Audit Materiality Definition
Audit Materiality is an important part of audit wherein the misstatements by the company will be considered as material in case it is likely that such misstatement will reasonably have the influence on the economic decision of the users of the financial statement of the company. While considering materiality both the quantitative as well as qualitative aspects are considered. In the case of the qualitative aspects, the approach generally is quite difficult to measure when compared with the quantitative approach.
Types of Audit Materiality
#1 – Overall Materiality
The level which represents the significant level in the financial statements of the company, which can influence the decision making of the users of the financial statement of the company as a whole, as judged by the auditor appointed by the company, is known as the “overall materiality.”
#2 – Overall Performance Materiality
“Overall Performance materiality” is the materiality level judged by the auditor of the company. It can be the amount that is less than the overall level of the materiality. This materiality level is reduced from “overall materiality level” to consider the risk of several smaller errors or omissions which the auditor was unable to find. But they are material if aggregated in totality, thereby reducing the probability that the aggregate amount of small misstatements exceeds the overall materiality level as a whole.
#3 – Specific Materiality
Specific materiality refers to the materiality level set to identify potential misstatements. These may exist in different areas in the company, for certain classes of transactions, for the account balances that may affect the economic decisions of the users of the financial statementUsers Of The Financial StatementFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers. of the company.
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Example of Audit Materiality
Let’s consider an example of Company XYZ Ltd, which took a loan from the bank for $ 100,000. Bank gave the loan but on the condition that the current ratio of the companyCurrent Ratio Of The CompanyThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities should not fall below the level of 1.0. The company agreed to this and signed an agreement with the bank in this aspect. Now while conducting the audit, the auditor of the company came to know about this agreement.
At present, the current ratio of the company is only slightly more than the level of 1.0. Now for the auditor of the company, a minute misstatement of $ 3,000 can be material. It could lead to a violation of the agreement between the company and the bank. With the $ 3,000 misstatement also the current ratio of the company would fall below the level of 1.0. So this would be considered part of the audit materiality as it could lead to the violation of the agreement. It can reasonably influence the economic decision making of the users of the financial statement of the companyFinancial Statement Of The CompanyFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels..
Why is Audit Materiality Important?
- Audit materiality is an important concept that considers both the quantitative as well as qualitative aspects. Both aspects have an impact on the economic decision making of the users of the financial statement of the company. Qualitative aspects such as adequate disclosures concerning the contingent liabilities, related party transactionsRelated Party TransactionsRelated party transaction is an arrangement between two related parties for the transfer of resources, services or obligations, irrespective of whether a price is charged or can affect the statement of profit or loss and the financial position of an entity., changes in the accounting policy, etc. of the company also influence the economic decision making of the users of the financial statement of the company significantly.
- It is the basis on which the opinion of the auditor about the company forms, as the auditor requires to obtain a reasonable level of assurance about whether financial statements of the company are free from the material misstatements or not.
- The auditor may not be able to set the materiality at the proper level, which may then hamper the purpose of the same.
- The misstatement that affects the company’s compliance with the regulatory requirements might not get detected by the auditor of the company.
- In the case of the qualitative aspects, the approach generally is quite difficult to measure when compared with the quantitative approach.
- Both the quantitative, as well as qualitative aspects, are considered in the case of audit materiality. The quantitative considerations include setting up of preliminary judgment for the materiality; Considering the performance materiality; Estimating the misstatement in a cycle or; account and Estimating the total aggregate amount of misstatements, etc.. The qualitative considerations include providing the adequate disclosures concerning the contingent liabilities of the company, providing the proper disclosures concerning the transactions with the related parties of the company, disclosure regarding the change in any accounting policyAccounting PolicyAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level. in the company, etc.
- While dealing with the material misstatements, an auditor must consider all the types of misstatements, which include Identified Misstatement, Likely Misstatements, Likely Aggregate Misstatements, Further Possible Misstatements, and Maximum Possible Misstatements.
- Three types of audit materiality include overall materiality, overall performance materiality, and the specific materiality. The auditor uses these as per the different situations prevailing in the company.
Audit materiality provides the opportunity to the user of the financial statement, auditor, and the company. The materiality level is set at the level that could reasonably influence the economic decision making of the users of the financial statement of the company.
This article has been a guide to what is audit materiality and its definition. Here we discuss three types of audit materiality with the help of an example. We also discuss its advantages and limitations. You can learn more about accounting from the following articles –