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Article: ZD Academy Seminars 2020 - Materiality & Analytical Procedures

9 Mar 2020

Article: ZD Academy Seminars 2020 – Materiality & Analytical Procedures

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Date: Friday 28th February 2020

Authors: Janice Lyn Schembri & Kris Bartolo

Introduction

To enhance audit quality and reduce audit risk, audit planning is a vital area of the audit and two important planning aspects are materiality and analytical procedures.

Materiality

The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements by giving an opinion on whether they are prepared, in all material respects, in accordance with an applicable financial reporting framework.  The concept of materiality is fundamental to the audit. It is applied by the auditor at the planning stage, when performing the audit and when evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements. Misstatements in the financial statements are material if they could influence the decisions of users of the financial statements (ISA 320, Audit Materiality).

The auditor sets the materiality for the financial statements as a whole – ‘overall materiality’ – at the planning stage by choosing the appropriate benchmark (e.g. profit before tax, revenue, etc) and applying professional judgment to determine a level (usually a percentage) of this benchmark.  To determine the overall materiality the auditor considers the inherent risks of the company.  The auditor then determines ‘performance materiality’ or that amount(s) set below overall materiality to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality. Performance materiality depends on the assessed level of risk of material misstatement and takes into consideration other components of audit risk, mainly the control risk. In practice, it is computed as a percentage of overall materiality and usually a range is applied. An example would be for the percentage range applied to vary from 75% (low risk) to 50% (high risk) of overall materiality. A lower level of materiality may be set for particular classes of transactions, balances or disclosures.

Overall materiality needs to be revised during the audit if the auditor becomes aware of information during the audit that would have resulted in different materiality levels initially. The auditor would also assess whether it is then necessary to revise performance materiality. If so, the auditor would need to consider the impact on the nature, timing and extent of the audit procedures.

Analytical Procedures

The auditor is required to perform risk assessment for the identification and assessment of risks of material misstatement at the financial statement and assertion level. Such risk assessment procedures should include analytical procedures (ISA 315, Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity). The auditor is also required to perform analytical procedures near the end of the audit that assess whether the financial statements are consistent with the auditor’s understanding of the entity (ISA 520, Analytical Procedures).

Analytical procedures consist of ‘evaluations of financial information through analysis of plausible relationships amount both financial and non-financial data’. They also include ‘such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount’. Analytical procedures are applied on the basic assumption that plausible relationships among data exist and are expected to continue in the absence of conditions indicating otherwise.

Analytical procedures are conducted for three primary purposes:

  1. Preliminary analytical review – risk assessment
  2. Substantive analytical procedures
  3. Final analytical review

The auditor performs preliminary analytical reviews to obtain an understanding of the business and its environment and to help assess the risk of material misstatement. ISA 520 does not prescribe one format for analytical review. The draft figures for the year under review may be compared to historical data (i.e. prior periods); expectation developed by client (e.g. budgets); industry averages/competitor’s results and expectations developed by the auditor. The auditor will then develop the audit strategy and programme.

During the audit, the auditor will use analytical procedures, when their use is deemed to be more effective and /or efficient than tests of details in reducing the risk of material misstatements at the assertion level to an acceptably low level. Analytical procedures may not be used on their own when testing high risk areas. When using substantive analytical procedures, the auditor will follow four steps:

  1. Develop an independent expectation.
  2. Define a significant difference or threshold.
  3. Compute the difference between the expected value and the recorded amounts.
  4. Investigate significant differences and draw conclusions.

The precision of analytical procedures will depend on the level of disaggregation of the data being used; the reliability of the data (externally generated data such as industry averages are preferable to internally generated data which is susceptible to manipulation); the predictability of the data (i.e. the stability of the expected relationships) and the type of analytical procedures being applied (e.g. reasonableness test vs simple trend analysis).

At the end of the audit, analytical procedures are performed as an overall review of the financial statements in order to assess whether they are in line with the auditor’s understanding of the entity. If inconsistencies are identified, the auditor should perform again her risk assessment to assess whether any additional audit procedures are necessary.  It is important that the auditor documents sufficiently analytical procedures used during the audit to enable an experience auditor, having no previous connection with the audit, to understand the work done.

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