Three Steps to Determining and Applying Materiality

• Part 11.1 - Summary of Qualitative Characteristics of GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
• Part 11.2 - How and When to Recognize Revenues & Expenses in Accrual Accounting
• Part 11.3 - Functions in the Purchasing Process and how to Segregate Purchasing Duties
• Part 11.4 - Three Steps to Determining and Applying Materiality
• Part 11.5 - Assertions of Management about Economic Events in the Business
• Part 11.6 - Bank Accounting - Types of Bank Accounts, Cash Receipts & Disbursements, Disclosures Required for Cash Accounting
• Part 11.7 - Objectives of Internal Controls set by Management
• Part 11.8 - How to Test Internal Controls of an Organization
• Part 11.9 - Positive Accounting Theory (PAT)
• Part 11.11 - Accounting Information - Complex Commodity & Information Asymmetry

What is Materiality?

Materiality is an amount that makes a difference to the users- an audit never provides 100% assurance- only “reasonable assurance." For instance, if a company has overstated its revenues by $5million when its total revenues are $4 billion, then this $5 million is considered 'immaterial.' However, if the company's total revenues are only $50 million, then this $5 million overstatement is considered 'Material."

1. Determine a base and calculate a number.

MATERIALITY GUIDELINES:

•5% of income from continuing operations (normalized)

•5% of net income before bonus,

•½ to 2% of revenues or expenses for non-for profit entities,

•½ to 1% of net asset value for the mutual fund industry, or

•1% of revenue for the real estate industry.

Note: Materiality is a matter of Professional Judgement so:

• When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues but for most for profit enterprises, income from continuing operations is the most appropriate.

Once a preliminary figure is calculated- then consider qualitative items i.e.

• Misstatements due to fraud/ illegal acts
• Amounts that may violate contractual covenants
• Amounts that may affect earnings trends
• Misstatements that may increase management compensation
• Amounts that may result in an entity missing its forecast
• Industry conditions
• Past number of misstatements

2. During the audit, auditors track the misstatements on the SUE- Summary of Unadjusted Errors

3. Estimate the likely misstatement and compare the total to the preliminary materiality.

• If the estimate misstatement is less than materiality- then the auditor can generally conclude the financial statements are fairly presented.
  
• If the estimate is greater than materiality then the adjustments should be recorded by the client- if the client refuses then the auditor cannot issue a clean audit report
  
• Unadjusted amounts from prior years should be carried forward in assessing the misstatement
  
• Preliminary materiality may be revised if the auditor feels it is necessary due to information obtained during the audit

Materiality Allocation

• auditors generally assign a lower level of materiality to each account balance in performing their audit procedures
  
• rationale is that several errors could exist within the account that together would result in a material misstatement to the financial statements
  
• may also use a lower level of materiality for testing balances that have a higher risk of misstatement (results in more testing)
  
• there are a variety of methods used to do this
  - i.e. may say tolerable error for account balances is 10% of materiality.