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IAASB Main Agenda (September 2004) Page 2004·1719 Agenda Item
5-A
Prepared by: Keith Billing (August 2004) Page 1 of 16
MATERIALITY IN THE IDENTIFICATION AND EVALUATION OF
MISSTATEMENTS
CONTENTS
Paragraphs
Introduction ........................................................................................................................... 1-
Nature and Causes of Misstatements..................................................................................... 4-
Materiality in the Context of an Audit .................................................................................. 6-
Users................................................................................................................................ 8-
Determining Materiality for the Financial Statements .......................................................... 10-
Use of Percentages of Benchmarks ................................................................................. 12-
Materiality for Particular Items of Lesser Amounts Than the Materiality
Level Determined for the Financial Statements ................................................................ 17-
Tolerable Error ...................................................................................................................... 20-
Considerations as the Audit Progresses................................................................................. 22-
Evaluation of Identified Misstatements................................................................................. 25-
Communication of Misstatements to Management............................................................... 29-
Evaluating the Effect of Uncorrected Misstatements............................................................ 36-
Documentation ...................................................................................................................... 45-
Effective Date........................................................................................................................ 47
International Standard on Auditing (ISA) 320, “Materiality in the Identification and Evaluation of Misstatements,” should be read in the context of the “Preface to the International Standards on Quality Control, Auditing, Assurance and Related Services,” which sets out the application and authority of ISAs.
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Introduction
- The purpose of this International Standard on Auditing (ISA) is to establish standards and provide guidance on materiality, including its relationship with audit risk and how it is used in the identification and evaluation of misstatements when performing an audit of a complete set of general purpose financial statements^1.
- The auditor should consider materiality when planning and performing the audit to reduce audit risk to an acceptably low level.
- ISA 200, “Objective and General Principles Governing an Audit of Financial Statements,” requires the auditor to plan and perform the audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risk of material misstatement of the financial statements and the risk that the auditor will not detect such misstatement. ISA 315, “Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement,” requires the auditor to identify and assess the risks of material misstatement at the financial statement level, and at the assertion level for classes of transactions, account balances and disclosures. ISA 330, “The Auditor’s Procedures in Response to Assessed Risks” requires the auditor to design and perform further audit procedures in response to assessed risks. In order to do so, the auditor considers materiality: (a) When identifying and assessing the risks of material misstatement; (b) When determining the nature, timing and extent of further audit procedures; and (c) When evaluating the effect of identified uncorrected misstatements on the auditor’s report.
Nature and Causes of Misstatements
- A misstatement causes the financial statements to be not in accordance with the applicable financial reporting framework. Misstatements can arise from error or fraud and may consist of: (a) An inaccuracy in gathering or processing data from which financial statements are prepared; (b) A difference between the amount, classification, or presentation of a reported financial statement item and the amount, classification, or presentation that is required for the item to be in accordance with the applicable financial reporting framework; (c) An omission of an amount or disclosure that is required by the applicable financial reporting framework, or is otherwise needed for the financial statements to give a true and fair view or present fairly in all material respects;
(^1) Much of the guidance in this ISA can be adapted for audits of financial information other than an audit of a
complete set of general purpose financial statements, such as special purpose engagements (ISA 800, “The Auditor’s Report on Special Purpose Audit Engagements”). Relevant ISAs provide additional guidance to the extent that it is necessary in such other engagements.
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misstatements on specific individual users, which may vary widely^4. For a profit oriented entity, as investors are providers of risk capital to the enterprise, the provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy. In the audit of such entities, therefore, the collective needs of investors as a group is an appropriate frame of reference when determining materiality.
- Users are assumed to: (a) Have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence. (b) Understand that financial statements are prepared and audited to levels of materiality and that there is a relationship between the level of materiality used and the cost and timing of the audit, and recognize that, to be economically useful, the auditor’s opinion needs to be derived within a reasonable period of time and at a reasonable cost; (c) Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment and the consideration of future events; and (d) Make reasonable decisions on the basis of that information.
Determining Materiality for the Financial Statements
- The auditor should determine a materiality level for the financial statements as a whole for the purpose of: (a) Determining the extent and nature of risk assessment procedures; (b) Identifying and assessing the risks of material misstatement; and (c) Determining the nature, timing and extent of further audit procedures.
