Ch. 5 Materiality Flashcards
How is materiality applied during the various stages of an audit?
It is used throughout…
During the planning stage, materiality is used to narrow a practitioners focus and procedures
During the execution stage, materiality is used to evaluate errors and to determine if additional procedures are required.
During the reporting stage, materiality is used to evaluate the aggregate of the incorrect errors (de minimis sum)
Can you explain Step 1 of Materiality?
Understanding the users of the financial statements may alter the materiality that is set for a specific case.
How is step 1 related to step 2?
By understanding who the users are and then identifying their objectives, the practitioner can understand which particular items in the financial statement may be more sensitive to material misstatements than others.
How is the base for materiality set in step 3?
The practitioner looks at the conclusions made in steps 1 and 2 and determines what FSLI users are most sensitive to and uses that as the base. If for example, a company is at a loss or their earnings are volatile and users are concerned with their profits, they may use revenue instead.
What are the most common bases/benchmarks?
- normalized income before tax (most common for for-profit entities)
- total assets
- total revenues
- total expenses
- total equity
How is the percentage threshold for materiality in step 4?
It depends on the users’ decisions and sensitivity that will drive the percentages
For-profit entities:
- 3% to 7% of normalized income before tax
- 1% to 3% of revenues or expenses
- 1% - 3% of total assets
- 3% to 5% of equity
Not-for-profit entities:
- 1% to 3% of revenues or expenses
- 1% to 3% of total assets
What is done in step 5 before determining overall materiality?
Once the base is set and the percentage is decided on the understanding of the client, unusual or non-recurring items that may need to be normalized or adjusted for are considered. Examples include:
- unusual or non-recurring revenue or expenses
- special management bonuses
- unusual gains or losses on the disposition of property, plant or equipment
Once it is normalized, it is then applied.
What is Performance Materiality? (Step 6)
It is an amount that is less than OM to prevent several smaller errors or omissions that have not been detected to fall through. It is reduced to adjust for this risk.
If items tested contain errors but are not greater than the overall materiality set, it is compared to PM and then summed using de minimis sum.
Step 7: Determine specific materiality
It is set if there are balances or classes of transactions where an amount less than overall materiality would influence or change the decision of a known user.
It is used to address specific risks and balances in sensitive audit areas.
Step 8: Determine specific performance materiality
Established by the practitioner based on what is required to reduce the risk of material misstatement to an appropriately low level.
It is at the class of transaction or account balance level that is set at a lower level than both OM and SM. SPM is required only when SM has been set for an account or group of accounts.
