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Material information means information that
matters, whether it is important or is essential. In accounting
parlance, it relates to information that should be recognised, measured
or disclosed in accordance with the requirements of a financial
reporting framework. In measuring or disclosing accounting information,
emphasis is on the needs of known or perceived users of the financial
statements.
In auditing, materiality refers to the largest
threshold of uncorrected errors, misstatements, or erroneous disclosures
or omissions that could exist in the financial statements and yet are
not misleading. Misstatements including omissions, are material if they,
individually or in aggregate, could reasonably be expected to influence
the economic decisions of users of the financial statements. The users
are considered as a group of users of the financial statements rather
than as individual users.
SA 320 – ‘Materiality in Planning and
Performing an Audit’ provides guiding principles to auditors on
consideration of materiality in audit of financial statements.
The
determination of materiality is a matter of professional judgment. In
determining the materiality of an item, the auditor considers not only
the item’s nature and amount relative to the financial statements, but
also the needs of the users of such financial statements. Materiality
has a pervasive effect in a financial statement audit. Materiality also
has significant implications for audit efficiency. In current times,
given the scale and volume of operations of enterprises, complexities in
business and supporting IT systems, plethora of regulatory compliances
etc., it is imperative for an auditor to be meticulous in determining
materiality for addressing the risk of material misstatements in an
effective and efficient manner.
Materiality is one of the most
important considerations in planning the audit approach-identifying
significant accounts/disclosures and determining the extent, nature and
timing of audit procedures. While determining materiality at the
planning stage, it may not be possible for the auditor to anticipate all
of the factors that will ultimately influence the materiality judgment
in the evaluation of audit results at the completion of the audit. These
factors must be considered as and when they arise, and therefore
materiality needs to be evaluated throughout the course of the audit and
revised if deemed appropriate.
In planning an audit, the
auditor would ordinarily assess materiality at the overall financial
statement level, because the auditor’s opinion extends to the financial
statements taken as a whole. However, in certain circumstances, for an
entity, it is possible that misstatement of a particular significant
account balance or disclosure could impact or influence the decisions of
the users of the financial statements for that entity. In such cases,
the auditor would need to determine materiality for that account or
disclosure at an amount which is less than the materiality for the
financial statements as a whole. For instance, in enterprises where
financial statements include large provisions with a high degree of
estimation uncertainty, the existence of such provisions may influence
user’s assessment of materiality for such provisions, for example
provisions for insurance claims in an insurance company, oil rig
decommissioning costs in the case of an oil company etc.
In
computing materiality for the financial statements as a whole, the
auditor needs to evaluate an appropriate benchmark to be used. The
benchmark could be profit (loss) before tax from continuing operations,
total assets, or total revenues. Materiality is determined based on the
amount of the benchmark selected. Some of the factors which need to be
considered while determining the amount/percentage of the benchmark are:
Debt arrangements – whether limited debt or publicly traded debt, existence of loan covenants sensitive to operating results.
Business
environment – whether entity operates in a stable or volatile business
environment, business operates in a regulated or non-regulated industry,
business sustainability, complexity of business operations/processes,
product portfolio, few or many external users of the entity’s financial
statements etc
As one can envisage, evaluation of the factors
stated above requires judgment and there can be no scientific formula to
arrive at the percentage to be applied to the benchmark to determine
materiality. SA 320 does not specify a range of percentages that could
be applied to the benchmark as this is left to the auditor’s judgment,
ideally the one selected by the auditor should be the benchmark that
most represents the needs of the users of the financial statements. The
commonly applied ranges are given below:
It
is pertinent to note that materiality is not a mere quantitative
measure. A misstatement that is quantitatively immaterial may be
qualitatively material. Qualitative factors often require subjective
judgment and evaluation in light of other information that may not be
readily available to the auditor.
While selecting account
balances for testing, one cannot assume on a generic basis that account
balances which fall below the materiality determined for the financial
statements as a whole should be scoped out from audit. The auditor
should be wary of the risk that accounts with seemingly immaterial
balances may contain understatements that when aggregated would exceed
the overall materiality, i.e., aggregation risk. To address the
aggregation risk, auditors usually discount (hair-cut) the overall
materiality by 25% or more. Such an adjustment is not a mere calculation
but is driven by factors such as:
Weak or strong Internal control environment at the entity.
Entity with a history of material weaknesses and/or a number of control deficiencies.
High turnover of senior management.
Entity with a history of large or numerous misstatements in previous audits.
Entity with more complex accounting issues and significant estimates.
Entity that operates in a number of locations etc.
Let
us consider some case studies to understand practical application of
the concept of audit materiality from a quantitative measurement
viewpoint.
Case study I – Size and nature
Background
XYZ
Ltd. is a company engaged in the business of dairy products with its
head office in Mumbai. The Company caters to customers in Pune, Mumbai,
Ahmedabad and Surat through its factories in Mumbai and Ahmedabad.
The
turnover and net profit after tax of the company for FY 20X0-X1 (April
20X0-March 20X1) was Rs. 1,456 million and Rs. 305 million respectively.
