Definition of Materiality Samples for Students †MyAssignmenthelp.com

Question: Discuss about the Definition of Materiality Behaviour. Answer: Definition of materiality As per the definition given by The International Accounting Standards Committee under the framework of presentation and preparation of the financial statement, the information will be considered as material if the misstatement or omission can influence economic decisions of the users that is taken depending on the financial statement. The term materiality depends on size of error of item that is judged under specific circumstances of the misstatement or omission (Edgley, Jones Atkins, 2015). Therefore, the materiality offers cut-off point or threshold and not just the primary quantitative characteristic that the information shall have to be useful. To be more specific, the term materiality is characterised by rate of acceptable error and degrees of the irregularities under the information that is used for the purpose of audit. Materiality can influence the behaviour and decisions of users of information that is included in financial statement. There are 3 types of materiality that are different from each other. These are Materiality by the nature this kind of materiality is determined through evaluation of the elements of client information and its presentation is very crucial for financial statement users (Budescu, Peecher Solomon, 2012). It is further determined through the situation where strong interest of the public is there owing to importance and nature of information. Materiality by the value this kind of materiality is determined as the percentage of expenditure, revenue or as absolute value or clients asset value or clients liabilities value (Christensen, Glover Wood, 2012). Materiality by the context this kind of materiality is determined through evaluation of the information that may not be material by the nature or value but is crucial due to circumstance under which it emerges and its probabilities, the possible consequences it may have and the misuse and fraud that may occur due to this (Stewart Kinney Jr, 2012). Computation of materiality Various benchmarks are there that can be chosen for computing the materiality and the range for percentage of materiality that can be used while computing materiality (Keune Johnstone, 2012). ISA 320 specifically does not mention the percentage ranges that can be taken as materiality and it depends on the judgement of the auditor (Pentland Singh, 2012). However, commonly used percentages are as follows Total asset 1% to 2% Revenue 0.5% to 1% Profit after tax 5% to 10% Net assets 2% to 5% For example, if the revenue of ABC Pvt. Ltd for the year ended 31st December 2017 is $ 15,000 and based on the last years assessment the level of materiality is 1% of revenue, then materiality will be ($ 15,000 * 1%) = $ 150. Review for the technique of materiality application ISA 450 on evaluation of the misstatements is recognized during audit while dealing with the responsibility of the auditors for analysing the impact of recognized misstatement and the uncorrected misstatement on financial misstatement, if any (Kunellis, 2013). It deals with the following issues Accumulating the misstatement while conducting audit the auditor shall accumulated the misstatement recognized while conducting audit except those that are not significant. The auditor may assign a benchmark under which the misstatement amount in independent statement will be insignificant (Eilifsen Messier Jr, 2014). It will be helpful if the small misstatements are avoided for recording. Therefore, the auditors set the benchmark for considering materiality. For determining the benchmark limit the auditors use their professional judgement, considering their experience regarding the company (Libby Brown, 2012). For example, generally the auditor considers the range of 5% of the overall materiality to be appropriate based on the experience of last year. Therefore, the amount beyond 5% of the overall materiality may be justified by the auditor based on their judgement. If larger history for misstatement is found, the amount close to the bottom line of range will be appropriate for r educing the risk that can be aggregated to high level that will be reportable to the management. Categorising the misstatement as per their nature auditors evaluate the impact of misstatement and then communicate the misstatement to the management. It assists to segregate various misstatements into projected, factual and judgemental misstatement. The factual misstatements are those where there is no doubt regarding misstatement. For example, invoice recorded in accounting records at $ 10,000 instead of $ 15,000. Judgemental misstatements are those where the differences generated from managements judgement that includes areas regarding measurement, recognition, disclosure and presentation(CHI? Achim, 2014). It further includes the application or selection of the accounting policies that are considered inappropriate or unreasonable. For example, if appropriate range for provision on obsolete inventory is ranged between $ 50,000 and $ 60,000 and the company provided provision for $ 40,000, then the judgemental misstatement will be amounted to ($ 50,000 - $ 40,000) = $ 10,000. The projected misstatements are those which are based on the best estimates of the auditors regarding misstatement in the population. It includes the audit samples with regard to total population from which samples are generated. Evaluating