- The auditor determines a materiality level for the financial statements as a whole when establishing the overall audit strategy for the audit (see ISA 300, “Planning and Audit of Financial Statements”)^5. Determining a materiality level for the financial statements as a whole helps to guide the auditor’s judgments in identifying and assessing the risks of material misstatements and in planning the nature, timing and extent of further audit procedures. This materiality level does not, however, establish a threshold below which identified misstatements are always considered to be immaterial when evaluating those misstatements and their effect on the auditor’s opinion. As discussed in paragraph 27, the circumstances related to some identified misstatements may cause the auditor to evaluate them as material even if they are below the materiality level determined for the purpose of planning the audit.
(^4) When determining materiality in audits of financial statements prepared in accordance with a financial reporting
framework designed for a special purpose, the auditor forms this judgment in the context of the auditor’s understanding of the needs of the specific users. (^5) The auditor reconsiders this materiality level if necessary as the audit progresses (see paragraph 22).
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U SE OF P ERCENTAGES OF B ENCHMARKS
- The determination of what is material is a matter of professional judgment. The auditor often applies a percentage to a chosen benchmark as a step in determining materiality for the financial statements taken as a whole. When identifying an appropriate benchmark, the auditor has regard to factors such as:
- The elements of the financial statements (e.g. assets liabilities, equity, income and expenses) and the financial statement measures defined in the applicable financial reporting framework (e.g. financial performance, financial position and cash flows), or other specific requirements in the financial reporting framework;
- Whether there are financial statement items on which, for the particular entity, users’ attention tends to be focused (e.g. for the purpose of evaluating financial performance);
- The nature of the entity and the industry in which it operates; and
- The size of the entity, nature of its ownership and the way it is financed. Examples of benchmarks that might be appropriate, depending on the nature and circumstances of the entity, include total revenues, gross profit and other categories of reported income, such as profit from continuing operations. Profit from continuing operations may be a suitable benchmark for profit oriented entities but may not be an appropriate benchmark for the determination of materiality when, for example, the entity's earnings are volatile, when the entity is a not-for-profit entity or when it is an owner managed business where the owner takes much of the pre-tax income out of the business in the form of remuneration. For asset based entities, an appropriate benchmark might be net assets.
- While in practice there are ranges of possible percentages to be considered, examples of percentages applied to benchmarks that might be considered appropriate include:
- For a profit oriented listed entity, five percent of profit after tax from continuing operations, or one half percent of total revenues;
- For a not-for-profit entity, one half percent of total expenses or total revenues;
- For an entity in the mutual fund industry, one half percent of net asset value; The benchmark selected and the percentage applied reflect, in the auditor’s professional judgment, the measures that users are most likely to consider important.
- When determining materiality, the auditor ordinarily considers prior periods’ financial results and financial positions, the period-to-date financial results and financial position, and budgets or forecasts for the current period, taking account of significant changes in the entity’s circumstances (e.g. a significant business acquisition) and relevant changes of conditions in the economy as a whole or the industry in which the entity operates. For example, when the auditor usually determines materiality for a particular entity based on a percentage of profit, circumstances that give rise to an exceptional decrease or increase in profit may lead the auditor to conclude that materiality is more appropriately determined using an annualized profit figure based on past results, or a different benchmark altogether such as total revenues.
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- When assessing the risks of material misstatements and designing and performing further audit procedures to respond to the assessed risks, the auditor allows for the possibility that some misstatements, of lesser amounts than the materiality level, could, in the aggregate, result in a material misstatement of the financial statements. To do so, the auditor uses professional judgment to determine levels of tolerable error^6 , which are amounts lower than materiality, for classes of transactions, account balances and disclosures.
Considerations as the Audit Progresses
- The auditor should revise the materiality levels in the event of becoming aware of information during the audit that would have caused different levels to have been determined initially.
- The auditor’s determination of materiality for the financial statements and for particular items at the time of establishing the overall audit strategy may differ from that at the time of evaluating the results of further audit procedures. This may be because of a change in circumstances that occurs during the audit or because of new information or changes in the auditor’s understanding of the entity and its operations as a result of performing further audit procedures. For example, the auditor may have based materiality on the anticipated period end financial results. If actual financial results are substantially different, the determination of materiality may also change.
- If the auditor concludes that, based on new information, a lower materiality level than that initially determined is appropriate, the auditor reconsiders the related levels of tolerable error and appropriateness of the nature, timing and extent of audit procedures.
