Materiality

1-Definiation:
Materiality is the Magnitude of an Omission or Misstatements of
Accounting Information that, in the light of surrounding circumstances,
makes it probable that the judgment of a reasonable person relying on
the information would have been changed or influenced by the omission
or misstatement
2-Importance of Materiality
If financial statements are materially misstated, users’ decisions may be
affected, and there by cause financial loss to them.
3-Auditor’s Responsibility:
Auditors are responsible for determining whether financial statements
are materially misstated
1-If the auditor determines there is a material misstatement, he will
bring it to the client’s attention so that a correction can be made to
correct
2-If the client refuses to correct the statement, a qualified or an adverse
opinion must be issued, depending on how material misstatement is
4-Difficulty of Applying Materiality
1-It is difficult to apply because there are often many different users of
the financial statements
2-Materiality is also difficult to apply because it is a relative concept,
and auditing standards offer little specific guidance for the application of
materiality

5-Steps In Applying Materiality

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Auditors follow Give Closely Related steps in applying materiality

Step (1)
Set Preliminary Judgment about
Materiality
(Set Materiality as whole)

Step (2)
Allocate Preliminary Judgment
about Materiality to Segments
(Tolerable Misstatements)
(Determine performance
Materiality)

Step (3)
Estimate Total Misstatement in
Segment

Step (4)
Estimate The Combined
Misstatement

Step (5)
Compare Combined Estimate with
Preliminary Judgment about
Materiality

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 Step (1)
Set Preliminary Judgment about Materiality
(Set Materiality as whole)
1-The Preliminary Judgment about Materiality is the Maximum Amount
by which the auditor believes that the statements could be Misstated
and still not affect the decision or reasonable user
2-The reason for setting Preliminary Judgment about Materiality is to
help the auditor plan the appropriate evidence to accumulate
3- The auditor will frequently change the Preliminary Judgment about
Materiality during the audit, Whenever, that is done, the new judgment,
is called a Revised judgment about materiality
Factors Affecting Preliminary Judgment about Materiality
The most factors affecting a Preliminary Judgment about Materiality are
as follows:
1- Quantitative Factors
1-Materiality is Relative rather than an Absolute concept
A misstatement of a given magnitude might be material for a small
company, whereas the same dollar misstatement could be immaterial
for a large company
2- Bases are Needed for Evaluating Materiality
Net income before taxes is normally the most important base for
deciding what is material, because it is regarded as critical item of
information for users
2- Qualitative Factors
1- Certain types of misstatements are likely to be more important to
users than other, even if the dollar amounts are the same,
for example, amounts involving irregularities (fraud) are usually
considered more important than unintentional errors for equal dollar
amounts
2- Misstatement that are immaterial may be material if they effect a
trend in earrings

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 Step (2)
Allocate Preliminary Judgment about Materiality to
Segments
(Tolerable Misstatements)
(Determine performance Materiality)
1- If auditor have a Preliminary Judgment about Materiality for each
segment accounts, then decide the appropriate evidence to accumulate
2- Most auditors allocate materiality to balance sheet rather income
statement accounts, because most income statement misstatement
have an equal effect on the balance sheet, because the double – entry
book keeping system
3- When the auditors allocate the Preliminary Judgment about
Materiality to account balances, the materiality allocated to any given
account balance is called Tolerable Misstatements

Example:
If an auditor decides to allocate $ 100,000 to A/R of a total Preliminary
Judgment about Materiality of $ 200,000
Tolerable Misstatements for A/R is $ 100,000, This means that the
auditor is willing to consider A/R fairly stated if it is misstated by $
100,000 or Less

Step (3)
Estimate Total Misstatement in Segment
Estimate total misstatement and compare it with Preliminary Judgment
Assume If the auditor finds 6 misstatements in a sample of 200 testing
inventory costs
1- These misstatements are used to estimate the misstatement in
inventory
2- The total is referred to as an estimate after a Projection or
Extrapolation because only a sample, rather than the entire population
was audited

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 Step (4) & (5)
Estimate The Combined Misstatement &Compare
Combined Estimate with Preliminary Judgment about
Materiality
The Projected misstatement amount for each account is combined and
then the combined misstatement is compared to Preliminary Judgment
about Materiality
Rules:
1- The Direct Projection Estimate (Project Misstatement)
Net Misstatement in the Sample
= -------------------------------------------------- X Total recorded population value
Total Sampled
Net Misstatement in the Sample
= Overstated Misstatement - Under Misstatement
2- The Estimate of Sampling Error
= The Direct Projection Estimate X Sampling Error (Percentage Given)
3- Total Estimated Amount of a Segment (Account)
= Direct Projection Estimate + Sampling Error
4- Comparison
1-Total Estimated Amount of a Segment > Tolerable Misstatement
Rejected
2- Tolerable Misstatement > Or = Total Estimated Amount of a Segment
Accepted

