Guide to Using International Standards on Auditing in - IFAC

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90 <strong>Guide</strong> <strong>to</strong> <strong>Using</strong> <strong>International</strong> <strong>Standards</strong> on Auditing in the Audits of Small- and Medium-Sized Entities Volume 1—Core Concepts Establishing Materiality Amounts Exhibit 7.5-2 Overall Materiality Overall Performance Materiality Specific Materiality Specific Performance Materiality Overall materiality relates <strong>to</strong> the financial statements as a whole. It is based on what could reasonably be expected <strong>to</strong> influence the economic decisions of the financial statement users, taken on the basis of the financial statements. It would be changed during the audit if the audi<strong>to</strong>r becomes aware of information that would have caused him/her <strong>to</strong> have determined a different amount (or amounts) initially. Performance materiality is set at a lower amount than the overall materiality. Performance materiality enables the audi<strong>to</strong>r <strong>to</strong> respond <strong>to</strong> specific risk assessments (without changing the overall materiality), and <strong>to</strong> reduce <strong>to</strong> an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeding overall materiality. Performance materiality would be changed based on audit findings (such as where a risk assessment was revised). Specific materiality is established for classes of transactions, account balances, or disclosures where misstatements of lesser amounts than overall materiality could reasonably be expected <strong>to</strong> influence the economic decisions of users, taken on the basis of the financial statements. Specific performance materiality is set at a lower amount than the specific materiality. This enables the audi<strong>to</strong>r <strong>to</strong> respond <strong>to</strong> specific risk assessments, and <strong>to</strong> allow for the possible existence of undetected and immaterial misstatements aggregating <strong>to</strong> a material amount. Materiality for the Financial Statements as a Whole Materiality for the financial statements as a whole (overall materiality) is based on the audi<strong>to</strong>r’s perception of the financial-information needs of users of the financial statements. This would typically be determined at an amount similar <strong>to</strong> that used by the financial statement preparer. <strong>Using</strong> professional judgment, the audi<strong>to</strong>r would set materiality at the highest amount of misstatement that would not influence the economic decisions of financial statement users. Once established, the overall materiality amount becomes one of the fac<strong>to</strong>rs by which the ultimate success or failure of the audit will be judged. For example, assume overall materiality was set at an amount of 20,000Є. If, as a result of performing audit procedures: • No misstatements were identified—an unmodified opinion would be provided. • Some small (immaterial) misstatements were identified and not corrected—an unmodified opinion would be provided. • Uncorrected misstatements exceeding materiality (of 20,000Є) were found and management was unwilling <strong>to</strong> make the necessary adjustments—a qualified or adverse opinion would be required. • Uncorrected errors exceeding materiality (of 20,000Є) exist in the financial statements but were not detected by the audi<strong>to</strong>r—then an inappropriate unmodified audit opinion may be issued. Refer <strong>to</strong> Volume 2, Chapter 21 for guidance on how <strong>to</strong> use materiality in evaluating the audit evidence obtained.
91 <strong>Guide</strong> <strong>to</strong> <strong>Using</strong> <strong>International</strong> <strong>Standards</strong> on Auditing in the Audits of Small- and Medium-Sized Entities Volume 1—Core Concepts Audi<strong>to</strong>rs are sometimes tempted <strong>to</strong> lower the overall materiality amount when the risk of material misstatement is assessed as high. This would not be appropriate, however, as overall materiality addresses the needs of financial statements users, not the level of audit risk involved. If audit risk was a fac<strong>to</strong>r in setting overall materiality, a high-risk audit would end up with a lower overall materiality amount than that set for a similar-sized entity where audit risk was low. Assuming that the information needs of financial statement users are the same, regardless of audit risk, setting the overall materiality amount at a lower level would result in: • Providing financial statement users with an expectation that smaller misstatements in the financial statements (than is actually necessary) will be identified by the audi<strong>to</strong>r; and • Additional audit work <strong>to</strong> ensure that audit risk has been reduced <strong>to</strong> an appropriately low level. Because overall materiality is set in relation <strong>to</strong> the needs of financial statement users, it would not be changed as a result of audit findings and changes in assessed risks. Overall materiality is required <strong>to</strong> be updated when the audi<strong>to</strong>r becomes aware of information that would have caused the initial determination of materiality <strong>to</strong> be a different amount (or amounts). At the conclusion of the audit, overall materiality will be used for evaluating the effect of identified misstatements on the financial statements and the appropriateness of the opinion in the audi<strong>to</strong>r’s report. Performance Materiality Performance materiality allows the audi<strong>to</strong>r <strong>to</strong> address the risks of misstatement in account balances, classes of transactions, and disclosures without having <strong>to</strong> change overall materiality. Performance materiality enables the audi<strong>to</strong>r <strong>to</strong> establish materiality amounts that are based on the overall materiality, but are set at lower amounts <strong>to</strong> reflect the risk of not detecting misstatements and <strong>to</strong> reflect risk assessments. This lower amount(s) establishes a safety buffer between the materiality used for determining the nature and extent of testing (performance materiality) and the materiality amount for the financial statements as a whole (overall materiality). Setting an appropriate amount for performance materiality will ensure that more work is performed, which increases the likelihood that misstatements (if they exist) will be identified. For example, if overall materiality was 20,000Є and audit procedures were planned <strong>to</strong> detect all errors in excess of 20,000Є, it is quite possible that an error of, say, 8,000Є would go undetected. If three such errors existed, amounting <strong>to</strong> 24,000Є, the financial statements would be materially misstated. However, if performance materiality was set at 12,000Є, it would be much more likely that at least one or all of the 8,000Є errors would be detected. Even if only one of the three errors was identified and corrected, the remaining misstatement of 16,000Є would be less than the overall materiality, and the financial statements as a whole would not be materially misstated. Setting an appropriate amount for performance materiality involves the exercise of professional judgment, and is not a simple mechanical calculation such as a percentage (e.g., 75%) of the overall materiality level. However, based on the particular circumstances of the entity being audited, it could be set as a single amount for the financial statements as a whole, or at individual amounts for particular balances, transactions, and disclosures.
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