Evaluation of Identified Misstatements
- As misstatements are identified during the course of the audit, the auditor should evaluate whether those misstatements are material, individually and in aggregate with other misstatements that have already been identified. The auditor should also consider the nature and circumstances of identified misstatements and evaluate whether there is any indication based on their nature and circumstances that other misstatements may exist that could be material and, if so, the auditor should consider whether the overall audit strategy and audit plan need to be revised.
- The auditor cannot assume that a misstatement is an isolated occurrence. Evidence that other misstatements may exist include, for example, where the auditor identifies that a misstatement arose from a breakdown in internal control or from inappropriate assumptions or valuation methods that have been widely applied by the entity. In such circumstances the auditor evaluates whether the overall audit strategy and audit plan, and consequently the nature, timing and extent of further audit procedures, need to be reconsidered to reduce audit risk to an acceptably low level. The auditor also considers whether misstatements reflect on the adequacy of the financial (^6) “Tolerable error” is the maximum error in a population that the auditor is willing to accept. ISA 530, “Audit
Sampling and Other Selective Testing Procedures,” for example, explains that tolerable error is one of the factors influencing sample size for substantive procedures.
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records maintained by the entity, or are indicative of internal control weaknesses, and the implications thereof for the auditor’s reporting responsibilities, if any.
- The circumstances related to some misstatements may cause the auditor to evaluate them as material, individually or when considered together with other identified misstatements, even if they are of a lower level than the auditor had determined to be material when establishing the overall audit strategy and audit plan. Circumstances that may affect the evaluation include whether the misstatement:
- Affects compliance with regulatory requirements;
- Affects compliance with debt covenants or other contractual requirements;
- Masks a change in earnings or other trends, especially in the context of general economic and industry conditions;
- Affects ratios used to evaluate the entity’s financial position, results of operations or cash flows;
- Affects segment information presented in the financial statements (e.g. the significance of the matter to a segment or other portion of the entity's business that has been identified as playing a significant role in the entity's operations or profitability);
- Has the effect of increasing management compensation, for example, by ensuring that the requirements for the award of bonuses or other incentives are satisfied;
- Is a misclassification between particular account balances (e.g. misclassification between operating and non-operating income or recurring and non-recurring income items; a misclassification between restricted and unrestricted resources in a not-for-profit entity; or a misclassification between balance sheet items that may not affect income);
- Is significant relative to the auditor’s understanding of users’ expectations. For example, where particular levels of forecast earnings have previously been communicated to users by management;
- Relates to items involving particular parties (e.g. whether external parties to the transaction are related to members of the entity’s management);
- Is an omission of information not specifically required by the applicable financial reporting framework but which, in the judgment of the auditor, is important to the users’ understanding of the financial position, financial performance or cash flows of the entity;
- Affects other information that will be communicated in documents containing the audited financial statements (e.g. information to be included in a “Management Discussion and Analysis” or an “Operating and Financial Review”) that may affect the expectations of the users of the financial statements. The circumstances listed above are only examples; not all of these circumstances are likely to be present in all audits, nor is the list necessarily complete. The existence of any circumstances such as these does not necessarily lead to a conclusion that the misstatement is material.
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(b) Likely misstatements These are misstatements that the auditor considers likely to exist based on an extrapolation from audit evidence obtained. For example, the amount obtained by projecting known misstatements identified in an audit sample to the entire population from which the sample was drawn.
- The auditor should encourage management to correct all known misstatements, other than those that the auditor believes are clearly trivial. Where appropriate, the auditor also requests management to take action to reduce the estimated amount of likely misstatements.
- Where the auditor estimates the amount of likely misstatement in a class of transactions, account balance or disclosure to be material, either individually or in aggregate with other misstatements, the auditor discusses with management the consequences for the auditor’s report if management fails to recheck the class of transactions, account balance or disclosure and, if possible, identify and correct misstatements found. When management performs rechecks and corrects misstatements that are found, the auditor then performs further audit procedures to reevaluate the level of likely misstatements in the class of transactions, account balance or disclosure.
- The auditor communicates details of misstatements that management declines to correct to those charged with governance in accordance with the requirements of ISA 260, “Communication of Audit Matters With Those Charged With Governance.”
Evaluating the Effect of Uncorrected Misstatements
- In forming the opinion as to whether the financial statements give a true and fair view, or are presented fairly in all material respects, in accordance with the applicable financial reporting framework, the auditor should evaluate whether uncorrected misstatements that have been identified during the audit are material, individually or in aggregate. In making this evaluation, the auditor should consider the size and nature of the misstatements, both in relation to particular classes of transactions, account balances and disclosures and the financial statements as a whole, and the particular circumstances of their occurrence.
