Materiality, Misstatements, and Reporting Part I ISAs 320, Materiality in Planning and Performing an Audit ISA Implementation Support

t Module Notes for Select Slides The following supporting notes accompany the PowerPoint slides for this module and do not amend or override the ISAs, the texts of which alone are authoritative. Reading these notes is not a substitute for reading the ISAs. The notes are not meant to be exhaustive and reference to the ISAs themselves should always be made. In conducting an audit in accordance with ISAs, the auditor is required to comply with all the ISAs that are relevant to the engagement.

Slide 2 Notes Overview of Module o Outcome of revision of ISA 320 was two separate ISAs for enhanced clarity: A revised ISA 320 on determining and using materiality in planning and performing an audit. A new ISA 450 on evaluating misstatements identified during the audit. o The concept of materiality links ISAs 320, 450 and 700. It is applied in both planning and performing the audit; in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements; and in forming the opinion on the financial statements. Slide 5 Notes Definition of materiality replaced by description of common characteristics often discussed in financial reporting frameworks (FRFs) o Old standard defined materiality based on definition in IASB literature o Standard specifies 3 main characteristics of materiality Misstatements are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users based on the financial statements. Judgments about materiality are made in context of surrounding circumstances, and are affected by the size and/or nature of a misstatement.

Module ISA 320-450-700 Part I Notes for Select Slides

What is material to users depends on a consideration of their common financial information needs and not their individual needs. Apply materiality in planning the audit o Judgments about materiality during the planning phase provide a basis for: Determining the nature, timing and extent of risk assessment procedures; and Identifying and assessing the risks of material misstatement.

o Important to bear in mind that materiality level(s) determined when planning the audit do not necessarily set an amount below which uncorrected misstatements, individually or in aggregate, will always be considered immaterial. Circumstances surrounding some misstatements may lead the auditor to evaluate them as material even if they are below materiality. Slide 7 Notes Standard provides guidance on choosing an appropriate benchmark o Factors that may be considered include: Nature of the entity and its industry The entitys ownership structure and how it is financed Relative volatility of the benchmark Profit before tax on continuing operations Total revenue Total equity Net asset value

o Examples of benchmarks include:

o In the case of a small entity, profit before tax from continuing operations may be consistently nominal, e.g. if owner-manager withdraws much of the profit before tax in the form of remuneration. In such circumstances, it may be more appropriate to choose profit before remuneration and tax as a benchmark. No specific guidance on percentages provided o IAASB intentionally avoided providing examples of percentages that may be used for specific types of benchmarks, for a number of reasons: Rules of thumb could become de facto standards. Examples may over-emphasize the quantitative aspects of materiality relative to the qualitative considerations. Specific examples could inappropriately discourage auditors from applying the necessary professional judgment to determine the materiality levels that are

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Module ISA 320-450-700 Part I Notes for Select Slides

appropriate in the particular circumstances of the engagement Reviewers and inspectors may focus more on why the auditor did not apply a given percentage as opposed to how and why the auditor determined a particular percentage. o There is a relationship between the percentage to be applied and the benchmark chosen, e.g. percentage applied to a profit-before-tax benchmark will normally be higher than one applied to a total-revenue benchmark. o Consideration of the nature of the entity and the surrounding circumstances is necessary in determining an appropriate percentage. Consider whether adjustments to benchmark needed for significant changes in entitys circumstances o E.g., if the entity has made a significant business acquisition giving rise to an exceptional increase or decrease in profit, it may be appropriate to use a normalized profit figure based on past results. o Note also that materiality relates to the financial statements being reported on, which may be for a period longer or shorter than 12 months. Slide 8 Notes Consider whether there are any relevant factors that may indicate whether there are particular items that would influence users judgments o For example: Users may be particularly sensitive to measurement or disclosure of certain items because of legal or regulatory requirements, e.g. disclosure of related party transactions and directors remuneration. Users may focus on specific line items or disclosures in the financial statements that affect key ratios, e.g. loan loss provisions for a bank or gearing. o Understanding the views and expectations of management and TCWG may help in identifying whether there are particular items for which it would be appropriate to determine a specific materiality level(s). Slide 9 Notes Performance materiality (PM) less than materiality for financial statements as a whole o An amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.

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Module ISA 320-450-700 Part I Notes for Select Slides

o If applicable, it also refers to an amount or amounts set by the auditor at less than the materiality level(s) for particular classes of transactions, account balances or disclosures. Serves two purposes o It is, in a sense, a means by which the auditor can ensure that the audit will be designed to obtain sufficient appropriate audit evidence on which to base the opinion on the financial statements. Slide 10 Notes Use of professional judgment is key o Relevant factors that may be considered include: Understanding of the entity Nature and extent of prior period misstatements Expectations of nature and extent of misstatements in current period

o While performance materiality may be one or more amounts, it is always less than materiality for the financial statements as a whole.

Copyright October 2010 by the International Federation of Accountants (IFAC). All rights reserved. Permission is granted to make copies of this work provided that such copies are for use in academic classrooms or for personal use and are not sold or disseminated and provided that each copy bears the following credit line: Copyright October 2010 by the International Federation of Accountants (IFAC). All rights reserved. Used with permission of IFAC. Contact permissions@ifac.org for permission to reproduce, store, or transmit this work. Otherwise, written permission from IFAC is required to reproduce, store, or transmit, or to make other similar uses of, this work, except as permitted by law. Contact permissions@ifac.org. ISBN: 978-1-60815-072-4

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