PSA 320: Materiality in Planning and Performing an Audit
1. Materiality:
• Materiality in an audit refers to the significance of financial information that could
influence the decisions of users (like investors, regulators, etc.). It’s a judgment-based
concept, and auditors must assess how the size or nature of an item impacts the
financial statements.
• Materiality is not fixed and can vary based on the context, like the size of the entity, its
industry, or the financial health of the organization. For example, a small error in a large
multinational corporation's financial statements may not be material, but the same error
in a small business could be considered material.
2. Application of Materiality in Audit:
• Risk Assessment: Materiality helps auditors in assessing risks during the audit. For
example, it can help them decide what areas of the financial statements are more
vulnerable to errors or fraud, and where they need to apply more scrutiny.
• Audit Procedures: By applying materiality, auditors determine how much testing is
required for a particular transaction or account. For example, they may decide to sample
fewer transactions if the materiality threshold is high, but more transactions if the
materiality threshold is lower.
• Evaluating Misstatements: If auditors find any uncorrected misstatements, materiality
helps them evaluate if the aggregate effect is significant enough to affect the overall
financial statement's reliability.
3. Materiality Levels:
• Overall Materiality (Financial Statements): This is the threshold used to determine the
significance of misstatements across the entire set of financial statements. If the
misstatements exceed this level, the financial statements might be misleading to users.
• Specific Materiality (Transactions or Accounts): Certain classes of transactions or account
balances may need more attention. For example, revenue or inventory might be more
scrutinized because of their high likelihood to be misstated or due to their relevance to
users.
4. Benchmarks for Materiality:
• Auditors select benchmarks, like a percentage of total assets, revenue, or equity, to
calculate materiality. These benchmarks depend on the nature of the entity and its
financials.
• Factors that influence the selection of a benchmark include:
o The importance of certain financial statement elements (e.g., a large proportion
of an entity's total assets being tied up in a specific account).
o The entity's lifecycle stage (e.g., a startup may have more volatile revenues).
o The economic environment and industry norms.
o Ownership and capital structure.
5. Performance Materiality:
• Performance materiality is set lower than the materiality for the financial statements as
a whole. This reduces the risk that the total misstatements go undetected.
• The idea is to set performance materiality at a level where even if there are small
undetected errors, the aggregate won't exceed the overall materiality level.
• Determining this level requires judgment. Auditors often base it on factors like the audit
risk, the entity's financial health, or past experiences with the company.
6. Documentation Requirements:
• It is crucial for auditors to document the materiality thresholds they use for the financial
statements as a whole, as well as for specific accounts or transactions.
• The documentation should include the reasons behind the materiality determinations,
any changes that occur during the audit, and the auditor’s conclusions about the impact
of uncorrected misstatements.
ISA 240: Auditor's Responsibilities Relating to Fraud
1. Fraud Defined:
• Fraud is an intentional act by one or more individuals (e.g., management, employees,
third parties) to deceive others, resulting in the misstatement of financial statements.
• The key distinction between fraud and error is intent. Fraud involves deception, whereas
error is unintentional.
2. Types of Fraud:
• Fraudulent Financial Reporting: This involves the deliberate manipulation of financial
statements to present a more favorable picture of the company's performance or
financial position. This could involve overstating revenue, hiding liabilities, or misstating
expenses.
• Misappropriation of Assets: This type of fraud occurs when individuals steal assets or
misapply funds for personal use, such as employees stealing company funds or
inventory.
3. Responsibilities in Fraud Detection:
• Management's Responsibility: The primary responsibility for fraud prevention and
detection lies with management and those charged with governance (like the board of
directors). They should establish effective internal controls to prevent fraudulent
activities.
• Auditor's Responsibility: Auditors are responsible for obtaining reasonable assurance
that the financial statements are free from material misstatements due to fraud or error.
While auditors cannot guarantee fraud will be detected, they must be alert to signs of
potential fraud.
4. Key Audit Considerations:
• Auditors face a higher risk of not detecting fraud compared to errors because fraud
involves intentional concealment.
• Management fraud is particularly concerning because those in positions of power may
have more opportunities to manipulate financial statements or override controls.
5. Risk Assessment Activities:
• Inquiring of Management: Auditors must inquire whether management has assessed
risks of fraud, including any identified fraud risks or vulnerabilities.
• Assessing Fraud Risk Factors: These factors are often indicative of potential fraud, such
as:
o Significant pressure on management to meet financial targets.
o Unusual or inconsistent transactions.
o Management’s override of internal controls.
6. Auditor's Response:
• Assigning Personnel: The auditor assigns personnel with the right expertise and
experience to the engagement based on the assessed fraud risks.
• Evaluating Policies: The auditor looks for indicators of fraudulent intent, especially in
accounting policies related to subjective estimates or complex transactions.
• Unpredictable Procedures: Auditors may introduce unpredictability in their audit
approach, such as changing the timing or nature of procedures to detect fraud more
effectively.
7. Unable to Continue Engagement:
• If auditors find evidence of fraud, they may be legally or ethically obligated to report it. If
the fraud is significant, auditors might need to withdraw from the engagement or report
it to relevant authorities.
• Communication: If auditors withdraw, they must inform management and governance
about the withdrawal and provide reasons, potentially escalating the matter to external
authorities.
8. Communication and Documentation:
• Communication with Management: If fraud is detected, the auditor must communicate it
to management or those charged with governance, ensuring they are aware of the
fraud's impact on the financial statements.
• Documenting Fraud Risks: Auditors must document any decisions made about fraud risks
and responses during the audit process. This includes the assessment of fraud risks and
the steps taken to address those risks.
These detailed explanations cover the critical aspects of both materiality in audits and fraud
detection, giving you a comprehensive understanding of these auditing standards. Let me know
if you need further clarification on any of these points!
