Question

Audit standards require the auditor to consider the combined amount of misstatement early in the audit. This is known as preliminary materiality judgment. List and discuss the three main factors that affect an auditor's preliminary judgment about materiality.

Answer 1

The preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users. Several factors affect the preliminary judgment about materiality and are as follows:

            1.         Materiality is a relative rather than an absolute concept.

            2.         Bases are needed for evaluating materiality.

            3.         Qualitative factors affect materiality decisions.

            4.         Expected distribution of the financial statements will affect the preliminary judgment of materiality. If the financial statements are widely distributed to users, the preliminary judgment of materiality will probably be set lower than if the financial statements are not expected to be widely distributed.

            5.         The level of acceptable audit risk will also affect the preliminary judgment of materiality.

Because materiality is relative rather than absolute, it is necessary to have bases for establishing whether misstatements are material. For example, in the audit of a manufacturing company, the auditor might use as bases: net income before taxes, total assets, current assets, and working capital. For a governmental unit, such as a school district, there is no net income before taxes, and therefore that would be an unavailable base. Instead, the primary bases would likely be fund balances, total assets, and perhaps total revenue.

If an audit is being performed on a medium-sized company that is part of a conglomerate, the auditor must make a materiality judgment based upon the conglomerate. Materiality may be larger for a company that is part of a conglomerate because even though the financial statements of the medium-sized company may be misstated, the financial statements of the large conglomerate might still be fairly stated. If, however, the auditor is giving a separate opinion on the medium-sized company, the materiality would be lower than for the audit of a conglomerate.

The following qualitative factors are likely to be considered in evaluating materiality:

a.         Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts.

b.         Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations.

c.         Misstatements that are otherwise immaterial may be material if they affect a trend in earnings.