AUDITING

July 2000

CURRENT MATERIALITY GUIDANCE FOR AUDITORS

By Thomas E. McKee and Aasmund Eilifsen

Sound materiality judgments are an important element of maintaining investor confidence in the public reporting system currently used by capital markets. Determining what (or how much) is material requires professional judgment about the relative importance and effect of financial reporting and disclosure choices on the decisions of the users of financial statements. Auditor materiality judgments affect both the amount of work done by auditors and financial statement disclosure decisions.

Auditors have to make materiality judgments on every audit. This process is difficult because both quantitative and qualitative factors must be evaluated. Additionally, the auditing standards give no formal guidance for how to implement materiality concepts. Although sometimes difficult to make, good materiality judgments are crucial for a successful audit.

Materiality and Risk

Materiality and audit risk are related. FASB Statement of Financial Accounting Concepts No. 2 defines materiality as follows:

The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying on the report would have been changed or influenced by the inclusion or correction of the items.

International Standards on Auditing (ISA) section 400 defines audit risk as the "risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated." This definition considers the risk of failure to modify an opinion on financial statements that are materially misstated but not the risk of incorrectly modifying an opinion on financial statements that are not materially misstated.

Audit risk is defined in terms of a "material misstatement." From both a theoretical and practical perspective this means that it is not possible to discuss audit risk in a meaningful way without also discussing a corresponding level of materiality.

As noted in ISA section 320, "There is an inverse relationship between materiality and the level of audit risk." For example, if the materiality amount is decreased from $1 million to $100,000, and the same audit evidence is gathered, the audit risk increases. To have the same level of audit risk for a $100,000 materiality level as for a $1 million materiality level, an auditor would have to obtain additional audit evidence, because the threshold for detection has been lowered.

Since most firms strive for a relatively constant level of overall audit risk, choosing the wrong materiality level affects decisions about the nature, extent, and timing of the fieldwork. These decisions, in turn, affect the effectiveness or efficiency of the audit. Thus, making proper judgments about materiality is an important part of audit planning.

Factors Affecting the Materiality Decision

The auditor's materiality decision is both quantitative and qualitative in nature. Moreover, as evidence is accumulated and facts change, materiality may evolve from a preliminary, planning judgment to a final, reporting judgment.

Materiality amounts derived using quantitative approaches may be increased or decreased based on the auditor's professional judgment about the possible effect of qualitative factors such as the following:

* Risk of earnings manipulation (e.g., motivation to manage or smooth earnings)
* Possible effect of misstatements on trends such as profitability
* Presence of restrictive debt covenants
* Magnifying effect of misstatement on share price for a company with high price/earnings multiple
* Closeness of projected earnings to net loss status
* Accuracy and reliability of accounting system
* Imminent acquisition, merger, or sale
* Possible effect of a misstatement on segment information
* Threat of litigation or other external review of the auditors' work (e.g., monitoring by a government agency)
* Relationship to stockholders' equity or retained earnings
* Imminent public stock offering
* Risk that there may be undetected misstatements
* Detection of fraud or fraud indicators in prior period
* Assessment of the risk of misstatement due to fraud.

This list includes factors that could also influence the auditor's inherent risk and control risk assessments.

Materiality levels may differ for different categories of audits. As noted by the General Accounting Office fieldwork standards for financial audits, "in an audit of the financial statements of a government entity or an entity that receives government assistance, auditors may set lower materiality levels than in audits in the private sector because of the public accountability of the auditee, the various legal and regulatory requirements, and the visibility and sensitivity of government programs, activities, and functions."

Quantitative Approaches

The auditing standards do not explicitly require the auditor to quantify materiality. However, although auditors may consider nonquantitative factors in making the materiality judgment, they typically prefer to quantify the preliminary materiality judgment.

Quantitative approaches by auditors to making the preliminary materiality judgment can be classified into the following categories:

* Single rules
* Variable or size rules
* Average or blending methods
* Formula methods.

Single rules are rules of thumb that use a single financial variable for computing materiality. As a matter of policy, an audit firm typically provides three or four such rules and allows the individual auditor to choose the most appropriate rule based on an assessment of qualitative factors. Examples of common single rules include the following:

* 5% of pre-tax income
* 0.5% of total assets
* 1% of equity
* 0.5% of total revenues.

Variable or size rules are similar to single rules but differ in that they provide a range of possible different materiality levels for companies of different sizes. An auditor uses an assessment of qualitative factors to help decide what materiality level to select within the appropriate range. Examples of variable rules include the following:

* 2 to 5% of gross profit, if less than $20,000
* 1 to 2% of gross profit, if between $20,000 and $1 million
* 0.5 to 1% of gross profit, if between $1 and $100 million
* 0.5% of gross profit, if more than $100 million.

Average or blending methods typically average four or five individual rules of thumb or weight each according to a particular formula. Presumably, the blending or averaging process provides an indirect way of considering qualitative factors. A simple example would be to average the previously listed four single rules, giving each a 25% weight.

Formula methods are often estimated by a statistical analysis of a sample of companies. The most widely known formula is used by KPMG, although there are many others in the audit literature. The 1998 version of KPMG's materiality formula is as follows:

Materiality = 1.84 * (Greater of Assets or Revenues) 1 @d

Hypothetical Illustration

To illustrate the previous materiality methods, assume the summary financial statements shown in Exhibit 1 for ABC Company.

The single rule method would result in the auditor selecting one of the four materiality amounts shown in the first section of Exhibit 2. The variable or size rule method would require the computations shown in the second section of Exhibit 2, with the auditor selecting a materiality amount somewhere in the computed materiality range. The average or blending method using the single rules previously given would use the computation shown in the third section of Exhibit 2. The formula method would entail the computation shown in the final section of Exhibit 2, if the KPMG formula were used.

