1. SA 315, 320 and 450 AMIT BACHHAWAT TRAINING FORUM
Risk and Materiality
SA 315, 320 and 450
AMIT BACHHAWAT TRAINING FORUM

2. Process of determining materiality
Identify Audit risk- (High/ Medium/ Low)
Identify benchmark- (PBT/ Revenue/ Total assets etc.)
Compute overall materiality- (___ % of benchmark) PLANNING STAGE
Compute performance materiality- (___ % of overall materiality)
Compute de minimis level- (___ % of overall materiality)
Perform Audit procedures- (Substantive/Analytical) EXECUTION STAGE
Revise materiality, if required
Opine whether financial statements are materially misstated COMPLETION STAGE

3. Materiality and its relation to Audit Risk
Materiality is defined as any amount which if known to the users of financial statement would influence their decision. It is a relative term. For a big organization, mistake of an amount say Rs 10lakh may not be material but that could be material for a small organization
Relation with Audit Risk
Materiality is inversely related to audit risk.
Higher the audit risk, lower is the materiality so that lower amount balances/ transactions are also covered in checking.
Lower the audit risk, higher is the materiality so that higher amount balances/ transactions are covered in checking.
Factor to be considered while setting up materiality
Items of materiality may be determined individually or in aggregate
Materiality depends upon regulatory or legal considerations.
Materiality has both quantitative and qualitative dimensions.
An item whose impact is insignificant at present but in future it may be significant may also be material. Eg: Onus of land mining on the company at the end of contract period. It entails a huge cost at the end of contract but is of insignificant amount at present.

4. ROMM- SA 315 Moderate 3(3*1) High 6(3*2) High 9( 3*3) Low 2( 2*1)
Risk that the financial statements of the client be materially misstated is defined as risk of material misstatement. It is a function of inherent risk and control risk.
The audit risk matrix is shown below :
ROMM= IR * CR
High (3)
INHERENT
RISK(IR) Moderate (2)
Low (1)
Low (1) Moderate (2) High(3)
CONTROL RISK (CR)
Moderate 3(3*1)
High 6(3*2)
High 9( 3*3)
Low 2( 2*1)
Moderate 4( 2*2)
High 6( 2*3)
Low 1(1*1)
Low 2 (1*2)
Moderate 3 (1*3)

5. ROMM- SA 315
Inherent risk is defined as the possibility of incorrect or misleading information in accounting statements resulting from something other than failure of controls. Examples of inherent risk are most common where accountants have to use a larger than normal amount of judgment and approximation, or where complex financial instruments are involved. The factors contributing to inherent risk are as follows:
Inattentive management
Management intergrity/ Client motivation
Susceptibility to theft
Related party transactions.
Control risk is a risk that the internal controls implemented by the management would not be able to detect and correct misstatements. The different components of internal control which the auditor needs to verify to compute control risks are:
Control Environment
Control Activities
Entity’s Risk Assessment Procedures
Information System
Monitoring of controls

6. Benchmark- SA 320 Nature Benchmark Rule of thumb For listed entity
Benchmark are decided based on knowledge of the client business and environment in which client operates.
Chosing a benchmark is matter of professional judgement and may vary from client to client/ year on year.
Auditor needs to document the rationale of chosing a certain benchmark ( Refer working paper for the same)
Examples of various type of benchmark used for different entities are as follows:
Nature
Benchmark
Rule of thumb
For listed entity
For non-listed entity
Profit oriented entity
PBT
______%
Not-for-profit entities
Total rev/ Total exp
Total assets
Other than not for profit entities where PBT is not considered appropriate
Entity where EBITDA is considered apt
EBITDA
Entity where net asset is considered apt
Net assets

7. Benchmark- SA 320
The list enumerated above is only indicative in nature and generally practiced among various big firms.
Eg of benchmark in various companies are as follows: a) Construction company- EBITDA( since their interest cost is very high ) and b) NBFC- Total Asset( since their strength is judged by the amount of loan they have disbursed to the third parties).
Considerations where different benchmarks can be chosen for different entities are as follows:
In case of owner managed business where owner takes much of the profit before tax as remuneration, a benchmark such as profit before remuneration and tax may be relevant.
In case of government entities, often the legislators and regulators are the primary users of their financial statements. In such scenario the decision of users may be materially affected by legislative and regulatory requirements and by the financial information needs of legislators and the public in relation to public utility programs/projects such as Accelerated Irrigation Benefit Programme( AIBP), Pradhan Mantri Gram Sadak Yojana (PMGSY) undertaken by these entities.
In an audit of entities doing public utility programs, total cost or net cost may be an appropriate benchmark.
Where an entity has custody of assets, assets may be an appropriate benchmark.
Volatility of selected benchmark.
Various factors considered in deciding benchmark are :
Items which can draw the attention of financial users
Nature of entity and its lifecycle and industry.
Entity’s ownership structure etc.

