1. AUDIT QUALITY AND ASSURANCE 2 ND AND 3 RD OCTOBER 2014 HILTON HOTEL MATERIALITY IN PLANNING AND PERFORMING THE AUDIT (ISA 320) 1

2. CONTENT 1. Introduction 2. Materiality in the context of an audit 3. Different types of materiality 4. How to determine materiality 5. Revising Initial materiality levels 6. Materiality in planning and risk assessment 7. Materiality in performing audit procedures and documentation 8. Other issues 2

3. 1. Introduction Two auditors are conversing: Auditor 1: My wife is driving me crazy… Auditor 2: Wow, I thought she is a very wonderful loving lady? Auditor 1: She is good but recently she has been focusing too much on mistakes that I make…which to me they are…… 3

4. 1. Introduction …….. IMMATERIAL! 4

5. 1. Introduction Financial statement audit enhances the degree of confidence of intended users in the entity’s financial statements. Accordingly, due to the importance of auditors’ attestation, the auditing standards require auditors to design the audit to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. 5

6. 1. Introduction The concept of materiality is applied by the auditor when: 1. Planning and performing the audit [ISA 320]; 2. Evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements [ISA 450]; and 3. Forming an opinion on the financial statements [ISA 700]. 6

7. 2. Materiality in the context of audit Materiality addresses the significance of financial statement information to economic decisions made by users on the basis of the financial statements. The assessment of what is material is a matter of professional judgement. ISA 320 specifies 3 main characteristics of materiality: 7

8. 2. Materiality in the context of audit 1. Misstatements are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users based on the financial statements; 2. Judgments about materiality are made in the context of surrounding circumstances, and are affected by the size (quantitative - the monetary amount involved) and/or nature of misstatements (qualitative); and 3. Judgments about materiality are based on considerations of common financial information needs of users as a group. 8

9. 2. Materiality in the context of audit Misstatements may arise from a number of causes and can be based on the following: Size; Nature of the item; and Circumstances surrounding the occurrence of misstatement. 9

10. 2. Materiality in the context of audit Examples of misstatements which may be significant to users of the financial statements due to the nature rather than size are as follows: 1. Transactions involving related parties may be very significant to a person making a decision based on the financial statements; 2. Illegal acts; or 3. Non-compliance with regulatory requirements. 10

11. 3. Different types of Materiality 11

12. 4. How to determine materiality 1. Overall Materiality A percentage applied to a benchmark (Elements of financial statements, Items that users will pay attention, Nature of the entity, structure of ownership, and volatility of the benchmark). Revenue and equity we can use about 1% to 3% and equity 3% to 5%. 12

13. 4. How to determine materiality 2. Specific Materiality Decision influencers (Laws, regulations and accounting framework requirements (for example, related party transactions) ~ Key industry disclosures (for example, research and development costs for a pharmaceutical company) ~ Disclosure of significant events and important changes in operations (for example, discontinued operations). 13

14. 4. How to determine materiality It will be useful to obtain an understanding of the views and expectations of those charged with governance and management in identifying whether there are particular items for which it would be appropriate to determine a specific materiality level(s) 14

15. 4. How to determine materiality The ISA Guide “Rules of Thumb” provides that specific materiality level(s) can be determined by establishing a lower, specific materiality amount (based on professional judgment) for the audit of specific or sensitive financial statement areas. 15

16. 4. How to determine materiality 3. Performance Materiality Relevant factors that may be considered in determining performance materiality include the auditor’s understanding of the entity, nature and extent of previous audits misstatements and expectations of nature and extent of misstatements in the current period. As there is no specific guidance given in the ISAs, the ISA Guide “Rules of Thumb” suggests using percentages ranging from 60% to 85% (of overall or specific materiality), depending on the risk of material misstatements. The higher the risk of material misstatements, the lower percentage should be used. 16

17. 5. Revising Materiality Levels 17

18. 6. Materiality in Planning & risk assesment 18

19. 6. Materiality in performing audit proc. In performing audit procedures, materiality is used to: Identify further audit procedures. Determine items for testing and whether to use sampling. Assist to determine sample sizes. Evaluate sampling errors by extrapolating across population to calculate ‘likely’ misstatements. Evaluate the aggregate total errors at the account level, financial statement level and opening retained earnings. Assess results of procedures. 19

20. 7. Documentation. As materiality amounts are based on auditor’s professional judgment, it is important that all factors and amounts involved in determining materiality are properly documented. The auditor shall include in the audit documentation the following amounts and factors considered in the auditor’s determination of: ~ Overall materiality; ~ If applicable, the specific materiality level(s); ~ Performance materiality; and ~ Any revisions to the above factors as the audit progresses. 20

21. 7. Other Issues In practice auditors can also consider other approaches both quantitative and qualitative. Quantitative approaches include: 1. Single rules 2. Variable Size 3. Blend methods 4. Formula methods 21

22. 7. Other Issues 1. Single rules: Use a single financial variable e.g 5% of revenue or 0.5% of total assets. 2. Variable size: Same as single but they provide a range of materiality levels e.g. 0.5% of Gross profit with a minimum of $50,000. 3. Blend methods: Take several rules of thumb and then get an average. 22

23. 7. Other Issues 4. Formula methods : Using a mathematical formula and could include statistical techniques. E.g. 1.5 times profits. Other non quantitative factors: 1.Cost (Some items are very expensive) 2.Analytical procedures results (May reduce materiality) 3.Prior period adjustments of results (No changes) 4.Consequence of misstatement (Legal/contracts) 5. Importance of account balance (Director emoluments) 23

24. FINALLY..... Questions? 24