The net assets of the Company as at 31st March 20X1 aggregated Rs.
13,570 million.
During the financial year 20X0-X1,
1. ZED Ltd., a distributor for Surat region who owed the Company Rs. 0.6 million was declared bankrupt.
2.
HUD Products Ltd., a supplier to whom the Company had paid Rs. 45
million as an advance for future supplies as per the terms of
arrangement had been facing cash crunch and has discontinued its
operations from June 20X0. The Company has not received any supplies
since April 20X1.
3. T he company has decided to curtail its
operations in Ahmedabad which has traditionally been a major source of
revenue for the Company in the past however on account of increase in
competition the Company is unable to sustain its market share. The
Company already commenced the process of dismantling one of the plants
in the month of March 20X1.
As an auditor which of the above events will be material for the Company?
Analysis
As per SA 320, judgments about materiality are made in the light of surrounding circumstances, and are affected by the size or nature of a misstatement, or a combination of both.
In the above scenarios, the default of Rs. 0.6 million by ZED Ltd. is immaterial for a Company with a huge turnover of Rs. 1,456 million. Thus, based on the size of the Company. the auditor would consider the said transaction as not material to be reported.
On the contrary, amount of advance given to HUD Products Ltd. of Rs. 45 million, which is considered doubtful of recoverability would be material to the financial statements as omission of the same could influence the decisions of the users of financial statements. Also, delay in supplies would affect the production schedule of the Company which would also impact sales adversely. Therefore this event would be considered as material.
Similarly, the Company’s decision of curtailing its Ahmedabad’s operations should be disclosed in the financial statements as it is by its nature material to understanding the entity’s scope of operations in the future.
Case study II – Selection of benchmark
Background
TED Private Limited (TED) is in the business of providing courier services. TED is located in Mumbai. It has a subsidiary LED Private Limited (LED), located in Delhi. TED was established in 2001 and its subsidiary was established in 2012. TED is a well established company in the market and is profit making since the year 2005. However, LED being recently established has lower profits and in fact profit has been volatile in nature during the past three years. The financial position for TED and LED given below:
XET & Associates (‘XET’) were appointed as auditors for the year 2014 for TED and its subsidiary LED. Ram Bhave, Audit Manager at XET selected profit before tax as the benchmark for the purpose of calculating the materiality of TED. Since LED had earned higher profit in 2014 as compared to the previous year, Ram selected profit before tax as an appropriate benchmark for the subsidiary as well. In the light of SA 320, evaluate:
a) Whether Ram did the right selection of the benchmark for the purpose of determining audit materiality for both the entities?
b) Also evaluate whether the materiality for LED will be the same if LED was financed solely by debt rather than equity?
c) Would the situation be different in case LED received revenue from TED on a markup of 10% on its expenses?
Analysis (a)
According to SA 320, determining materiality involves the exercise of professional judgment. Factors that may affect the identification of an appropriate benchmark include the following:
- Whether there are items on which would be subject to specific focus by the users of the financial statements of the entity in question?
- The nature of the entity, the stage at which the entity is in its life cycle, and the industry and economic environment in which the entity operates.
- The entity’s ownership structure and the way it is financed.
- The relative volatility of the benchmark.
Profit before tax from continuing operations is often used for profit-oriented entity. However when profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as total revenue or gross profit.
In the above case, based on financial position for past three years, it is evident that TED is a profit-oriented company and accordingly the profit before tax is an appropriate benchmark taken by the auditor for the purpose of calculating the materiality.
Analysis (b)
Ram selected profit before tax as benchmark for calculating materiality for LED however the company has yet to fully establish its operations and accordingly the profit before tax is volatile in nature. In such a case, based on the relative volatility, Ram must select gross measures like total revenue as the benchmark for calculating the materiality.
Analysis (c)
In case if LED is financed solely by debt, users may lay more emphasis on assets and claims (such as charges/ mortgages/encumbrances or like) on them rather than on the entity’s earnings. In this situation, Ram could consider either net assets or total assets as the benchmark for calculating the materiality.
Analysis (d)
If LED were to earn revenue from TED at a constant markup of 10% on its aggregate expenditure, it would not be appropriate to take profit before tax or revenue as the benchmark as revenue and profits would fluctuate every year in proportion to the expense and may not be considered as the right measure to reflect the financial performance of the entity. In such a scenario, Ram may choose to use total expenses or net assets or total assets as benchmark for purpose of determining materiality.
The above case studies elucidate the quantitative aspects of materiality. In the next article, we shall discuss case studies revolving around other aspects of SA 320 such as qualitative factors, normalisation, materiality at account balance and revision of materiality.
Closing remarks
Materiality is one of the factors that affects the auditor’s judgment about the sufficiency of audit evidence. One may generalise that lower the materiality level, the greater would be the quantum of evidence needed. At the same time, auditing standards do not establish an absolute level or a percentage or a mathematical formula which is universally applicable. The elements an auditor uses to determine the benchmark are based on his experience and on numerous other factors some of which were elucidated in this article. As a judgmental concept, however, materiality is susceptible to subjectivity.