materiality of the misstatement various issues are there that are required to be considered and includes qualitative assessment, offsetting of misstatement, misclassification of balance sheet, disclosure of misstatement and effect of un-rectified misstatements associated with the prior periods. An example for evaluating the materiality for misstatement is that misstatement may be there with regard to expenses and revenue that are misstated individually that exceeds the amount of overall materiality(Moroney Trotman, 2016). However, the net effect on the profit before paying tax is not material. If the auditor determines the overall materiality through taking into consideration the PBT as benchmark, it is unlikely that the misstatement in individual accounts will not be material. The auditors shall carefully think regarding whether the views of the user can be affected if expenses and revenues are restated. Taking into consideration the effect of misstatement on audit after identifying the misstatements during audit procedure, the auditor shall assess the effect of overall audit plant and strategy. These strategies include understanding the reason for misstatement and evaluating the risk for further unidentified misstatements(Czerney, Schmidt Thompson, 2014). For example, suppose in a situation where the auditor has determined the overall materiality amounted to $ 100,000. During audit, judgemental and factual misstatements are recognized; the impact for that on PBT is amounted to $ 90,000. The auditors did not consider the amount lower than overall materiality. However, how the auditors will be sure about further undetected misstatement is matter of judgement? Here in the given circumstance, the auditor shall use the performance materiality for performing and planning the audit that will offer some allowances for undetected misstatements. It will assist the auditors in assuring that the factual misstatements are rectified. Case Studies of Risk faced by Auditor There are various instances where it is seen that the risks which arises due to material misstatements are in most cases reasons for material misstatements. The material misstatements which arises during the course of audit are in most cases reasons due to which auditor issues qualified report and also adverse report in some cases. Material misstatements are determined by their importance, occurrence or value (Knechel Salterio, 2016). Material misstatements are reasons for which in many cases frauds and error takes place. The cases studies as given below depicts similar results and also reviews the risks which are associated with material misstatements: AB Cable Incorporation: ABCable, Inc. is a publicly traded cable provider. The services which are provided by AB Cable are cable services, which includes television, Internet access and local telephone service. The revenue of the company has increased, however the income of the company started to decline. The reasons for the declining incomes of the company was due to the high maintenance costs which was associated with cable lines especially in newly coverage areas.The management of the company decided to transfer such cable maintenance cost to Capitalized Cable Account. The management of the company recognized these expenses on a quarterly basisas per the needs and requirements of the business. The is considered as a significant misstatement which can also be treated as fraudulent activities. These transactions must have been treated as expenses and therefore the financial statement was misstated. Rocky Mountain Electric: In the case of Rocky Mountain Electric, the company has two stores which was one main store and a branch store. The senior auditor of the company looked after the audit process of main store and an accountant under the senior auditor was sent for the audit of branch store. It was discovered that a material amount of $ 100,000 was in excess of adjustments which is significantly material amount. An enquiry was made into the situation and it revealed that the branch store was engaged in unethical activities. The material misstatement was in account receivable ledger and sales ledger. The subledger balances of the store did not match the general ledger balances. It was revealed that the manager of the branch store was stealing money from the customers on accounts. The fraud was revealed due to the materiality of the amount which was out of balance. Welco Company: In a case study analysis of Welco company which revealed a material misstatement in the receipt for a transaction. The transaction was personal dinner with a client which costed as per the receipt an amount of $ 750. On close scrutiny it was revealed that the amount on the receipt waschanged and the actual amount charged was $ 150. In this case the person swapped the digit 1 with 7 and thus it resulted in material misstatement. Further reviewing of the records revealed that similar work was done in relation to previous two dinners earlier. In this case the auditor was of the opinion that the amount involved in the misstatement was not material enough to affect the financial statements and thus the investors or stakeholders of the business. However, the nature of the misstatement can be considered to be significant. This is case where fraud existed, however it was the opinion of the auditor that in a company which has a net worth of certain million, a fraud occurrence o f few thousand dollars was not material enough to be reported against in the case. Fred Stern and