Does Audit Risk Affect Materiality?
Most of us would answer that audit risk does affect materiality. That's what SAS No. 107 says, SAS No 47 before that. Drilling down, perhaps the question should be, "Do we appropriately reflect risks of material misstatements in setting materiality levels that guide audit engagement performance?" Again, most of us would answer yes.
Deeper still, maybe the question is, "Do we reflect both high and low levels of applicable risk of material misstatement in calculations of tolerable misstatement and the lower limit for indiviually significant items at both the financial statement level and the assertions level?" Now we are down to it! A common answer would probably be yes, but many of our materiality computation schedules would likely betray us!
While many providers of audit practice aids could be cited, an example is PPC's Materiality Worksheet. Designed to generically accomplish a determination of planning materiality, tolerable misstatement and the lower limit for individually significant items, the calculations are based on the largest financial statement bases to estimate the maximum amount of error or fraud, known and unknown, an auditor can accept in the financial statements taken as a whole without adjustment. The generic form is designed to facilitate use on a wide range of audits. It is a good model but it makes some assumptions users must recognize. Here are a few.
- It assumes the table approach to determining percentage calculations is applicable to all audits. This table is not required by professional standards and, as I understand it, was developed by various studies that have evolved over the years. This table is one tool for applying materiality standards to audits. AICPA training seminars suggest using a range of percentages for individual accounts to set materiality levels.
- Taken on It's face, the form assumes that tolerable misstatement at the financial statement level is always 75% of planning materiality. While this may be a commonly applied factor, it is not cast in concrete. In fact, risk at the financial statement level may cause this factor to be modified. Higher risk could cause an auditor to reduce tolerable misstatement at the financial statement level to 40% or 50% of planning materiality. Lower risk could cause an increase in the factor to 80% or 90%.
- The lower limit for individually significant items at the financial statement level should also reflect risk. One-third to one-sixth of tolerable misstatement is a common factor applied in practice. This factor should, however, reflect risk at the financial statement level and can actually range from 10% to 100% of tolerable misstatement.
- While this form has space to calculate differenct levels of tolerable misstatement at the assertion (or financial statement classification) level, most auditors use tolerable misstatement calculated at the financial statement level for setting lower limits of individually significant items and applying the model approach to sampling at the assertion level. While risk at the assertion level is affected by risk at the financial level, it almost always is greater or lesser. Tolerable misstatement and the lower limit for individually significant items at the assertion level, therefore, is almost always different from calculations at the financial statement level.
The bottom line in professional standards is that risk always affects materiality. Depending on practice aids from major publishers may help ensure engagements meet quality control standards, but they may not clearly present the most efficient methods for completing an engagement. Thinking and reasoning skills are still the keys to engagement efficiency!
I've developed an illustrative Tolerable Misstatements Computation Form that requires users to consider the issues above. If you'd like to request a copy of this form, please use the "Contact Us" feature on our website, www.cpafirmsupport.com. Post a comment here and let us know how you reflect risk in your materiality computations.
by Larry Perry, CPA, CPA Firm Support Services, LLC - Larry has over 40 years experience as a CPA practitioner, author of accounting and auditing manuals, author and presenter of live staff training seminars and author of webcast and self-study CPE programs. He is co-founder of CPA Firm Support Services, LLC (www.cpafirmsupport.com), an organization providing resources, training and consulting to smaller CPA firms. Larry writes a weekly blog on AccountingWEB.com focusing on small audits, reviews and compilations. He is currently developing documentation manuals and handbooks for small audits, reviews and compilations and related electronic practice aids.