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Using Materiality in Audit Planning

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Using Materiality in Audit Planning ence the judgment of a reasonable person. Although the determination of what is materi- USING al to financial statements is necessarily an ac- counting concept, materiality also is a basic consideration in the audit process. An objec- tive of an audit is to search for errors that, MATERIALITY either individually or in the aggregate, would be material to the financial statements. Be- cause Smith will have to decide if he is satis- IN AUDIT fied that the financial statements aren't mate- rially misstated, it is essential that he plan his audit to obtain sufficient evidential matter to PUNNING make that evaluation. This article will describe how Smith, and other auditors, can use a preliminary estimate A practicai way to of materiality in planning an effective—and relate the auditor's efficient—audit. What Is a Preliminary materiality estimate Estimate of Materiality? According to Statement on Auditing Stan- to the design of dards no. 22. Planning and Supervision.^ the auditor considers, among other things, pre- audit procedures. liminary estimates of materiality levels when he plans an audit of financial statements. SAS hy George R. Zuher. Robert K. Elliott, no. 22 doesn't explicitly require an auditor to William R. Kitmey, Jr., and James J. Leisenring quantify, either as a specific or an approxi- mate amount, his preliminary estimate of ma- John Smith. CPA, is the auditor ofAjax. Inc. teriality. However, quantification is the most Recetitly. Smith had listened to another CPA practical way to consider such an estimate in describe how a careful consideration of mate- audit planning. Because financial statement*^ riality during the planning phase improved the are used to assess an entity's current position coordination and efficiency of an audit. In and performance and to predict an entity's planning his cutrent examination of Ajax. future flow of cash, changes in the amount, Inc.'s.. financial statements (see exhibit 1. timing or uncertainty of the entity's cash flow page 44). Smith decided to apply some of are matters that would be expected to affect those materiality concepts in the design of the judgment of a reasonable person. Because audit procedures. Auditors like Smith, who are engaged to 'statement on Auditing Standards no 22. Phinniiif; ami Su- examine financial statements, seek to deter- pervision (New York; AICPA. 197H). See also AfCPA Profes- sional Standards, vol. 1 (Chicago; Commerce Clearing mine whether the financial statements taken House). AU section .^11, as a whole are materially misstated. Material- ity has been defined over the years by. among others, accounting standard-setting bodies, GEORGE R, ZUBER, CPA. now a diKtoral student at the L'niversity of Michigan. Ann ,'\rbor. was a manager in the courts, regulatory agencies and auditors. Gen- American Institute of CPAs auditing standards division when erally, these definitions indicate that an omis- this article was written. Mr, Zuher is a member of the AICP,'\ sion or misstatement is material if knowledge statistical sampling subcommittee. ROBERT K. ELLIOTT, CPA. is a partner of Peat. Marwick. Mitchell & Co,, New of the omission or misstatement would influ- York. A former chairman of the staiistieal sampling subcom- mittee. Mr. Elliott is ;t member of the Institute's auditing Authors' ntilL-: The Amcriciin Institute of CPAs audiling stan- standards board (ASR) and tbe materiality and audit risk task dards board has exposed a proposed statement on auditing force, WILLIAM R. KINNEY, JR., CPA. Ph,D,, is the John F. standards entitled MateriuUty mid Audit Risk in Coiitttatiiig tin Murray Professor of Accounting and the director of the Insti- Audit (New York: AICPA. Deecmber 6, 1982), This article tute t)f Aecouniing Research at the I'niversity of Iowa. Iowa isn't an interpretation or digest ot the exposure draft, although City. He is u member of the .ASB and a former member of (he the methods discussed in this article would be. in the authors' statistical sampling subcommittee. JAMES J. LHISENRING, view, one method ot complying with certain provisions of the CPA. is director of research and technical aciivities at the exposure draft. Financial Accounting Standards Board. Stamford. Connecti- cut, Mr. Leisenring is immediate past chairman of the ASB. 42 Journal of ,^ceoun(ancy. Mareh these assessments and predictions are ex- pressed in quantitative terms, the definition of materiality must relate to these quantities. In addition, some quantification of "allowable error" is essential to communicating with staff assistants about the design and perfor- mance of audit procedures. SAS no. 22 suggests that there may. in fact, be more than one level of materiality for tbe financial statements taken as a wbole to be considered by an auditor. For example. Smith believes that $125,000 may be material if the error affects Ajax. Inc.'s. net income.