The materiality amounts computed using either the single rule method or the variable rule method varied from a possible low of $10,000 to a possible high of $45,000, depending on the auditor's judgment. Because the materiality judgment is related to the extent of audit work necessary, variability in materiality judgments can result in auditors in the same audit firm doing widely differing amounts of work for essentially similar clients. Accordingly, many firms have adopted the average or blending method as way to eliminate the variability inherent to the materiality judgments. As the example showed, the average method materiality amount of $27,500 is in the middle of the $10,000­45,000 range of the single rule method and close to the middle of the $20,000­40,000 range given by the variable or size method. The KPMG formula resulted in a materiality amount approximately twice the size provided by the alternative methods, which may be due to differences in the firm's audit process and to the typical audit client. For example, the KPMG formula may be especially appropriate for large financial institutions.

Quantitative approaches are best seen as decision aids that help auditors make their materiality judgment.

Materiality at the Account Level

As stated in ISA section 320, an auditor must consider materiality "at both the overall financial statement level and in relation to individual account balances, classes of transactions, and disclosures." Regarding the planning considerations for a substantive test of details, SAS No. 39 (AU350) uses the term "tolerable misstatement," which is the "monetary misstatement in the related account balance or class of transactions" that "may exist without causing the financial statements to be materially misstated."

The standards require only that the auditor "consider" tolerable misstatement. Nevertheless, many auditors prefer to allocate or assign in some way the numerical estimate of preliminary materiality at the financial statement level into specific amounts of tolerable misstatement at the account or class of transactions level. This allocation, or splitting, of the overall materiality amount normally results in a lower tolerable misstatement amount being used at the account or class of transactions level than at the overall financial statement level.

The auditor may establish different materiality levels for different accounts, classes of transactions, or disclosures due to factors such as differences in individual financial statement account balances and legal or regulatory requirements. The account or class of transactions materiality amount does not necessarily have to be in proportion to its size. For example, assume that the overall financial statement materiality level is $100,000 and the auditor is setting the tolerable misstatement level for the inventory account at 10% of total assets. The auditor might assign a tolerable misstatement level of $50,000 to inventory (50% of materiality) even though the inventory balance is only 10% of total assets. The auditor might assign a tolerable misstatement level of $50,000 to each major account in the balance sheet even though when added together the individual account tolerable misstatement amounts might exceed the tolerable misstatement amount for the overall
financial statements.

Auditors are justified in using materiality amounts at the account level that add up to more than overall financial statement materiality based upon statistical theory and double-entry bookkeeping. However, unless the auditor is fully conversant with statistics, the total allocated should not exceed some percentage of financial statement materiality (e.g., 150%).

Specific Approaches

Auditors use a variety of approaches to move from overall financial statement materiality to materiality at the account level:

* Judgmental approach. The auditor sets the account materiality on a purely judgmental basis.

* Ratio approach. The auditor sets the account tolerable misstatement at a range that depends on the auditor's assessment of risk. For example, the range may vary from one-third to one-sixth of the overall financial statement materiality. If risk is high, then the auditor uses one-sixth of the overall materiality, resulting in the account being audited more closely to reduce the risk level. This approach factors the inherent risk aspect of the audit risk model into the materiality allocation.

* Adjusting entry assessment. The auditor sets the account tolerable misstatement at some fraction of overall financial statement materiality depending upon the number of adjusting entries from the previous year's audit. For example, if last year's audit had five adjusting entries, the auditor might set materiality for the account at one-fifth of the overall materiality, with reasoning that the more adjusting entries expected, the poorer the system and the closer the accounts need to be audited. This approach adjusts materiality for control risk in the same manner that the prior approach considers inherent risk.

* Formula approach. Some auditors use a formula that assigns some proportion of overall materiality to the individual accounts based on their relative size and the possibility of offsetting errors. This formula has the effect of allocating a larger percentage of overall materiality to relatively large accounts. For example, using the following formula, an individual account that was 40% of the total value of all accounts would have 63% of materiality assigned to it, while an account that was only 10% of the total value of all accounts would have only 32% of materiality assigned to it:

Materiality for Account = Overall Materiality ­ Expected Uncorrected Error * (Account Balance / Total of All Account Balances) 1/2

Auditors can view these three approaches as decision aids to help their judgment.

Auditors also consider a variety of nonquantitative, qualitative factors when assigning materiality at the account level. These factors include the following:

* Cost. Some accounts cost more to audit. The auditor may assign more of the overall materiality to these accounts and less to others.

* Analytical Procedures Results. If preliminary analytical procedures signal a potential problem with an account, the auditor may use a lower materiality level for that account so it will be audited more closely.

* Prior Period Adjustments for Account. An account that has no adjustments after detailed substantive testing in a prior audit might be assigned a higher materiality level if the overall environment is stable.

* Consequences of Misstatement. Some accounts might be allocated a very small materiality amount if the consequences of a misstatement could be severe. For example, if failure to make adequate royalty payments could result in loss of a key technology, the auditor may use a low level of materiality for that account.

* Use of Account Data for Other Purposes. An account might be audited 100% regardless of materiality if data accuracy is important for other purposes or reasons. For example, officers' compensation might be audited very closely if it has to be separately reported to a regulatory agency or the tax authorities. *


Thomas E. McKee, PhD, CPA, is a professor in the department of accountancy at East Tennessee State University, Johnson City.
Aasmund Eilifsen, Dr. Oecon, is an associate professor in the Institute of Accounting, Auditing, and Law at the Norwegian School of Economics and Business Administration, Bergen, Norway.


Editors:
Neal B. Hitzig, PhD, CPA
Saint Peter's College

Jerry M. Klein, CPA
M.R. Weiser & Co. LLP



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