1. Materiality Tisa Madson Kelly Purdy SiJia Pang Yihong You

2. Auditing Standards PCAOB AS 11 AU 312 Consideration of Materiality in Planning and Performing an Audit AICPA SAS no. 107 Audit Risk and Materiality in Conducting an Audit ISA 320 Materiality in Planning and Performing an Audit

3. Definition Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. -FASB’s Statement of Financial Accounting Concepts No. 2 “Qualitative Characteristics of Accounting Information”

4. Considering Materiality Auditor exercises professional judgment Materiality is assessed in terms of a misstatement’s potential effect on a reasonable user

5. The Reasonable User • Have an appropriate knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with an appropriate diligence. • Understand that financial statements are prepared and audited to levels of materiality. • Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events. • Make appropriate economic decisions on the basis of the information in the financial statements

6. Three-Step Process Step 1: Determine a materiality level for the overall financial statements Step 2: Determine Tolerable Misstatement Step 3: Evaluate Audit Findings

7. Step 1: Planning Materiality Planning Materiality- Maximum amount by which the auditor believes the financial statements could be misstated and still not effect the decisions of users Materiality is relative Use benchmarks

8. Benchmarks Rule of thumb- 5% Profit before tax from cont. ops Total revenue Net asset value

9. Qualitative Factors Material misstatement in prior years Small amounts may violate covenants in a loan agreement Small amounts may cause entity to miss forecasted revenue or earnings

10. Step 2: Determine Tolerable Misstatement Tolerable Misstatement is the amount of planning materiality that is allocated to an account or class of transactions. Set tolerable misstatements between 50 and 75 percent of planning materiality. Establish a scope for the audit process for individual account balances or class of transactions.

11. The Safety Net Financial statement materiality serves as a safety net IF Individual misstatements are less than tolerable misstatement, but aggregate misstatements are greater than planning materiality: Auditor will need to perform more testing Audit client needs to adjust the financial statements And/or the auditor issues a qualified or adverse opinion

12. Step3: Evaluate Audit Findings Determine the likely misstatement Aggregate misstatements from accounts Compare aggregate misstatement to the planning materiality

13. Likely misstatement Closest reasonable estimate The difference between recorded amount and the amount at the closest end of the auditor’s range

14. Aggregate misstatement Consider the effect of misstatements not adjusted in the prior period Planning materiality may differ from the materiality used in evaluating

15. Comparison If less than planning materiality, fairly presented If more than planning materiality, request the client adjust the financial statement

16. Review 1st Determine Planning Materiality Usually 5% of pre-tax net income 2nd Determine the tolerable misstatement 50-75% of planning materiality for each account 3rd Evaluate If greater than planning materiality Client adjusts financial statements Auditor may render an adverse opinion

17. Source Messier William, Steven Glover and Douglas Prawitt. Auditing and Assurance Services. New York: McGraw-Hill/Irwin, 2010.