- [Proposed revised] ISA 700, “The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements,” provides guidance for the auditor on forming the opinion on the financial statements. It states that the auditor considers all audit evidence obtained and evaluates whether, based on that evidence, the auditor has obtained reasonable assurance that the financial statements are free from material misstatement. That evaluation includes considering not only the sufficiency and appropriateness of audit evidence obtained, but also the effects of the misstatements identified.
- Before considering the aggregate effect of uncorrected misstatements, the auditor considers each uncorrected misstatement separately:
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(a) To evaluate its effect in relation to the relevant individual classes of transactions, account balances or disclosures; (b) To evaluate whether, in considering the effect of the individual misstatement on the financial statements as a whole, it is appropriate to offset misstatements. For example, it may be inappropriate to offset misstatements of items that are disclosed separately in the financial statements; (c) To evaluate the effect of a misstatement from prior periods and any cumulative effect becoming material in the current or subsequent reporting periods.
- When considering what is the appropriate treatment of misstatements related to prior periods, the auditor has regard to the requirements of the applicable financial reporting framework (e.g. whether accounting standards require or permit prior period misstatements to be corrected by way of restating the prior period or by correction in the current period).
- In evaluating whether the financial statements as a whole are free of material misstatement, the auditor considers the effect of the aggregation of uncorrected misstatements and management bias, if any, on the fair presentation of the financial statements. Certain matters when looked at in isolation may not appear to result in a material misstatement but, when considered together with the uncorrected misstatements, may collectively cause the financial statements as a whole to be materially misstated. For example, if there are a number of biased accounting estimates that fall at the ends of ranges of reasonably and equally possible outcomes there is a risk that those accounting estimates, when looked at collectively with uncorrected misstatements, result in material misstatement of the financial statements, notwithstanding that each accounting estimate is considered reasonable when looked at individually (e.g. the combined effect on reported earning of uncorrected misstatements and bias may be material).
- ISA 540, “The Audit of Accounting Estimates and Related Disclosures (Excluding Those Involving Fair Value Measurements and Disclosures),” requires that the auditor evaluate whether there is any audit evidence indicating bias in the making of accounting estimates and, where there is such evidence, quantify the bias. Management bias with respect to accounting estimates arises in those circumstances where the applicable financial reporting framework does not specify which point within a range of reasonably and equally possible outcomes is recognized and management selects an outcome which is not neutral. With respect to a range of reasonably and equally possible outcomes there is a rebuttable presumption that the mid point of the range is free from bias and therefore neutral. ISA 540 provides examples of indicators of bias and its quantification.
- Possible management bias is one of the qualitative aspects of the entity’s accounting practices that the auditor communicates to those charged with governance in accordance with ISA 260.
- If the auditor confirms that, or is unable to conclude whether, the financial statements are materially misstated, the auditor should consider the implications for the auditor’s opinion on the financial statements.
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Appendix
[ Note to the IAASB: This Appendix is new, incorporating text that was originally in the main body of the proposed exposure draft of revised ISA 320. The revision marks indicate proposed changes to the other ISAs. ]
Conforming Changes to Other ISAs
ISA 260 “Communication of Audit Matters with Those Charged with Governance”
11a. The auditor should inform those charged with governance of those uncorrected misstatements aggregated by the auditor during the audit that were determined by management to be immaterial, both individually and in the aggregate, to the financial statements taken as a whole.
11b. The uncorrected misstatements communicated to those charged with governance need not include the misstatements below a designated amount.
C OMMUNICATION OF M ATERIALITY
11a. The auditor should communicate to those charged with governance the materiality level the auditor determined for the financial statements unless the auditor believes it probable that such communication would influence management’s approach to the preparation of the financial statements.
11b. The auditor ordinarily discusses with those charged with governance the application of materiality in the audit as part of a broader communication of the general approach and overall scope of the audit. The auditor explains that the circumstances related to some misstatements may cause the auditor to evaluate them as material, individually or in aggregate, even if they are of a lower level than the auditor had determined to be material when planning the audit. The auditor also makes clear to those charged with governance that, due to the inherent limitations of an audit, there may be misstatements that the audit will not detect.
11c. The auditor does not communicate to those charged with governance, or to management, the materiality level for the financial statements if the auditor believes that such communication might, for example, result in management being less attentive to the detection and correction of misstatements.