8. Overall materiality- SA 320
The primary objective of an auditor is to express an opinion whether financial statements are true and fair.
An e.g of auditor’s opinion is “ In all MATERIAL ASPECTS, the financial statements represents true and fair view.”
The auditor defines materiality to determine the nature, timing and extent of audit procedures to form an audit opinion.
Overall materiality is determined at a financial statement level and any misstatement that is equal to or greater than overall materiality renders the financial statements as materially misstated.
Overall materiality is calculated by multiplying certain % to the chosen benchmark.
Chosing the appropriate % is a matter of professional judgement and varies from auditor to auditor.
There is a relationship between the percentage and the chosen benchmark, such that a percentage applied to a profit before tax from continuing operations will normally be higher than a percentage applied to total revenue.
Overall materiality is used to calculate the performance materiality and de minimis level( discussed later on).

9. Overall materiality- SA 320
The indicative % used to calculate the overall materiality are as below:
Nature
Benchmark
Rule of thumb
For listed entity
For non-listed entity
Profit oriented entity
PBT
Up to 5%
Up to 10%
Not-for-profit entities
Total rev/ Total exp
Up to 1%
Up to 3%
Total assets
Other than not for profit entities where PBT is not considered appropriate
Entity where EBITDA is considered apt
EBITDA
Up to 2.5%
Up to 3.5%
Entity where net asset is considered apt
Net assets

10. Overall materiality- SA 320
The factors which indicate that a percentage at the lower end of the range as stated above may be appropriate are:
The financial statement users are widely distributed/entity is a listed entity.
The entity has a significant level of debt.
There are specific factors such as financial covenant which increases the sensitivity of the selected benchmark.
The factors which indicate that a percentage at the higher end of the range as stated above may be appropriate are:
The financial statement users are limited/unlisted entity.
The entity has no significant level of external debt/no close call on financial covenants.
The benchmark may be focused on particular relevant factors.
When overall materiality is determined based on a percentage at the upper end of range, certain financial statement line item may therefore be out of scope for testing. Auditor needs to consider specific risks attributable to this line items which warrant a lower materiality being used for these particular classes of transactions, account balances or disclosures.

11. Performance Materiality- SA 320
Performance materiality is computed to chose the account balances, transactions and disclosures on which audit procedures are to be performed. For eg. If performance materiality is set at Rs 5lakhs and there is one account with balance of Rs 2lakh, then auditor can ignore the testing of that account if he considers that there are no separate risks associated with that account balance.
The technical definition of performance materiality is as follows , “Performance materiality is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in the financial statements exceed materiality for the financial statements as a whole”.
The purpose of setting up performance materiality is as follows-
Performance materiality is set at a level lower than the overall materiality. Now take an eg that Overall materiality is Rs 1crore. While checking various balances we noticed misstatements of value lower than Rs 1 crore( say two misstatement of Rs 75lakhs each). Since both the misstatements are lower than the overall materiality, hence we will end up ignoring the misstatements but the aggregate value of such misstatement exceeds overall materiality.
Hence we set performance materiality at a level lower than the overall materiality so that the risk that aggregate of uncorrected and undetected misstatements exceeds overall materiality is reduced to a low level.

12. Performance Materiality- SA 320
Setting up performance materiality is again a matter of professional judgement. Generally across firms, performance materiality is usually set up at 90%,75% or 50% of overall materiality. Some of the factors that determine the appropriate use of % are as follows:
Factors
90%
75%
50%
History of misstatements
History of limited/no booked or proposed audit adjustment.
History of frequent audit adjustment.
Risk assessment and aggregation risk
Low aggregation risk due to potential misstatement due to reasons such as management pressure, uncertainity etc.
Medium aggregation risk due to potential misstatement due to reasons such as management pressure, uncertainity etc.
High aggregation risk due to potential misstatement due to reasons such as management pressure, uncertainity etc.
Effectiveness of control
Controls have been operating effectively.
Expected or known significant deficiencies in controls.

