LECTURE 0524

DETERMINING PERFORMANCE MATERIALITY

Types of Materiality
• Overall Materiality/ Planning Materiality: This is set for the financial statements
as a whole so that aggregate of misstatements do not exceed this limit and if they
do then the financial statements are said to be materiality misstated.

• Performance Materiality: It refers to amount set by the auditor in planning and

actual performance of the audit. It is calculated as a percentage of overall
materiality level (usually 50-75%). It depicts the level of misstatements above
which general ledgers are to be verified.

• Tolerable Misstatement: It is similar to performance materiality. The only

difference is that it is applied to individual transactions and not on a financial
statement level. It is calculated as a percentage of performance materiality
(usually 5%). It represents a level in excess of which individual transactions are to
be verified.
Example
• A company makes a profit before tax of K 1 million.
• Now, Overall materiality = 5% of Profit before tax = K 50, 000.
• Performance materiality = say 75% of planning materiality = K 37, 500
• Specific performance materiality = say 5% of performance materiality
= K 1, 875.
Definition of Performance Materiality
• Amount(s) set by auditors at below overall materiality
• To reduce to an appropriately low level the probability that the
aggregate of uncorrected and undetected misstatements exceeds
overall materiality.
Risk of Material Misstatement not Detected
• If overall materiality was applied throughout the planning and
fieldwork stages there is an undue risk that material misstatements
may not be detected. (RMM)
Purpose of Performance Materiality
• Broadly it serves two functions:
• to reduce the aggregation risk (the risk that the aggregate of
uncorrected and undetected misstatements individually below
materiality will exceed materiality for the financial statements as a
whole) to an acceptable level; and
• to provide a safety net (buffer) against the risk of undetected
misstatements.
Aggregation Risk
• Now, undetected misstatements use up materiality if we have done
the audit. It is complete. We found no misstatements. We’ve got to
remember, we didn’t test everything. So, we should assume that we
have missed misstatements equal to materiality. Okay, so undetected
misstatements equal materiality and we have no room left. If we
expect uncorrected errors or misstatements, then we need to deduct
those uncorrected errors from materiality and that gives us
performance materiality.
Setting Performance Materiality
• The key word therefore is ‘risk’.
• Having set overall materiality, performance materiality is a lower
figure. How much lower will depend on, for example, the assessed
level of risk of material misstatement.
Percentage Range of Performance Materiality
• Usually audit methodologies require performance materiality to be a
percentage of overall materiality (or variations amounting to much
the same thing).
• The higher the assessed risk, the lower the percentage.
• And you cover more account balances & transactions
• Typically the percentages range from 75% (low risk) to 50% (high risk).
Example
• Take two entities in the same industry with similar levels of revenue and assets.
The shareholders, potential shareholders, employees and customers (ie, users of
the financial statements) are also similar. If all things are equal then overall
materiality (however determined) ought to be similar.

• However, based on knowledge and experience of the first entity the auditors do
not anticipate any adjustments will be needed as there is a very strong control
environment and management consistently applies effective control procedures.
• By contrast the second entity has a weak control environment and the auditors
anticipate they will identify numerous areas requiring adjustment. While overall
materiality will be similar, clearly the risk in the second entity is greater and
performance materiality should therefore be lower.
Illustration
• If overall materiality is K 140,000 and performance materiality has
been set at K 105,000, the response to a simple balance such as the
prepayments figure (where the key audit assertion is existence) could
vary as follows.
Example
Applying materiality to the evaluation of
identified misstatements
• evaluate effect of identified misstatements on the audit and of
uncorrected misstatements on financial statements. This section
looks at the practical issues around:

• accumulating misstatements during the audit;

• categorising misstatements according to their nature;
• assessing the materiality of misstatements; and
• considering the impact of misstatements on the audit.
Accumulating Misstatements During the Audit
• Auditors accumulate misstatements identified during the audit other
than those that are clearly trivial.
• They are recorded in the summary of misstatements
• Therefore, auditors often set a threshold for recording misstatements.
This is referred to as a ‘clearly trivial threshold’.
• Those small misstatements below this threshold are not considered.
• Even if accumulated they may not reach this threshold.
• In practice, it is in the range of up to 5% of overall materiality
Exceptional Trivial Misstatements
• It is considered if the nature of the misstatement means that it is not
clearly trivial. E.g. Fraud

• There may be a number of small misstatements all affecting the same area
such as inventory, indicating that there could be deficiencies in internal
control in that area, and this information may be useful for management.

• Sometimes, those charged with governance ask auditors to report all

misstatements identified during the audit, irrespective of size, and in that
case no threshold is used.
Categorizing Misstatements
• Misstatements are categorized into factual, judgemental and projected
misstatements

• Factual misstatements are misstatements about which there is no doubt.

• Judgemental misstatements are differences arising from the judgements
of management and auditors range and auditors consider unreasonable or
inappropriate.
• Projected misstatements are auditors’ best estimate of misstatements in
populations, involving the projection of misstatements identified in audit
samples to the entire populations from which the samples were drawn.
Factual Misstatements
• Factual misstatements

• A factual misstatement includes, for example, a simple error in

recording transactions.

• An invoice recorded in the accounting records at K 5, 000 instead of K

15, 000.
Judgemental Misstatements
• Judgemental misstatements arise in relation to accounting estimates.
• Auditors generally develop a range of amounts for each estimate that
would be considered reasonable. Management’s estimate would
normally be acceptable if it falls within this range. If it doesn’t then
the difference is considered by the auditor as a misstatement.
• E.g. The auditors may determine that an appropriate range for a
provision for obsolete inventory is between K 160, 000 and K 200,
000. If the entity has recorded a provision of K 140, 000, the
judgmental misstatement is K 20, 000 (ie, K 160, 000 – K 140, 000).
Projected Misstatement
• Where misstatements are found as a result of audit sampling, auditors project
the results of the sample to the entire population and record this projected
misstatement on their summary of misstatements.

E.g. The auditors have designed a test for accounts receivable which involves two
methods of selecting items for testing.

• selecting some specific items for testing (based on their size and/or risk); and
• taking a sample of items from the remaining population.

• Misstatements have been identified both in the specific items tested and in the
sample. The misstatements in the sample have been projected to determine the
potential misstatement in the population:
Assessing the Materiality of Misstatements
• Having accumulated the various factual, judgemental and projected
misstatements on the summary of misstatements, auditors determine
whether uncorrected misstatements are material, individually or in
aggregate.
• Auditors request management to correct factual misstatement(s)
• Discuss with management regarding differences in judgement in order to agree
whether an adjustment is needed. Given sampling risk, it is difficult to persuade
management.
• Where projected misstatement, in combination with other identified
misstatements, is below overall materiality, the auditors can still conclude that
the financial statements are not materially misstated.
• But where overall materiality is exceeded, the auditors have a problem as the
financial statements could be materially misstated.
• In instances where combination of projected misstatement and other identified
misstatements is below overall materiality but very close to it, the auditor may
either request management to investigate the population (and then to check the
results of management’s work), or to perform sufficient additional testing
directly in order to reduce the impact of any projected misstatement.
Assessing the materiality of misstatements
• Uncorrected Factual, Judgemental and Projected misstatements are
material, individually or in aggregate
• The effect of each individual misstatement on the relevant classes of
transactions, account balances or disclosures
• This includes if materiality level for particular class of transactions, account
balance or disclosure, if any, has been exceeded.
• Both size and nature of those misstatements are considered to assess
whether misstatements are material.
• In terms of the size, consider if quantitative amounts of those
misstatements exceed overall materiality (or lower specific materiality).
Other Issues
• But there are number of other issues that auditors may need to
consider, including:

• qualitative assessment;
• balance sheet misclassifications;
• offsetting of misstatements;
• disclosure misstatements; and
• impact of uncorrected misstatements related to prior periods.
Qualitative assessment
• Nature of the misstatements may be low but because of their nature
they are considered material.
• misstatements relating to incorrect application of an accounting
policy that has an immaterial effect now, but it is likely to have a
material effect on future periods’ financial statements.
• misstatements that would turn a profit into a loss if corrected
• Misstatement that may breach a loan covenant.
• Misstatement arising from fraud. E.g. For example, if management
has deliberately pushed sales near the year end into the next financial
year, it may have done so in order to reduce the entity’s tax liability.
Balance Sheet Misclassifications
• Where there is a misclassification in the balance sheet between line
items and misstatement emanating from that is immaterial; however,
if it affects important ratios such as working capital and current ratio
then its material.
• This could result in breach of loan covenants
• E.g. Misclassification involving cash and accounts receivable are
important as they affect important financial ratios
Disclosure Misstatements
• Auditors need to record incomplete, omitted or inaccurate financial
statement disclosures unless they are clearly trivial
• It can be purely narrative or a combination of narrative and monetary
amounts
• Whether such disclosures are material or not is purely dependent on
auditors judgement
• E.g. If there are going concern uncertainties, and it is material if the
disclosure does not make it clear that such a situation exists.
(significant doubt about entity’s ability to continue as a going
concern.)
Impact of uncorrected misstatements related
to prior periods
• immaterial uncorrected misstatements related to prior periods can
have a material effect on the current period’s financial statements.
Forming an Overall Judgement
• Overall, auditors consider both size and nature in determining
whether a misstatement is material.
• Hence, professional judgement is applied.
• The test is whether the users of financial statements have been
influenced by misstatements identified during the audit that remain
uncorrected.
CONSIDERING THE IMPACT OF
MISSTATEMENTS ON THE AUDIT
• Where misstatements are identified during the course of the audit;

• Understand why the misstatement arose: for example, was it due to

a deficiency in controls and if so, could there be other similar
misstatements, particularly if there were systemic control issues?
• Assessing the risk of further undetected misstatements: if the
aggregate of the identified misstatements is close to materiality,
there could be an unacceptably high risk that the financial statements
are materially misstated taking into account that there could be
further undetected misstatements.
Example
• Overall materiality is set at K 100, 000.
• During audit, factual & judgemental misstatements added up to K 90,
000.
• The amount is below overall materiality hence immaterial
• No qualitative factor to suggest that it is material
• But how confident can they be that there are no further undetected
misstatements?
• Therefore, it would make sense for auditors to at least ensure that
factual misstatements are corrected.
Actions when Aggregate of Misstatements is
Close to Overall Materiality
• If misstatements in aggregate are close to overall materiality, auditors
must:

• Request that the identified misstatements be corrected.

• Request entity management to examine the affected areas to understand
why the misstatements occurred, and perform procedures to determine
whether there are further misstatements. In this case, auditors need to
perform appropriate testing of management’s procedures.
• Perform additional testing focused on the areas considered to be of greater
risk of misstatement.
• If misstatements are identified to be pervasive, reduce original
performance materiality, and reassess impact on testing throughout audit.