By Willie E. Gist and Trimbak Shastri

The Sarbanes-Oxley Act of 2002 reiterates the importance of ensuring that financial statements are free of material misstatements due to error or fraud. While this law applies to public companies, auditors of nonpublic companies should also take note of its requirements. A recent study indicated that nearly 75% of nonpublic company audit malpractice claims are caused by inadequate disclosures and technical errors, and another 20% caused by failure to detect defalcations (internal control risk-assessment related). The Sarbanes-Oxley Act and SAS 99, Consideration of Fraud in a Financial Statement Audit, which superseded SAS 82, are likely to improve the audit focus on detecting material misstatements.

Skepticism and Judgment

Audit failures could be significantly reduced if audits were planned and executed with due care. Implicit in the application of due care is maintaining an attitude of professional skepticism at a heightened level (AU 230.07 and SAS 99) and exercising professional judgment when conducting GAAS audits. Professional skepticism requires that auditors remain alert to the following:

Although the concept of materiality, in conjunction with audit risk and its components (AU 312A), forms the backbone of the audit process, applying it properly has often been elusive, and professional standards do not provide specific guidelines or approaches to operationalizing these concepts. For example, professional standards state that “the auditor’s consideration of materiality is a matter of professional judgment and is influenced by his or her perceptions of the needs of a reasonable person who will rely on the financial statements” (AU 312A.10). In addition, omission of material items or facts and inclusion of untrue statements about a material fact in the financial statements could adversely influence the decisions of a reasonable person. Thus, for materiality considerations the focus should be on items included in or omitted from the financial statements that would likely influence the judgment of a reasonable person. “Reasonable shareholder or investor” could be substituted for reasonable person, because the Supreme Court has noted [TSC Industries (426 U.S. 450), as cited in SAB 99] that determinations of materiality require “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him.”

One approach to applying the concept of materiality in audits consists of considering it during three stages: the planning stage, during the audit, and the wrap-up stage.

Planning-Stage Materiality

Materiality judgments should be based on the perceived needs of a reasonable investor. Investor needs for quality accounting information relate to the operations, financial position, cash flows (and related disclosures for assessing profitability), liquidity, and solvency of a company. It is essential, therefore, that the auditor consider both quantitative and qualitative materiality for planning the nature, timing, and extent of audit procedures.

With regard to quantitative materiality, the auditor should estimate a preliminary materiality level (AU 311.03). A percentage of some bases can be used as a rule of thumb. For example, the auditor may use 5% of income from continuing operations or 1% of revenue or assets. Another rule of thumb for determining materiality could be based on revenue or assets using a sliding or incremental rate (see AICPA Audit Guide, “Audit Sampling,” 2001), as shown in Exhibit 1.

Furthermore, materiality should be considered in terms of the smallest level of misstatement that could be material to either the income statement or the balance sheet (AU 312A.19). It is important to remember that SAB 99 states that placing exclusive reliance on quantitative benchmarks in performing audits to evaluate financial statements is inappropriate.

With regard to qualitative materiality, auditors should (through personnel inquiry, discussions with audit staff, reading minutes, and analytical procedures) assess the conditions or “red flags” that may signal potential risk of material misstatements. Consideration of these red flags in conjunction with quantitative materiality judgments should guide an auditor in determining appropriate audit procedures for gathering sufficient competent evidential matter. Conditions that should be continuously scrutinized by the auditor include the following:

For a list of conditions and events that may indicate risk of material misstatements, see Appendix C in the ASB’s Exposure Draft on “Understanding the Entity and Its Environment and Assessing Risk of Material Misstatement” (December 2, 2002).

During the Audit

Once established, preliminary materiality is allocated to individual accounts and is referred to as tolerable error or misstatement (TM) (AU 350.18). TM represents the maximum amount of misstatement the auditor is willing to tolerate in concluding that the financial statements are fairly presented.

Materiality is allocated to determine the necessary sample size (extent of audit) in light of the assurance required. Usually, the auditor initially determines the nature and timing of tests (which collectively influence the competency or quality of evidence), and then determines the extent of evidence based on TM. In addition, allocated materiality is used to evaluate the maximum estimated misstatements in an account or group of accounts.

The auditor should recognize the importance of qualitative matters when allocating quantitative materiality. This consideration is critical because, from an investor’s perspective, the materiality relative to certain highly liquid line items (e.g., marketable securities and accounts receivable) is more important than that relative to less liquid line items. Also, qualitative materiality factors are important in circumstances such as related-party transactions, litigation, and transparency of disclosures. In this regard, the auditor must use professional judgment.

Applying professional judgment includes exercising due care in complying with standards and regulations, maintaining an attitude of professional skepticism, being technically proficient in auditing the client’s financial statements, and reaching an objective decision effectively and efficiently. For example, an auditor may not allocate materiality (quantitatively) to a land account that has not changed since the last audit, and may undertake a minimum review to verify assertions. By contrast, an auditor may substantially increase the audit effort in searching for unrecorded liabilities, based on a relatively high assessed control risk.

