The auditor is required to determine three different levels of materiality
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Latest from TaxmannTable of Contents 1. Introduction 2. Factors affecting Materiality 3. Types of Materiality 4. Overall Materiality 4.1 Determining Overall Materiality 4.2 Selecting an appropriate benchmark 4.3 Identifying appropriate financial data Check out Taxmann's Audit of Financial Statements which comprehensively covers the entire cycle of audit of financial statements, starting from the ‘appointment of the auditor’ to the ‘issuance of the audit report’. It also provides guidance on ‘risk-based audit’ as per the Standards on Auditing issued by the ICAI. This book will be helpful for audit assistants, engagement partners, and small & medium practitioners. 1. IntroductionThe concept of materiality is fundamental to the entire audit process and is applied by the auditor:
Materiality applies not only to amounts in the financial statements, but also to disclosures that are non-quantitative.
Materiality is a relative rather than an absolute concept. A misstatement of a given magnitude might be material for a small company, whereas the error of the same amount could be immaterial for a large one.
The auditor may consider the following illustrative factors in assessing whether an amount is material: (i) the potential impact of the misstatement on trends, especially trends in profitability; (a) an intentional misstatement to ‘manage’ earnings; 2. Factors affecting MaterialityCalculation of Materiality is not simply following the firm’s guidance or a rule of thumb.
For instance, how did the engagement team decide that 5% was appropriate, and that net income was an appropriate base? In determining overall materiality:
3. Types of Materiality1. Overall Materiality 2. Performance Materiality 3. Specific Materiality 4. Specific Performance Materiality 4. Overall MaterialityOverall materiality is based on the auditor’s professional judgment as to the maximum amount of misstatement(s) that if not corrected in the financial statements will not affect the economic decisions taken by a financial statement user. If the amount of uncorrected misstatements, either individually or in the aggregate, is higher than the overall materiality established for the audit, it implies that the financial statements are materially misstated. The overall materiality amount is one of the factors by which the ultimate success or failure of the audit will be judged.
4.1 Determining Overall MaterialityThere are three steps in determining overall materiality: i. Selecting an appropriate benchmark; 4.2 Selecting an appropriate benchmarkOverall materiality is based on the common financial information needs of the various users as a group and therefore, the possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered. In selecting the most appropriate benchmark to determine materiality, the auditor should develop an understanding of the users of the financial statements specific to their client. Some of the benchmarks commonly used include: revenue, profit before taxes, total assets or expenses. The auditor makes a judgment on which benchmark to use by understanding what the users of the financial statements are most likely to be concerned about. For example, if an entity is financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity’s earnings. An illustrative list of factors that affect the selection of an appropriate benchmark by the auditor includes:
The users of the financial statements include: investors, creditors, suppliers, employees, customers, state institutions, public in general. However, in every case, the users, who are interested in financial statements and its information, are different. Some users of the financial statements and their needs are illustrated below: UserInterest of the userShareholders/investors
Commonly used benchmarks (a) Profit before tax Illustration 1 ParticularsFY 2019-20(` Crs) FY 2018-19(` Crs) FY 2017-18 (` Crs) Turnover2,7002,0971,823Profit before Tax (PBT)325286187PBT%12.03%13.64%10.25%In this example, both the revenue and profit before tax are increasing from year to year and the profit before tax as percentage of sales is fluctuating. The company estimates the turnover for FY 2020-21 to be ` 2,800 crores based on 11 months actual sales and orders in hand. The auditor considers that it is more appropriate to use ‘normalised’ profit before tax to determine materiality. The auditor considers average profit before tax of past three years, that is ` 266 crores to calculate materiality. Illustration 2 ParticularsFY 2019-20(` Lakhs) FY 2018-19(` Lakhs) FY 2017-18 (` Lakhs) Turnover 1,17,262.48 1,17,895.79 1,04,221.92Profit before Tax (PBT)83.5857.063.16Exceptional itemsRetrenchment Cost1,545.451,794.782,012.15Normalised PBT1,629.031,851.842,015.31Normalised PBT%1.39%1.57%1.93%In this example, the profit before tax is fluctuating on year on year basis both in absolute terms and as percentage of sales. The auditor notes that the company is rationalising its operations and has been retrenching workers in the past three years. However, there is no further retrenchment in FY 2020-21. Accordingly, the auditor considers it appropriate it to first compute normalised profit by excluding retrenchment costs and then use the average of three years’ normalised profit before tax to calculate materiality Therefore the auditor considers ` 1,832.06 lakhs as the benchmark for calculating materiality. (b) Turnover (c) Total Assets/Net Assets (d) Other benchmarks
4.3 Identifying appropriate financial dataIdentifying the financial data is not as straightforward as it appears. It may be necessary to consider materiality before the financial statements to be audited are prepared, for example when planning is done prior to the year-end. In other cases, planning takes place after the draft financial statements to be audited have been provided, but it may be apparent that those statements require significant modification. In such situations materiality is based on a reasonable expectation of the amounts in the eventual financial statements. This may be obtained by extrapolating amounts either from interim management reports or from interim financial statements (for example nine months financial results) or the financial statements of one or more prior annual periods, as long as these are adjusted for major changes in the entity’s circumstances, such as a significant merger. Disclaimer: The content/information published on the website is only for general information of the user and shall not be construed as legal advice. While the Taxmann has exercised reasonable efforts to ensure the veracity of information/content published, Taxmann shall be under no liability in any manner whatsoever for incorrect information, if any. Taxmann Taxmann Publications has a dedicated in-house Research & Editorial Team. This team consists of a team of Chartered Accountants, Company Secretaries, and Lawyers. This team works under the guidance and supervision of editor-in-chief Mr Rakesh Bhargava. The Research and Editorial Team is responsible for developing reliable and accurate content for the readers. The team follows the six-sigma approach to achieve the benchmark of zero error in its publications and research platforms. The team ensures that the following publication guidelines are thoroughly followed while developing the content: What are the 3 types of materiality?Overall Materiality. When establishing the overall audit strategy, the auditor determines materiality for the financial statements as a whole. ... . Performance Materiality. ... . Specific Materiality. ... . Specific Performance Materiality.. What are the three levels of materiality in the context of an audit?Three types of audit materiality include overall materiality, overall performance materiality, and specific materiality.
What the auditor should consider when determining the level of materiality?How do auditors determine materiality? To establish a level of materiality, auditors rely on rules of thumb and professional judgment. They also consider the amount and type of misstatement. The materiality threshold is typically stated as a general percentage of a specific financial statement line item.
What are the three 3 methods of collecting audit evidence?Gathering audit evidence as part of an audit involves a mix of techniques that are used interchangeably: visual observation, examination of records, and employee interviews.
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