^ while an error of up to $200,000 may be immaterial if the error affects only classification. The various levels of materiality result from the varying significance of different errors to the user's assessments and predictions of future cash flow. Although there may be more than one level of materiality, it is practical to design audit procedures using only one preliminary esti- mate of materiality for the financial state- ments taken as a whole. The selection of one preliminary estimate results from the inability of an auditor to simultaneously plan the na- ture, timing and extent of an audit procedure with different sensitivities to error. For exam- ple, it isn't practical for Smith to try to design one inventory test which would find pricing errors that aggregate to $ 10.000 and extension errors that aggregate to $20,000. Because in- procedures when he decides whether the fi- come is frequently considered the most sensi- nancial statements include material error. In tive predictor of future cash flow for a busi- making a preliminary estitTiate of materiality, ness entity, auditors often establish as an auditor can anticipate many of those fac- preliminary estimates of materiality tbe aggre- tors. For example, by <ibtaining an under- gate level of errors affecting income that they standing of the client's business, an auditor would consider to be material.^ Accordingly, has a reasonable understanding of the size of Smith decided that $125,000 is a reasonable the entity (for example, total assets, equity. preliminary estimate of financial statement sales and average earnings) and the nature of materiality to use in planning the audit of the client's operations and related transac- Ajax, Inc. tions. Those factors would ordinarily be con- Numerous factors would likely influence an sidered in developing a preliminary estimate auditor's evaluation of the results of his audit of materiality. As a result, those factors wouldn't be likely to cause the preliminary estimate of materiality to differ from the mate- Virtually all errors in Ajax. Inc's. financial statements that affect income are mitigated by a lax effect. If the marginal lax riality standard used in evaluating the finan- rale (federal and state) is 50 percent, the aftertax effect of cial statement presentation after the audit is $125.00(1 of error would be about 6 percent of net income, complete. Certain factors, however, may ^Tie fact that income is often considered the most sensitive cause the auditor's preliminary estimate of predictor of future cash fitws doesn't mean that an auditor materiality to differ from the materiality stan- can't develop a preliminary estimate of materiality until the net income for the period is known. Because materiality gen- dard used for evaluation. Those factors in- erally relates to a notion of longer-run expected income or clude significant changes in the circumstances average income, some auditors use total assets or average considered in making the preliminary estimate sales in eonjunetion with average income rates to estimate materiality. (such as a merger or a disposal of a segment of the business) and information disclosed by the application of audit procedures that couldn't Journal of Accountancy, March I9X.1 4.1 Inc., sells a significant portion of its products Exhibit 1 to a foreign country that prohibits any form of payment to governmental officials in ex- Financial statements for Ajax, Inc. change for favorable trade arrangements. If an Ajax. Inc, agent would pay SI.000 to an offi- Balance sheet cial of that country, the future cash flow of (as of December 31. J9XX) Ajax, Inc., might be materially affected by Cash $ 1.830.000 the loss of trade. Although such a payment Accounts receivable 2.627.000 could lead to a material effect on Ajax, Inc.'s, Inventory 5.155.000 financial statements, it would be impractical Property, plant and equipment 4.573.000 for Smith to plan for. and Ajax, Inc., to pay Other assets 205.000 for, an audit that could be expected to reveal $14,390,000 any improper payments as small as SI,000. As a result, while such factors—if discovered Current installments of during the audit—are ordinarily considered in long-term debt S 257.000 evaluating the financial statement presenta- Accounts payable 1,419.000 tion after the application of audit procedures, Accrued liabilities 1.996.000 they can't effectively be considered when the Long-term debt 3,115.000 auditor makes a preliminary estimate of mate- Deferred income taxes 755.000 riality. Common stock 1.679.000 We believe materiality is essentially a Retained earnings 5.169.000 quantitative consideration of what is impor- $14,390,000 tant to the presentation of a company's finan- cial statements. Both quantitative and qualita- tive matters, while not necessarily all precise Statement of earnings (for the vear ended amounts, can be considered either in terms of December 31.
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