Understanding Materiality in Financial Audits

The Concept of Materiality in Auditing

The auditor assesses the amount of errors or omissions that could affect the decisions of a reasonable user. This concept involves:

• Flexible guidelines.
• Both quantitative and qualitative elements.

Stages in the Application of Materiality

1. Establish a Preliminary Judgment on Materiality (Planning)

   This is the maximum amount of misstatement the auditor believes can exist in the financial statements without affecting the decisions of reasonable users. It is affected by the relative size of the company being audited.

   First, the auditor establishes a base (e.g., total assets, profits, turnover), which is multiplied by a percentage factor to determine an initial quantitative judgment. This initial judgment is then adjusted using relevant qualitative factors, such as:

   • Irregularities or illegal acts.
   • Small amounts that may violate the terms of a contract.
   • Amounts that may affect the profit trend.

2. Allocate Materiality to Individual Transactions (Planning)

   The objective is to plan the scope of the audit procedures for specific items or transactions. The lower the materiality level assigned to an item, the more evidence must be obtained.

   Tolerable Misstatement: This is the amount of the preliminary judgment on materiality assigned to a specific item.

   The allocation will depend on:

   • The relative size of the account with respect to the financial statements.
   • The expectation of error.
   • The relative cost of auditing the item or transaction.

3. Estimate Misstatements and Compare with Judgment (Evaluation)

   Once the results of the procedures are collected, the auditor aggregates the misstatements for each item. The outcome, or likely misstatement, is compared with the preliminary judgment.

   When the likely misstatements are less than the materiality amount from the preliminary judgment, the financial statements are considered to accurately reflect the company's situation.

   If the likely misstatements are greater, the auditor will ask the client to adjust its financial statements:

   • If the client agrees, the audit report is unqualified (clean).
   • If the client does not accept the adjustments, the audit report will be modified (not clean).