AUDITING CONCEPTS: TRUE AND FAIR, MATERIALITY

AUDITING CONCEPTS: TRUE AND FAIR, MATERIALITY

CHAPTER OBJECTIVE

1. THE AUDIT REPORT AS A MEANS OF COMMUNICATION
2. TRUE AND FAIR
3. REASONABLE ASSURANCE
4. MATERIALITY
5. ASSESSING MATERIALITY

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1. THE AUDIT REPORT AS A MEANS OF COMMUNICATION

• The External Audit Report

A means of written, formal communication between auditor and shareholders in which the auditor expresses an opinion on the truth and fairness of the financial statements under audit.
It is also a very condensed form of communication, usually covering no more than a single page.

• The Standard Unmodified Opinion

The standard format and wording of the opinion from ISA 700 is presented below : In our opinion the financial statements give a true and fair view of ( or “present fairly” the financial position of ABC Company as at December 31, 20×1, and of its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards.

2. TRUE AND FAIR

Perhaps the most significant phrase in the audit report is the reference to true and fair view ( an alternative wording is that the financial statements are fairly presented. Both phrases have identical meanings.

The word true include: factually correct, not false, and accurate. Unfortunately it is not possible to confirm if the financial statements as a whole are factually accurate. The two key reasons are: that the auditor cannot investigate every single transaction and balance and , for that reason, must adopt a sample testing basis. The latter point refers mainly to the existence of estimates and judgments in the financial statements, for example; the useful economic life of an asset or a provision for future, uncertain costs.

The term fair include: reasonable, unbiased, impartial, and equitable. Again, as the auditor performs testing on a sample basis, it would be impossible to conclude that the financial statements are entirely free of management basis. It is also important to remember that the estimates made by the business are made by internal managers, all of whom have a self-interest in the profitability of the business (bonuses!).
Therefore truth and fairness cannot be measured in absolute terms by an auditor. Instead auditors offer reasonable assurance based upon obtaining sufficient appropriate evidence to satisfy the requirements of the audit and international standard of auditing.

3. REASONABLE ASSURANCE

An auditor cannot give absolute assurance because there will always be inherent limitations in an audit that affect the auditor’s ability to detect material misstatements, such as:
 The use of testing and sampling during the audit
 The inherent limitations of internal control (for example, the possibility of management override)
 The possibility of misrepresentation for fraudulent purposes.

4. MATERIALITY

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.

Note that this definition relates materiality to the impact of an accounting item on the reader or user of the financial statements. A common-sense way of assessing the materiality of an item, error or omission is to put yourself in the position of the reader and attempt to judge what impact, if any, the item would have on the picture which the financial statements present to you. The auditor also needs to consider the materiality of cumulative errors or omissions found as they may not be material in isolation, but may be material cumulatively.

5. ASSESSING MATERIALITY

Quantitative test

– Revenue (0.5%-1%)
– Profit (pre- or post-tax), error or omission of less than 5% of profit before tax is not material.

Qualitative test

1. Nature of the item involved

Where there are any items that have to be correct in the financial statements e.g. to comply with legislation, then even if the difference is very small it will be considered to be material.

2. Impact of the item involved

Consider the following situation: the draft financial statements of a company show a small pre-tax profit. The auditor discovers an inventory error which, if corrected would have the impact of changing the draft profit into a pre-tax loss. The error may not be material on normal numerical tests of materiality, but many auditors would see the impact of the item (turning a profit into a loss) as being material and would expect an adjustment to be made.

Source:

1. Phnom Penh HR (www.pp-hr.com)
2. Kaplan, FAU