C OMMUNICATION OF M ISSTATEMENTS
11d. The auditor should communicate misstatements identified by the auditor during the audit that management declines to correct, other than those that the auditor believes are clearly trivial, to those charged with governance, unless they are the same persons as management (as may be the case in smaller entities). The auditor should also consider whether the
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auditor has a responsibility to report certain misstatements to regulatory and enforcement authorities.^8
11e. In communications with those charged with governance, the auditor explains why the auditor considers misstatements to be material. As described in ISA 320, “Materiality in the Identification and Evaluation of Misstatements,” misstatements are not dismissed as immaterial solely because they are of a lesser amount than the auditor determined as the materiality level for the financial statements as a whole when planning the audit. The circumstances related to some misstatements may cause the auditor to evaluate them as material even if they are of a lesser amount.
11f. Where it aids the communication process, the auditor may communicate a summary of those uncorrected misstatements that the auditor judges to be immaterial in aggregate (e.g. by informing those charged with governance of the number and overall sum of immaterial misstatements) rather than communicating the details of each individual misstatement.
11g. The auditor discusses with those charged with governance management’s reasons for not correcting the misstatements, the implications for the auditor’s report and the possible implications in relation to future financial statements if they remain uncorrected (e.g. where, although immaterial in the current period, the accumulation of such misstatements over time could lead to an aggregate material misstatement in the future). Where the auditor considers it appropriate, the auditor requests those charged with governance to ask management to correct the misstatements.
11h. The auditor considers whether misstatements that management has previously corrected, of which the auditor is aware, should be communicated to those charged with governance so as to assist them to fulfill their governance responsibilities. It may be helpful to communicate material misstatements that have been previously corrected by management, or frequently recurring immaterial misstatements which, although corrected, may be indicative of significant weaknesses in the systems of internal control or the design or operation of the entity’s financial reporting process.
C OMMUNICATION OF Q UALITATIVE A SPECTS OF THE E NTITY ’ S A CCOUNTING P RACTICES
11i. The auditor should communicate to those charged with governance the auditor’s views about the qualitative aspects of the entity’s accounting practices and financial reporting that the auditor considers when forming an opinion on the financial statements.
11j. In the course of the audit of the financial statements, the auditor considers the quality, as well as the acceptability, of the entity’s accounting practices and financial reporting, including matters that have a significant impact on the relevance, reliability, comparability and understandability of the information provided by the financial statements (e.g. the consistency of the entity’s (^8) Requirements specific to the communication of misstatements resulting from fraud, or a suspected fraud, are set out
in ISA 240 (Revised), ‘The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements’. In some jurisdictions the auditor may have other responsibilities to report certain misstatements to regulatory and enforcement authorities.
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misstatements of the components’ financial information and the consolidation on the group financial statements. The gGroup materiality level is based on the group financial statements.
- The group auditor also establishes group planning materiality to determine the nature, timing and extent of audit procedures to be performed on the group financial statements. Group planning materiality is also based on the group financial statements.
- The group auditor uses group planning materiality to determine planning materiality to be used when performing work on the components’ financial information. The group auditor’s determination of planning materiality for components is a matter of professional judgment and may be impacted by factors such as the individual financial significance of a component and whether a component has been identified at group level as likely to include significant risks of material misstatement of the group financial statements. Planning materiality for a component does not exceed, and in practice sometimes is lower than, group planning materiality.
- The group auditor also determines the materiality levels to be used for group reporting purposes when performing work on the components’ financial information. The group auditor’s determination of materiality levels for individual components is a matter of professional judgment and may be affected by factors such as:
- The structure of the group (for example the number of components and their individual financial significance);
- Whether a component has been identified at group level as likely to include significant risks of material misstatement of the group financial statements; and
- Group wide controls (which may affect the auditor’s evaluation of the expected level of misstatements in components). For group reporting purposes, to allow for the aggregation of identified misstatements and the possible existence of undetected misstatements, the materiality level of a component is lower than group materiality.
- When planning audit procedures for a component for group reporting purposes, the component auditor ordinarily establishes levels of tolerable error lower than the component materiality level to allow for the possibility that some misstatements, of lesser amounts than the materiality level, could be material in the aggregate.
31 Where the work on a component will be performed by a related auditor or other auditor, the group auditor communicates the planning materiality level determined by the group auditor for the component. The group auditor also communicates a threshold below which misstatements are regarded as clearly inconsequential and, as a result, need not be communicated to the group auditor.
