Auditing Special Purpose Frameworks: Materiality Levels

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Calculating financial statement materiality levels under the auditing standards is framework neutral. The concepts are the same for all financial reporting frameworks.

The preliminary estimate of materiality at the financial statement level, often called planning materiality, is the maximum amount by which the auditors believe the statements could be misstated, by known or unknown error or fraud, and still not affect the decisions of reasonable financial statement users. Clarified Auditing Standards require quantification of materiality levels, which are estimates to guide auditors' decision-making and design of auditing procedures. This estimate is only a guide and is not a specific determination of what is, and is not, material in an audit.

Usually, a single base such as the higher of total revenues or total assets is selected for the financial statements taken as a whole. Once the base is determined, the dollar amount of the base is normally multiplied by a percentage factor, sometimes determined by the volume of the base, to determine the allowance for known and unknown error and fraud in the financial statements taken as a whole. Next, a percentage factor based on risk at the financial statement level is multiplied by planning materiality to determine tolerable misstatement, or performance materiality, which is the maximum amount of known error and likely error an auditor can accept in the financial statements without adjustment.

A general range of 50 percent to 75 percent of planning materiality, based on moderate risk at the financial statement level, is commonly used to calculate tolerable misstatement (performance materiality) at the financial statement level. Extremely low risk could enable an auditor to calculate tolerable misstatement at an even higher level, say 80 percent to 90 percent. Lower risk at the financial statement level will result in fewer individually significant items, which are required to be audited 100 percent.

When risk is high at the financial statement level, a lower level of tolerable misstatement will normally result by using a factor of, say, 10 percent to 30 percent. This will result in a lower limit for individually significant items, and gathering more evidence from auditing smaller account balances, general journal entries, unusual transactions, for example.

All the percentage factors illustrative above are based on auditors' professional judgment resulting from the assessed level of risk at the financial statement level. None of the factors are specified in the auditing standards.

Individually Significant Items for Financial Statements Taken as a Whole

Tolerable misstatement (performance materiality) is the base for determining the lower limit for individually significant items in the financial statements taken as a whole, ranging from 10 percent to 100 percent of tolerable misstatement, depending high risk or low risk respectively. For engagements with higher risk of material misstatement at the financial statement level, individually significant items will generally be those account balances, transactions or general journal entries in excess of 10 percent to 30 percent of tolerable misstatement. When risk of material misstatement at the financial statement level is lower, a percentage of up to 100 percent may be used for determining individually significant items. When risk is low at the financial statement level, the lower limit may be commonly calculated at 80 percent to 90 percent of tolerable misstatement; moderate risk calculations may be 50 percent to 60 percent of tolerable misstatement and high risk 20 percent to 30 percent.

Individually Significant Items for Financial Statement Classifications—Assertion Levels

Auditing standards clearly indicate that tolerable misstatement (performance materiality) is affected by risk. Risk of material misstatement is usually different for each financial statement classification. Because the lower limit for individually significant items is calculated based on tolerable misstatement, and because tolerable misstatement must be determined separately for each material financial statement classification, the lower limit for individually significant items will also vary by financial statement classification. Tolerable misstatement at the assertion or account classification level can range from 10 percent to 100 percent of tolerable misstatement at the financial statement level. The same general rule of 10 percent to 100 percent, based on high or low risk, may be followed for calculating individually significant items at the assertion level.

We have posted an example, listing 10 steps to calculating the lower limit of individually significant items.

More information about calculating materiality levels can be obtained from my live webcasts which can be accessed by clicking the box on the left side of my home page, www.cpafirmsupport.com.

 

 

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