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 Exercises
Exercise (1):
If an auditor decides to allocate $ 36,000 of total preliminary judgment
about materiality of $ 50,000 to inventory, in auditing inventory, the
auditor found $3,500 of net overstated amounts in a sample $ 50,000 of
the total population of $ 450,000, sampling error 50%
Required:
Explain the auditor decision towards the acceptance of inventory
balance
Answer
1- Direct Projection
Net Misstatement in the Sample
= ---------------------------------------------- X Total Recorded Population value
Total Sampled
= 3,500/ 50,000 x 450,000 = $ 31,500
2- Sampling error = 31,500 x 50% = $ 15,750
Total estimated misstatement amount of the inventory
= 1+2 = 31,500 + 15,750 = $ 47,250
3- Comparison
Tolerable misstatement $ 36,000
Total estimated misstatement $ 47,250
Decision
The auditor Reject the inventory balance as it appears in the balance
sheet, and requires adjustments made by management
Exercise (2):
If an auditor decides to allocate $35,000 of total preliminary judgment
about materiality of $ 80,000 to A/R in auditing A/R, the auditor found $
4,000 of overstated and $ 6,000 of understated amounts in a sample
$100,000 of the total population of $1,000,000
Required:
Explain the auditor decision towards the acceptance of A/R balance
Answer
The Projected Misstatement
6,000 - 4,000
= ------------------------ X 1,000,000 = $ 20,000
100,000
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Tolerable Misstatement = 35,000
Projected Misstatement = 20,000
Decision
A/R balance is accepted
Exercise (3):
You are evaluating audit results for assets in the audit of Roberts
Manufacturing. You set the preliminary judgment about materiality at
$ 50,000, the account balances, tolerable misstatement, and estimated
overstated in the accounts are shown as follows:
Account Account Tolerable Estimate of total
Balance Misstatement Overstatements
Cash 50,000 5,000 1,000
Accounts Receivable 1,200,000 30,000 20,000
Inventory 2,500,000 50,000 ?
Other assets 150,000 15,000 12,000
Total 4,000,000 100,000

1- Assume you tested inventory amounts totaling 1,000,000 and found

10,000 in overstatement, ignoring sampling risk, what is your estimate
of the total misstatement in inventory
2- Based on the audit of assets accounts and ignoring other accounts,
are the overall financial statements acceptable. Explain
3- What do you believe the auditor should do in the circumstances
Answer
Required (1);
The Direct Projections of the total misstatement in inventory
Net Misstatement in the Sample
= ----------------------------------------------X Total Recorded Population value
Total Sampled
= 10,000 / 1000,000 x 2,500,000 = $ 25,000

Required (2);
The estimated Total overstatements
Cash 1,000
A/R 20,000
Inventory 25,000 (Required 1)
Other Assets 12,000
Total 58,000
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 Required (3);
The auditor should either propose an audit adjustment, so that the
unadjusted statement amount is less than the materiality, and / or
perform more testing to obtain a better estimate to the population
misstatements.
The additional testing will likely focus on receivables and inventory
because they have a largest estimated misstatement
Exercise (4):
In allocating tolerable misstatement, the auditor uses judgment in the
allocation, subject to the following two arbitrary requirements:
1- Tolerable misstatement for any account cannot exceed 75% of the
preliminary judgment about materiality
2- The sum of all tolerable misstatements cannot exceed twice the
preliminary judgment
After the auditor completed the audit, he prepared the following table
which includes a comparison of estimated total misstatement to
preliminary about materiality

Comparison of Estimated Total Misstatement to Preliminary

Judgment About Materiality
Account Tolerable Estimated Misstatement Amount
Misstatement Known Sampling Total
Misstatement Error
and Direct
Projection
Cash $ 4,000 2,000 NA 2,000
A/R 20,000 12,000 6,000 18,000
Inventory 36,000 31,500 15,750 47,250