Company: The company was engaged in in importing business of rubber. The auditors of the company had issued an unqualified report as it was discovered that the company had falsified journal entries which had overstated the account receivable accounts. The accounts receivable was overstated by such an amount which was materially significant and affect the investment decisions of the shareholders of the company. The auditing firm was sued by a third party as they had issued money to the company for business purposes. Recommendations The primary consideration of any auditor is not to detect material misstatements which are associated with the financial statements of the company but to provide an overall view of fairness and accountability of the financial statements. The auditor however needs to detect such material misstatements as a financial statement which is showing true and fair view should be free of such material misstatements(Carcello, 2012). While conducting an audit, the auditor is able to detect material misstatements but not all of them are identified which are the reasons due to which detection risks arises. Another audit risk which contributes to material misstatements is control risks which arises due to weakness in internal control structure of the company. The judgement of materiality is entirely on the auditor and therefore there is always a chance of risks associated with the audit.There are two kinds of material misstatement which generally arises during a course of audit which are qualitativ e and quantitative misstatements. Qualitative consideration that is totally depended on the judgement of the auditor also is taken on the importance or significance of the transaction (Legoria, Melendrez Reynolds, 2013). For example, any transaction which affects the going concern principle of the company will be considered to material misstatement if the same is not disclosed in the financial statements. On the other hand, quantitative misstatements refer to misstatements of those transactions which are of significant value and an over or understatement of the figures can drastically change the financial data of the annual report and thereby mislead the potential shareholders. In order to avoid the risks which can arise fromsuch material misstatements, the following recommendations are given below: In many circumstances, certain transactions are repetitive in nature and such are considered to be material as they are regular in occurrence. In order to identify the transactions or area which are recurring in nature the auditor needs to review prior years audit documentation if any, go through journals, ledgers, adjustment entries and pin-point any uncorrected audit differences. The auditor must also check how such a area impacts the financial statements. Once such transactions are identified the risks which is associated with material misstatement will be minimized (Ruhnke Schmidt, 2014). The auditor needs to ensure that the company has a strong internal control system and proper structure. The auditor can identify the weaknesses in the internal control system and advise the management on what improvements can be brought in the internal control system of the company (Foster Shastri, 2013). In this way, the auditor will be able to minimize any control risks and also adhere to rectifying future cases of material misstatements. The auditor can perform detailed audit procedure and collect as much audit evidences which can reveal the material misstatements which are present in the financial statements of the company (Lobo Zhao, 2013). Besides collecting audit evidences, the auditor must maintain a detailed documentation for future reference. In the detailed analysis of the financial statements, the auditor will be applying analytical procedures, vouching and verifications, compliance procedures, external confirmations with the related parties of the transaction. These procedures help the auditor to take into consideration both the qualitative and quantitative aspect of the misstatements. In additions to this, the auditor is able to apply better judgement in deciding whether an item is material or not for the consideration of audit (Mala Chand, 2015). These procedures will minimize the risks associated with material misstatements. In certain cases, there are misstatements which arises due to judgemental difference between the judgement of the management on accounting treatment and between the consideration of the auditor. In such a situation the auditor needs to ensure that there is a proper communication between the auditor and the client about the different treatments and policies following which the management has prepared the financial statements (Ettredge, Fuerherm Li, 2014). The management can provide information to the auditor about the policies which it has followed by management representations. Such judgemental difference often leads to material misstatement getting undetected by the auditor. For example, in some cases the management might not disclose certain expenses due to the policies of the organisation however such expenses might be material enough to be disclosed as per the auditors judgement. The auditor needs to determine and identify such difference and the material misstatement which aris es from such differences. The auditor will also advise the management on the weakness of the policies and structure of the management. References Budescu, D. V., Peecher, M. E., Solomon, I. 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