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 and 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 as judged by the auditor of the company which can be the amount that is less than overall level of the materiality. This materiality level is reduced from that of overall materiality level in order consider the risk of several types of smaller errors or small omissions which the auditor was unable to find but are material if aggregated in totality thereby reducing the probability that aggregate amount of small misstatements exceeds overall materiality level as a whole.
#3 – Specific Materiality
Specific materiality refers to the materiality level set in order to identify the potential misstatements that may exist in case of the certain different specific areas in the company, for certain classes of transactions, for the account balances that may have an effect on economic decisions of the users of the financial statement of the company.
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 to the company but on the condition that the current ratio of the company 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 as it could lead to the violation of the agreement between the company and the bank because 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 as part of the audit materiality as it could lead to the violation of the agreement between the company and the bank as well as reasonably have an influence on the economic decision making of the users of the financial statement of the company.
Why Audit Materiality is Important?
- Audit materiality is an important concept which considers both the quantitative as well as qualitative aspects as not only the quantitative aspects have impact on the economic decision making of the users of the financial statement of the company rather the qualitative aspects such as adequate disclosures with respect to the contingent liabilities, related party transactions, changes in the accounting policy etc of the company also influence significantly the economic decision making of the users of the financial statement of the company.
- It is the basis on which the opinion of the auditor about the company is based as it is required that the auditor should obtain a reasonable level of assurance about whether financial statements of the company are free from the material misstatements or not.
- It is possible that the auditor is not able to set the materiality at the proper level which may then hamper the purpose of the same.
- It is possible that the misstatement that has affected on the compliance of the company 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 case of the audit materiality where the quantitative considerations include setting up of preliminary judgment for the materiality, Considering the performance materiality, Estimating the misstatement in cycle or in an account and Estimating total aggregate amount of misstatements etc and the qualitative considerations include providing the adequate disclosures with respect to the contingent liabilities of the company, providing the adequate disclosures with respect to the transactions with the related parties of the company, disclosure regarding the change in any accounting policy 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.
- There are three types of audit materiality that may exist which include overall materiality, overall performance materiality, and the specific materiality. These are used by the auditor 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 as the materiality level is set at the level that could reasonably have an influence on the economic decision making of the users of the financial statement of the company.
This 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 –