Total Estimated 50,000 45,500 16,800 67,250

Preliminary
judgment about
materiality
NA = Not applicable, Cash audited 100%
Required:
1- What is the auditor’s decision regarding the acceptability of the
financial statements?
2- What are the alternative actions that the auditor will take before he
issued the audit report?
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 Answer
Required (1):
The total estimated misstatement $ 67,250 Exceeds the preliminary
judgment about materiality $ 50,000 Because the estimated combined
misstatement Exceeds the preliminary judgment, the financial
statements are not acceptable
Required (2):
The auditor can do:
1- Determine whether the estimated likely misstatement actually
exceeds $ 50,000 by performing additional audit procedures
2- If the auditor decides to perform additional audit procedures, they will
concentrate in the inventory area, because its estimated misstatement
$47,250, which is significantly greater than tolerable misstatement of
$ 36,000
3- Required from the client to make adjustment for estimated
misstatement
Exercise (5):
The Auditor of ABC Company set the preliminary judgment about materiality at $
100,000, the audit results as follows:
Account Account Tolerable Estimate of total
Balance misstatement Overstatements
Cash 60,000 6,000 1,200
Accounts Receivable 2,600,000 60,000 ?
Inventory 1,200,000 89,000 30,000
Other assets 300,000 45,000 15,000

Total 4,160,000 200,000

In addition:
The results of the audited sample of accounts receivable are as follows
Accounts Receivable Recorded Balances Balances According to Audit
Results
First group of A/R 80,000 75,000
Second group of A/R 30,000 31,000
Third group of A/R 90,000 90,000

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Required
1- Are the overall financial statements acceptable? Explain
2- What do you believe the auditor should do in the light of this decision about the
financial statement’s acceptability

Answer

Required (1)
1- Compute the Net Misstatements:
First Group = 80,000 – 75,000 = 5,000 overstated
Second Group = 30,000 – 31,000 = 1,000 Understated
Net misstatements = 4,000 Overstated
2- The Direct Projection of the misstatement in A/ R
= 4,000 / 200,000 (Total Sampling A/R) X 2,600,000
= 52,000
Note
Sampling A/R = Total amounts recorded in the three groups
= 80,000 + 30,000 + 90,000 = 200,000
3- Estimated of Total misstatement
= 1,200 + 52,000 + 30,000 + 15,000 = 98,200
Decision
The overall financial statements are acceptable because the total estimated
misstatements 98,200 does not exceed the preliminary materiality of 100,000
Required (2)
The auditor issues unqualified report, and required management to correct
misstatements in accounts receivable
Exercise (6)
If an auditor decided to allocate $ 35,000 of materiality to A/R , which is
total balance is $ 650,000 , in the sample of $ 80,000 of A/R , the
auditor discovered misstatements in the sample $5,000 overstated and
$5,000 understated , if you assuming that the sampling error is $ 40,000
what is the auditor decision
Answer
1- The direct projection = (5,000 -5,000)/ 80,000 x 650,000= 0
2- Total estimated misstatements = 0 + 40,000 = 40,000
The auditor will not accept the balance of the A/R 40,000 > Tolerable
35,000

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 Exercise (7)
The audit results of the Success Company are as follows
Accounts Account Tolerable Total
Balance Misstatement Estimated
Misstatement
Cash 48,000 2,000 440
Accounts Receivable 690,000 24,000 ?
Inventory 540,000 12,000 ?
Other assets 400,000 22,000 11,440
1,678,000 60,000 ?

The results of the audited sample are as follows

Accounts Sample Overstatement Understatement Sampling
Size Errors
Accounts Receivable 50,000 10,000 8,000 20%
Inventory 40,000 7,000 7,000 3,000
Required:
1- How much the amount of the preliminary judgment about materiality
if you know that the estimated combined misstatement exceeds the
materiality with L.E 8,000
2- In this case, what do you believe the auditor should do?
Answer
Required (1)
Accounts Receivable:
The direct projection = Net Misstatement / Sample size x Recorded
population value
= (10,000 – 8,000) / 50,000 X 690,0000 = 27,600
Total estimated misstatement
= 27,600 + (27,600 x 20%) = 33,120
Inventory
The direct projection = Net Misstatement / Sample size x Recorded
population value
= (7,000 – 7,000) / 40,000 X 540,0000 = Zero
Total estimated misstatement
= 0 + 3,000 = 3,000
Total estimated combined misstatement
= 440 + 33,120 + 3,000 + 11,440 = 48,000
Materiality = 48,000 – 8,000 = 40,000

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Required (2)
The estimated combined misstatement (48,000) exceeds the
preliminary (40,000), the financial statements are not acceptable, the
auditor
1- perform additional audit procedures concentrated in accounts
receivable (Tolerable misstatement 24,000 while estimated
misstatement 33,120
2- Require the client to make additional adjustments for estimated
misstatement

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