Regarding materiality thresholds in AUDIT

[Jamesaccountant]

Regarding materiality, the textbook says that there are three materiality thresholds we use in audit. The first is "Materiality threshold for the FS as a whole", the second is "Materiality threshold for each account", and the last is "Tolerable misstatement (or CT)".

As a general flow, perform a substantive test, aggregate the misstatements that are above CT by account, and if the total misstatements for the certain account exceed the materiality threshold set for the account, that means the account has material misstatements, which can result in a qualified opinion.

Lastly, if you aggregate the misstatements that are above CT for the entire FS, not for each account, and the total amount exceeds Materiality threshold for the FS, it means the FS has material misstatements, which results in an adverse opinion.

Am I understanding correctly? Would you let me know if you spot any piece to be wrong above? Thank you in advance!

 

[UncleSam]

Yes basically I would say you have a fairly firm grasp upon materiality just remember that materiality is usually based quite a bit upon auditors judgement which is determined by what the auditor determines is the "Risk of Material Misstatement" which is comprised of Inherent Risk x Control Risk.

Also, if you end up taking AUD in the CPA exam I recommend checking out Uworld Roger CPA Review. Material was fantastic in helping me understand audit.

 

[Jamesaccountant]

Thank you for your kind reply Mr. UncleSam.

If you could answer the 3 questions below, that would be really helpful.

1.

Which way of evaluation misstatements is correct?

(1) Aggregating all the misstatements that are above CT and compare it to the Materiality for the FS, or
(2) Aggregating the misstatements that are above PM at the account level and compare it to the the Materiality for the FS



2.

If (1) is correct above,

I guess there are cases where the misstatement don’t go above PM (which is set for accounts) in each account, but the total misstatements go above Materiality.

E.g. Let’s say the Materiality for the FS is 100 and the PM for accounts is 70. There are, let’s say, only 4 accounts in the FS. After doing substantive tests, we found that the misstatements in the 4 accounts are 30, 30, 40, and 50 respectively. So All of them are under PM 70 in facts which doesn't result in a qualified opinion, but the total misstatements are 150 (30+30+40+50), which is above the Materiality.

How does this result affect your audit opinion? Will it most likely be an adverse opinion because the total misstatements are above the materiality?


3.
Regarding Tolerable misstatements (CT), is this material threshold set for each assertion? Or each sample? I don’t really know what it’s applied to.
My textbook says that it's applied to assertions, but some say its applied to every sample you test on the internet.



Thank you very much in advance.

 

[Goku]

I am gonna share my concept with you tell me if I am right otherwise correct me and tell me if it answers your query.


1st you determine a materiality for the financial statements as a whole by selecting a relevant benchmark depends on what type of business you are auditing ( if auditing profit oriented entity then revenue or pre tax profit might be a good benchmark) and multiplying it with certain %age.


2- Now the thing is that you don't want misstatement in the business to be more than the materiality you just set earlier (let's assume it 100,000$).


3.but what if the individual account balances or transactions reported on FS does not show misstatement of 100,000$ or above but the misstatements in them aggregately exceed $100,000.?


4-here is when performance materiality plays its role. Now you determine performance materiality for FS as a whole which is lesser than the materiality level of FS. May be a single performance materiality for whole FS or different for each account balance depending on the risk associated with the account balance or transaction.lets assume it to be 40,000$ for all balances for simplicity .


5-Tolerable misstatement is nothing but application of this performance materiality concept you just applied earlier on even smaller level that is in sampling of account balance.


6-lets suppose you assessed the risk associated with the account receivable(an account balance) as high. So tolerable misstatement must be kept low for sample. Like we say 12000$. And thus you will increase sample size.


7-Now what you're gonna do is you will defeinetly select specifically recievables of having individual values of 40,000$ or more and also test remaining receivables on sampling basis.you select a sample of receivables test it for all relevant assertions(like confirmation, accuracy etc) and note down the misstatements you have found in the sample during testing of every assertion. Let's suppose the recievables have population of 500,000$(excluding the specifically selected recievables) , now you have tested the sample of high size as tolerable misstatement was high covering let say 280,000$ and found misstatements in it of 28,000$ that is 10%.Now you are gonna extrapolate that 10% over whole population so you determined that misstatement in recievables population is (500,000x10%) is 50,000$, plus 2000$ which we assume was mistated in specifically selected item. Thus total misstatement in receivables is 52,000$ which is greater than 40,000$. Now note that down. If it would have been less then that then consider it immaterial.Then follow same procedure for other account balances like inventory,property, plant equipment etc.


8-Now you have the material misstatements for every account balance shown on FS now just aggregate it and check that whether it exceeds the materiality of FS if exceeds then adverse opinion other wise qualified opinion.


You asked that some immaterial misstatements lower than performance materiality in line items of FS when aggregated might exceed materiality level for FS so for this purpose we obtain written representation from management.