CHAPTER 3 MATERIALITY AND RISK

CHAPTER THREE: MATERIALITY AND RISK

Overview

• Date: Thu 13 Feb 2025, 9:34

INTRODUCTION

Materiality Concept

• Materiality refers to the significance of an amount, transaction, or discrepancy.

• In financial reporting, it is the threshold where omitted or incorrect information can impact user decisions, including investors, creditors, and regulatory bodies.

Materiality in Accounting

• Determines an item's importance in financial statements.

• An item is deemed material if its omission or misstatement can influence users' economic decisions.

Materiality in Auditing

• Guides auditors in the scope of the audit and the nature, timing, and extent of audit procedures.

• It helps identify which misstatements must be reported due to their potential impact.

ISA 320 Definition

• Defines materiality based on the influence of omitted or misstated information on economic decisions depending on size relevant to specific circumstances.

STEPS IN APPLYING MATERIALITY

1. Set Preliminary Judgment: Establish an initial assessment of materiality.

2. Allocate Preliminary Judgment to Segments: Distribute the judgment across different segments.

3. Estimate the Combined Misstatement: Calculate the total estimated misstatement.

4. Compare Estimates and Preliminary Judgment: Assess whether the combined misstatement exceeds the initial judgment.

5. Estimate Total Misstatement in Segments: Finalize estimates for individual segments.

AUDIT BASED ON SEGMENTS

• Segmented areas include:

  • Revenue Cycle

  • Purchase Cycle

  • Property, Plant, and Equipment (PPE) Cycle

  • Liability Equity

  • Payroll Cycle

  • Cash Cycle

  • Inventory Cycle

• Allocate materiality based on previous assessments and current economic conditions.

GUIDELINES ON MATERIALITY

Judgment by Auditor

• No strict rules dictate materiality amounts; it remains a judgment call by the auditor.

Factors Affecting Auditor Judgment

1. Quantitative Factors: Based on the amount or size; larger amounts are more likely to be material.

2. Qualitative Factors: Focuses on the reason and effect of the misstatement, where a smaller amount could be material based on qualitative aspects, e.g., legal compliance.

QUANTITATIVE MATERIALITY

• Measured numerically, often as a percentage of key financial metrics such as revenue, profit, or assets. Common thresholds:

  • 5% of net income

  • 1% of total assets

QUALITATIVE MATERIALITY

• Pertains to the nature of the item rather than its size. Small amounts could still be material if they impact decision-making, like errors affecting compliance or contractual agreements.

MAKING JUDGEMENTS ABOUT OVERALL MATERIALITY

• Example: For Syarikat Y Sdn Bhd with an estimated net income of RM 250,000 and a 5% threshold, overall materiality = RM 250,000 x 5% = RM 12,500. This figure allocated across various accounts.

MATERIALITY IN PRACTICE

Financial Reporting

• Materiality influences decisions on adjustments, disclosures, and consolidations.

Auditing

• Auditors utilize materiality to create audit procedures and evaluate misstatements individually and collectively.

RISK IN AUDITING

Definition

• Risk refers to the potential for material misstatements in financial statements due to errors or fraud, impacting users' decisions.

Uncertainty in Auditing

• Auditors must accept risk levels for reasonable assurance. Measuring risk is challenging and requires careful judgement.

AUDIT RISK MODEL

• PDR (Planned Detection Risk) = Acceptable Audit Risk (AAR) x Inherent Risk (IR) x Control Risk (CR).

TYPES OF RISK

Planned Detection Risk

• Relates to the risk that audit procedures might not detect significant misstatements.

Inherent Risk

• The likelihood of material misstatements before considering internal control effectiveness.

Control Risk

• The risk that existing internal controls will not prevent or detect misstatements.

Business Risk

• Risks regarding the ability of an entity to meet business objectives due to external factors.

Fraud Risk

• Risk of material misstatement due to fraudulent activities.

ASSESSING AAR (Acceptable Audit Risk)

• Establish the AAR based on engagement risk related to client business risk.

ASSESSING IR (Inherent Risk)

• Factors affecting IR include business nature, past audit results, client relationship, and environment.

THE AUDITOR'S RISK ASSESSMENT PROCEDURES

• Understanding the client and environment is critical.

• Identify and evaluate responses to business risks for material misstatement.

THE RELATIONSHIP BETWEEN MATERIALITY AND RISK

• Higher risk typically leads to lower materiality thresholds due to a higher potential for misstatement.

• An effective risk-based approach allows auditors to focus resources on higher-risk areas, impacting audit opinions and outcomes.

AUDIT TESTING PROCEDURES

• Involves various testing approaches:

  • Test of controls

  • Substantive testing (detail and balance)

• Consideration of materiality in testing processes, adjusting the scope depending on risk levels.