Approaches for allocating materiality include the following:

Allocation of materiality applies whether sampling or nonsampling techniques are used. Exhibit 2 illustrates an approach for establishing materiality for all accounts based on a “rule of thumb,” allocating materiality to an account balance for sampling, and determining sample size. The following equation is an approach for determining sample size:

Sample size = (Population’s recorded amount X Assurance factor) - Tolerable Misstatement

In the sample size formula, the population’s recorded amount refers to the recorded book value of the account subject to testing. The assurance factor is based on the degree of assurance required from substantive work by the auditor. The degree of assurance depends on the assessed level of combined inherent and control risk for specific financial statement assertions (auditors should consider qualitative aspects when assessing combined inherent and control risk). For example, a high degree of assurance from tests of details would be required when the assessed level of combined inherent and control risk is at maximum and the risk that other substantive procedures (e.g., analytical procedures) will fail to detect a material misstatement is also relatively high. In such a situation, the auditor might use an assurance factor of three. By contrast, if the assessed level of combined inherent and control risk were low, and the risk that other substantive procedures would fail to detect a material misstatement is also low, then the auditor might use an assurance factor of one (AICPA, “Audit Sampling,” 2001; see also Gafford, W.W., and D.R. Carmichael, "Materiality, Audit Risk and Sampling: A Nuts-and-Bolts Approach,” Journal of Accountancy, October 1984).

Wrap-Up Stage

Based on the audit of various accounts and transaction classes, an auditor should determine whether the financial statements are materially misstated, whether quantitatively or qualitatively.

Quantitative misstatement. The auditor would not be able to determine the exact amount of total misstatements because of the imprecision inherent in the auditor’s estimation and inability to audit all items. Based on the audit, the auditor would accumulate known (identified) errors and misstatements and project likely errors and misstatements individually, then aggregate unadjusted and uncorrected misstatements, which, under AU 312A, should include the following actions:

With regard to assessing misstatement, an auditor would calculate likely aggregate misstatements (LAM) by combining the above (IM in specific items + LM), then compare the LAM with the acceptable level of materiality in determining whether the amount is materially misstated quantitatively. The acceptable level of materiality would be the planning-stage materiality adjusted in light of the entity’s changed conditions and the needs of a reasonable investor.

The auditor should recognize that a LAM estimate might not include all misstatements, as there may be further possible misstatements (FPM) remaining undetected (AU 312A.39). FPM may arise out of sampling risk and the imprecision inherent in the auditor’s estimation of likely misstatements, such as in a minimum review of some of the accounts (e.g., prepaid expenses) and in the audit of accounting estimates (e.g., allowance for doubtful accounts), which are subject to the unpredictability of future events. Sampling risk arises from the use of audit samples (AU 350.10 and 11), and if the sampling risk is larger than the precision acceptable to the auditor, then the misstatement would exceed materiality. Therefore, for comparison with the acceptable level of materiality, an auditor should estimate maximum possible misstatement (MPM) by adding the estimated LAM and FPM.

LAM may exceed materiality or be lower than materiality. When LAM exceeds materiality, the auditor should request management to eliminate the material misstatement to ensure that the estimated MPM does not exceed materiality. If management does not eliminate the material misstatement, then the auditor should consider the effects on the auditor’s report (AU 312A.38).

When LAM is lower than materiality, the auditor should consider how close LAM is to materiality. As LAM increases and approaches materiality, the risk that the financial statements may be materially misstated also increases. The auditor would estimate the MPM for comparison to the acceptable level of materiality.

The auditor should use judgment to estimate FPM. For example, consider a case where the acceptable level of materiality is $5,000 and, based on the audit, LAM is $1,000. If the auditor establishes 45% of materiality as allowance for FPM ($2,250), this leaves $2,750 for comparing with LAM. When LAM exceeds $2,750, an auditor should be concerned about quantitative materiality. In such a situation, the auditor might extend audit procedures or ask the client to correct the misstatements that would bring LAM sufficiently below the acceptable level. Nevertheless, quantitative materiality alone is not sufficiently competent. In this example, although the estimated maximum possible misstatement of $3,250 ($1,000 LAM + $2,250 FPM) is well below the materiality of $5,000, the financial statements could be materially misstated as a result of qualitative factors.

Qualitative misstatement. Misstatements involving fraud are more likely to have an adverse impact than errors of the same magnitude. Even a small amount of intentional misstatement can constitute fraudulent financial reporting. Auditors should ensure that the client’s letter of representation includes, among other matters, a statement that the uncorrected misstatements proposed by the auditor are immaterial to the financial statements taken as a whole, and the auditors should include with the letter a summary of unadjusted misstatements (AU 333.06).

In connection with the quality of financial reports, the auditor should evaluate the following matters: