6 - materiality and substantive audit procedures

Question 1

what is materiality?

Answer 1

inherent in accounting (true and fair view) and auditing (ISA200)

definition per ISA 320: Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. Judgements 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

thus no general rules prescribed, rather based on judgement in particular circumstances.

Question 2

what are the steps in applying materiality?

Answer 2

planning extent of tests

1. set material for financial statement
2. determine performance materiality

evaluating results

1. estimate total misstatement in segment
2. estimate combined misstatement
3. compare combined estimate with preliminary or revised judgement about materiality

Question 4

what are the two types of likely misstatement in an audit?

Answer 4

1. differences between mgment’s and auditor’s judgement about estimates of account balances
2. projections of misstatements based on auditor’s test of a sample

Question 5

when is the materiality for the financial statements as a whole set?

Answer 5

at the planning stage

Question 6

how is materiality often stated? what other ways might it be stated?

Answer 6

as % of profits

because empirical support for importance of profit numbers to share price and investment decision making

may be set for other figs like total assets, or use accounts balances and adopt different materiality levels for different aspects of the audit

Question 7

what are (typically) the three key steps in setting materiality level?

Answer 7

choosing an appropriate benchmark

determining the level of the benchmark

justifying the choices/explaining the judgement

Question 8

what does ISA320 include as factors to consider when choosing a materiality benchmark? what are some appropriate benchmarks?

Answer 8

nature of entity and industry

whether users focus on particular items in the financial statements

relative volatility of benchmark

appropriate benchmarks:
profit before tax/normalised profit before tax, total income/total expenses, gross profit, total equity, net assets

Question 9

how can an auditor determine the level of the materiality benchmark?

Answer 9

generally go off previous years, consider rises or falls in revenue die to exceptional orders, consider rises/drops in profit before tax.

Question 10

what challenges should an auditor think about when justifying their choices about the materiality benchmark?

Answer 10

whether to set specific level of materiality for individual balances, classes of transactions or disclosures

short and long periods of account

Question 11

what does the auditor need to consider/decide upon with regards to materiality?

Answer 11

auditors need to identify primary user group for audit report and opinion

assume users have a reasonable knowledge of business and accounting

at outset of audit - particularly during planning - auditor has to decide what level of error or mistatement could occur in financial statements before decsions of someone with these qualities would be influenced

might suggest setting materiality low as possible, but auditor’s judgement also balances cost implications (lower level = more evidence needed)

Question 12

what are projected misstatements?

Answer 12

calculated by (misstatements in sampling/total sample)*(total population-specific items tested-sample). all in terms of £.

factual misstatements (misstatements actually found) and projected misstatements should be included on the summary of misstatements

Question 13

what influences materiality level?

Answer 13

size (value) relative to balance

importance of heading - e.g. account balance being 40% of total assets more important, lower materiality level may be justified

nature (user relevance) - auditors may judge some balances more important.

auditor’s past experience - detection of misstatement in particular balance in past may lead to reducing materiality level.

trend in account balance - lower levels where balances have changed markedly from prio year or departed from trend.

Question 14

how should errors be treated during the audit and at the evaluation stage?

Answer 14

during audit - errors on account balance should be looked at in aggregate, several immaterial errors may be material together.

evaluation stage - even if detected errors immaterial, does size and frequency suggest that together with undetected errors there is material misstatement?

Question 15

what are the issues in closing accounts where materiality should normally be overridden because of specific disclosure needs?

Answer 15

required disclosures: even immaterial differences should be adjusted where there is a specific requirement for disclosure. e.g. companies act 2006 requirements for disclosures of director remuneration and capital commitments

improper disclosure of accounting policies: capacity to mislead user in overall appraisal

improper classifications: form of misrepresentation, e.g. including part of current tax charge in deferred tax.

Question 16

what ISA guidance is there on the physical inventory count?

Answer 16

ISA 501 audit evidence - specific considerations for selected items provides guidance for auditors on attending physical inventory count. states that where inventory is material, auditors shall obtain sufficient appropriate audit evidence regarding its existence and condition by attending physical inventory count (unless this is impracticable).

Question 17

what process should be followed for the physical inventory count?

Answer 17

evaluate mgment’s instructions and procedures for recording and controlling the result of the physical inventory count

observe the performance of the count procedures

inspect the inventory

perform test counts

perform audit procedures over entity’s final inventory records to determine whether they accurately reflect count results

Question 18

what is involved in planning the inventory count?

Answer 18

before physical inventory count, auditors should ensure audit coverage of the count is appropriate, and that client’s count instructions have been reviewed. factors to consider when planning attendance at inventory count includes:

risks of material misstatement to inventory

internal controls related to inventory

whether adequate procedures are expected to be established and proper instructions issued for counting

timing of the count

whether entity maintains a perpetual inventory system

locations at which inventory is held (inc material amounts held by 3rd parties)

whether assistance of auditor’s expert required.

Question 19

what audit procedures are needed during attendance at inventory count?

Answer 19

observe whether client’s staff are following inventory count instructions to ensure count is complete and accurate

perform test counts to ensure procedures and internal controls operating efficiently, and gain evidence over existence and completeness of inventory

ensure procedures for identifying damaged, obsolete and slow-moving inventory operate effectively to confirm valuation of inventory:
obtain info about inventory’s condition, age and usage
obtain info concerning stage of completion of WIPs

confirm that inventory held on behalf of third parties is separately identified and accounted for to ensure that inventory not overstated

obtain copies of last GRN and last GDN in order to confirm cut-off of inventory

conclude whether any amendment necessary to subsequent audit procedures

gain an overall impression of the levels and values of inventories held in order to be able to judge whether the inventory figure in the financial statements appears reasonable.

Question 20

should purchase GRNs before the year end be included in purchases, payables or inventories?

Answer 20

yes to all

Question 21

should revenue GDNs before the year end be included in revenue, receivables or inventories?

Answer 21

yes to revenue and receivables, no to inventories