear to berelated, note that materiality is not part of the Audit Risk Model . Yet, materiality is added incrementally to the auditprogram to determine the planned extent of evidence required. Both lower materiality thresholds and lower detectionrisk, will increase the audit procedures and the sample sizes. A very common misconception for new practitioners tomistakenly suggest that because we simply have high audit risk, we must choose a lower materiality. While high audit risk and low materiality are common outcomes, the two are based in different considerations. Audit risk is based on anassessment of inherent risk and control risk. Whereas materiality is based on the anticipated judgements of users. Sohopefully that makes sense, and until next time, dont stop until you get to the top and when you get to the top dontstop.