13. De-minimis level- SA 450
SA 450 requires the auditor to accumulate misstatements identified during the audit other than those that are clearly trivial.
The auditor may designate an amount below which misstatements of amounts in individual statements would be clearly trivial and would not need to be accumulated because the auditor expects that the accumulation of such amounts clearly would not have a material effect on the financial statements. This amount which the auditor sets is called de-minimis level.
The auditor can set the de-minimis level as per his professional judgement. Normally the level is set at 0%, 3%, 5% and 10% of overall materiality depending upon the following factors:
The number and amount of prior year’s misstatements, whether corrected or uncorrected
Result of risk assessment
Client expectation of a threshold amount of what will be communicated to them
For eg: Overall materiality is Rs 10lakhs. Performance materiality is Rs 7.5lakhs(75%). De minimis level is Rs 50 thousand (5%). Now while checking auditor notices misstatements of Rs 30000, and respectively in three different accounts. Now he can ignore amount of Rs and Rs would be required to be accumulated.

14. De-minimis level- SA 450 Factors 0% 3% 5% 10%
The various factors relevant which is practiced across various firms for setting up de-minimis level are as follows:
Factors 0% 3% 5%
10%
Number and amount of misstatements
Audit of entity often give rise to material audit adjustments.
Audit of entity often give rise to audit adjustments. Amount is not material.
Audit adjustments are expected to occur from time to time. Amount not material.
Audit adjustment has been virtually non existent.
Risk assessment
High ROMM. Numerous significant risks identified
High ROMM. Some additional significant risk identified.
High ROMM. Very few significant risk identified.
Low ROMM
Management expectation
Management expect all misstatement to be communicated irrespective of amount.
Management expects misstatement of less than 5% of overall materiality to be communicated.
Management expects misstatement of approx 5% of overall materiality to be communicated.
Management expects misstatement of approx 10% of overall materiality to be communicated.

15. Revision and accumulation- SA450
The misstatements idenitified that are above de minimis level needs to be accumulated and if the same approaches the materiality as decided, the auditor needs to communicate the differences to the management to get it rectified. If the management refuses to rectify, then
Take written representation from the management regarding the uncorrected misstatement.
Consider qualifying the report if required.
Auditor is satisfied with only taking written representation if he is of the opinion that the misstatements does not render the account materially misstated( normally when misstatement is approx. close to performance materiality).
If auditor thinks that the misstatement is of such magnitude that it renders the account as materially misstated, then he qualifies the report( normally when misstatement approaches overall materiality)
Generally the benchmark and materiality is decided at planning stage using the estimated figures. If the estimated figures differ significantly from the actual figures then the auditor also need to revise his materiality and testing.

16. Example- Also refer specimen working paper
As per working paper- OM= Rs 3.5cr, PM= Rs 2.6cr, De-minimis= Rs 17.5 lakh
Now lets take an eg. There are 4 account balances: Sales- Rs 100 cr, Purchase- Rs 50cr, Other expense Rs 2cr, Interest Rs 5 cr and other income Rs 1 cr . Hence now other expenses and other income will not be picked up for testing since their balance is below PM. But since the total balance of untested balance is Rs 3cr(2+1), auditor may decide to test this balance considering both the account as single account.
Now during the testing, assume there are misstatement found
Scenario 1: Two misstatement of Rs 10lakh each and 10 misstatement of Rs 20 lakh each. Auditor will ignore 2 misstatement of Rs 10 lakh each since they are below de-minimis level. Auditor will accumulate the balance 10 misstatement of Rs 20lakh each since they are above de-minimis. Since the balance of misstatement is approx. close to PM, auditor will ask the management to rectify it or if management refused to rectify, then take a written representation/or consider qualifying the report if misstatement renders the financial statements as materially misstated.
Scenario 2: Say the ten misstatement were of amount Rs 35 lakh each. In this case since the misstatement is equal to OM, auditor will ask the management to rectify it and if management refuses, then qualify the report. No written representation considered sufficient in this case.