Question

Material” has a different definition in accounting than it does in everyday life. What does “material” mean in the context of an audit, and who determines whether an item is material? How does the materiality of an item affect the acceptable and inherent risk borne by an audited company?

Answer 1

The materiality concept of accounting provides that the material information should not be ignored while preparing the financial statement. If the material information is missing then, the users would not be able to make a correct decision.materiality is an entity-specific aspect of relevance based on nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.

How do auditors determine materiality?

To establish a level of materiality, auditors rely on rules of thumb and professional judgment. They also consider the amount and type of misstatement. Regardless of whether a misstatement of revenue is considered material, it may trigger a material misstatement in accounts receivable. In other words, the balances recorded as due from customers may be materially different from the actual amounts due.

The auditor has an opinion on the financial statements whether these are materialistic or not.

The materiality of an item affects the acceptable and inherent risk borne by an audited company.

We know that Audit risk is the risk that an auditor will fail to modify his or her opinion when the financial statements contain a material misstatement.

Inherent risk is the susceptibility of an assertion to a material misstatement, assuming that there are no related controls. The risk of such misstatement is greater for some assertions and related balances or classes than for others. For example, complex calculations are more likely to be misstated than simple calculations. Cash is more susceptible to theft than an inventory of coal. Accounts consisting of amounts derived from accounting estimates pose greater risks than do accounts consisting of relatively routine, factual data. External factors also influence the inherent risk. For example, technological developments might make a particular product obsolete, thereby causing inventory to be more susceptible to overstatement.

The less the inherent and control risk the auditor believes exists, the greater the detection risk that can be accepted. Conversely, the greater the inherent and control risk the auditor believes exists, the less the detection risk that can be accepted. These components of audit risk may be assessed in quantitative terms such as percentages or in nonquantitative terms that range, for example, from a minimum to a maximum.

Auditors rely on controls and reduce the substantive testing approach. Generally, inherent risk and control risk is low to moderate, and detection risk is moderate to high. For example,

1. Confirm accounts receivable 2 months before the balance sheet. Rely on controls over-processing of accounts receivable to reduce the risk that error will not occur during the final two months of the year.

2. Rely on analytical procedures to detect unusual situations that might arise.

3. Confirm accounts receivable as of the balance sheet date. However, the auditor sends out fewer confirmations because internal controls over accounts receivable are good.

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