Audit Approach and materiality

Substantive procedures

Designed to detect MM @ assertion level

Include tests if details and substantive analytical procedures (SAP)

Must still understand controls even if fully committed to substantive approach

Use when DR is low, but can be used at any CR level

Tests of control

Evaluate the operating effectiveness of the controls in preventing MM @ assertion level

if CR is high, do not rely on controls and instead use a substantive approach

Combined approach

Rely on both tests of controls and substantive procedures

1. Expectation that controls are working and will be tested

2. SAP alone cannot provide SAE @ assertion level

   Ex: automation, high # of low value transactions

Materiality

Threshold above which missing/incorrect info in F/S is considered to impact decisions

Requires qualitative and quantitative factors, and may need to be revised during the course of the audit

Steps to calculate materiality

1. Identify users

2. Identify user objectives

3. Determine benchmark

4. Identify threshold percent

5. Calculate overall materiality

6. Calculate performance materiality

7. If needed, specific materiality

8. if needed, specific performance materiality

Step 1: Identifying the users

Based on organizational circumstances

Lenders, shareholders, investors, management (when performance or compensation is based on F/S)

Step 2: Identify user objectives

Lenders - monitor leverage, liquidity, covenants, asset values, debt ratios

Investors - stewardship, FCF generation, earnings

Management - compensation

Step 3: Determine benchmark for materiality

Normalized profit before tax - always use in for profit organizations

Total assets - consider for NPO

Total revenues

Total expenses

Total equity

Consider one with most commonality for users

Step 4: Identify percentage threshold for materiality

3 to 7% for normalized profit before tax

1 to 3% for revenues, expenses, or total assets

3 to 5% of equity

Choose based on user not the RMM @ OFSL

Step 5: calculate overall materiality

Determine if there are unusual/non-recurring items and round down

Step 6: Calculate performance materiality

Audit focused decision where a buffer amount is applied to the overall materiality from step 5

Reduce overall by 25 to 40 percent