Materiality

Question 1

Concept of Materiality

Answer 1

• recognizes transactions/amounts/errors that directly influence relevance and reliability of information for decision making purposes

Question 2

Step 1: Identify users

Answer 2

• bank, regulators, other businesses, shareholders, investors, other stakeholders (employees)

Question 3

Step 2: Identify user objectives

Answer 3

• lenders concerned with liquidity and debt ratios
• investors concerned with cash flows and earnings
• executives concerned with compensation (bonus based on revenue)

Question 4

Step 3: Determine materiality base

Answer 4

• consistent revenue = net income, volatile revenue = revenue based
• NFPO = expenses based, as spending is the main concern
• normalized net income before taxes is the most common
• total assets, revenues, expenses or equity are other examples

Question 5

Step 4: Identify percentage threshold

Answer 5

• always LINK back threshold percentage to user objectives
• highly sensitive to MM = lower %, not sensitive to MM = higher %
• for profit: 3%-7% of normalized NIBT, 1%-3% of revenues/expenses, 1%-3% of total assets, 3%-5% of equity
• NFPO: 1%-3% of revenue/expenses, 1%-3% of total assets

Question 6

Step 5: Determine overall Materiality

Answer 6

• always normalize base for non-recurring or unusual transactions
• apply threshold to normalized based

Question 7

Step 6: Determine performance materiality

Answer 7

• auditor focused, therefore risk impacts the choice (in other words not user based)
• PM = 60% - 75% of OM
• Higher risk = lower PM%
• Lower risk = higher PM%

Question 8

Step 7: Determine specific materiality

Answer 8

• based on user objectives, not risk
• SM chosen for specific accounts/balances (bank loan based on inventory and AR, therefore SM would be set for inventory and AR)
• SM% is based on professional judgement and must be less than OM

Question 9

Step 8: Determine specific performance materiality

Answer 9

• required when SM set
• based on % of SM

Question 10

Is materiality based on risk?

Answer 10

• NO
• risk is based on company factors, but materiality is based on user needs
• Do not assess risk in determining OM and SM

Question 11

RMM vs Audit evidence

Answer 11

• high RMM = collect more audit evidence
• Low RMM = do not need to collect more evidence