Cpa firms can establish policy guidelines to help their auditors determine materiality
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Show Determining overall group materiality and materiality levels for individual components is becoming more of a hot-button issue as the number and complexity of large and international group audits increases. Auditing standards and other professional materials offer little practical guidance on the topic. Internal and peer reviews and regulatory inspections have revealed a variety of approaches in this area. In some instances, reviews have discovered potentially troubling practices. Our conversations with regulators and practitioners indicate an intense and growing interest in the development of conceptually sound guidance. This article outlines a practical approach that group engagement partners can consider in establishing or evaluating component materiality. GUIDANCE IN THE AUDITING STANDARDS U.S. auditing standards (AU section 312 and PCAOB’s Auditing Standard no. 5, paragraphs B10–B16 of Appendix B) provide a list of factors to consider in determining the extent of testing on a multicomponent audit. However, these standards don’t provide specific practical guidance on establishing componentlevel planning materiality, one of the principal factors used to determine the extent of testing. The International Auditing and Assurance Standards Board (IAASB) recently released a revised and redrafted International Standard on Auditing (ISA) 600, Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors), to provide additional guidance to group engagement partners. Paragraphs 21–23 and A42–A46 of ISA 600 provide guidance to help inform group engagement partner materiality decisions. Paragraph A43 provides the following guidelines regarding component materiality:
Using the following examples, we hope to provide additional practical guidance to help group engagement partners navigate these guidelines AGGREGATE COMPONENT MATERIALITY On the conservative extreme of the continuum, the group engagement partner could allocate an arithmetical portion of group overall materiality to each component, in which case aggregate component materiality is equal to group overall materiality. For example, given a group overall materiality of $5 million, $1 million is allocated to each of five equal-sized components. On the aggressive end of the continuum, the group engagement partner could set materiality for each component at nearly the group overall materiality figure, resulting in an aggregate component materiality that far exceeds group overall materiality. For example, given a group overall materiality of $5 million, approximately $5 million is allocated to each of five equal-sized components. Allocating full group materiality to each component results in an unacceptably high risk of audit failure. To illustrate this, assume that the desired audit risk at each component is 5%. Since each component is allocated the full amount of group overall materiality, the risk of an undetected material misstatement at the group level is the likelihood that any one of the five components has an undetected material misstatement, which is about 23% (1 – (0.95)5). Note that aggregate component materiality can exceed group overall materiality for many of the same reasons that the aggregate of tolerable misstatement allocated to account balances can exceed overall materiality in a financial statement audit. Conversely, allocating an arithmetic portion—a simple proportion—of group overall materiality would generally result in over-auditing because the achieved audit risk at the group level would be extremely low. While ISA 600 implies it is appropriate for group engagement partners to avoid the extreme endpoints of the continuum shown in Exhibit 1, it does not spell out how to determine a reasonable and justifiable level of aggregate component materiality between these two extremes.
 MAXIMUM AGGREGATE COMPONENT MATERIALITY The multiples derived from the model to determine the maximum aggregate component materiality (MACM) are presented in Exhibit 2. We refer to these MACM multiples as benchmark multiples. Our set of benchmark multiples assumes that the group engagement partner has used appropriate professional judgment to determine the number of significant components to which MACM will be allocated, including removing any insignificant components that are immaterial in aggregate and that are of sufficiently low risk (in accordance with ISA 600, paragraphs A50–A53). To determine the upper bound suggested by the model, the group engagement partner multiplies group overall materiality by the appropriate benchmark multiple from the table and then uses the calculated MACM as a reference point in establishing component materiality levels or evaluating the component materiality levels proposed by component auditors. Returning to our example of a group audit with five components, applying the benchmark multiple of 2.5 to group overall materiality of $5 million yields an MACM of $12.5 million—a reasonable upper bound available for allocation to the components. See the sidebar, “Approaches for Allocating MACM,” for additional examples using the benchmark multiples to calculate MACM. It is important to note that in evaluating audit results, the aggregate of known and projected misstatements from all components cannot exceed group overall materiality. Thus, even though the total amount of materiality allocated to the components ($12.5 million in our example) can exceed group overall materiality ($5 million in our example), evaluation of the aggregated known and projected audit differences for the consolidated entity is conducted using group overall materiality.
ADDITIONAL GUIDELINES FOR ESTABLISHING COMPONENT MATERIALITY An example of a weighted allocation technique is to take the square root of a component’s revenues and divide it by the sum of the square roots of each component’s revenues. The result is multiplied by MACM to determine materiality for that component. The proportional or weighted allocation techniques provide group engagement partners with a preliminary allocation strictly based on size. The preliminary allocation is then adjusted as appropriate based on each component’s risk characteristics. The sidebar provides examples of how both of these allocation techniques can be used. When there are different-sized components or required limits on the amount of materiality that can be allocated to some components, as in statutory audits, the following guidelines help ensure that the allocation achieves the desired level of audit risk at the group level:
While the approach we suggest will help inform the group engagement partner’s judgment, we stress that because of the complexity and subjectivity of the variables involved, no single “correct” or “optimal” solution is possible. Auditors should apply appropriate professional judgment and follow local standards when establishing the materiality allocation for each component. Approaches for Allocating MACM These examples allocate MACM to components based on revenues; other financial bases could also be used. Company 1 In this example, the group engagement partner multiplies the benchmark multiple of 2.5 (the multiple pertaining to five components—see Exhibit 2) by the group overall materiality of $1 million to determine the maximum aggregate component materiality, which is $2.5 million. For a simple proportional allocation of MACM (column 1), divide component revenues by total revenues, and multiply by MACM (for example to compute the allocation for component 5: 250,000 = 2,500,000 × 20,000,000 ÷ 200,000,000). For a weighted allocation of MACM (column 2), first take the square root of each component’s revenues and then take the sum of the square roots of all individual components’ revenues to compute the denominator for the weighted allocation formula (see illustrative weighted allocation formula on page 46). The square root of each component’s revenues is divided by the denominator and is then multiplied by MACM to determine the weighted allocation (for example, to compute component 5’s allocation: 359,601 = 2,500,000 × 4,472 ÷ (7,746 + 7,071 + 6,324 + 5,477 + 4,472). After considering the potential allocation approaches, the engagement partner established the final component materiality levels shown in column 3. Company 2 * See below, “Illustrative weighted allocation formula for component materiality.” The significant size differences among the components of Company 2 preclude using strictly proportional or weighted allocations of the maximum aggregate component materiality (MACM). Under a simple proportional allocation approach (column 1), the largest component would have been allocated more than group overall materiality, which violates ISA 600. The allocation guidelines in the article also suggest that the aggregate allocation of materiality to the largest components not exceed the level indicated by the benchmark multiples. Thus, the three largest components should receive no more than two times group overall materiality (in this case, $5.3 million). However, a proportional allocation of MACM would result in $6.25 million in aggregate being allocated to the three largest components, and the weighted allocation of MACM would result in $5,518,097 in aggregate being allocated to the three largest components. Therefore, considering the risk characteristics of the components, the materiality allocations shown in the component materiality column (3) would be appropriate.
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Steven M. Glover, CPA, Ph.D., and Douglas F. Prawitt, CPA, Ph.D., are professors of accounting at Brigham Young University. Prawitt is also a member of the Auditing Standards Board. Their e-mail addresses, respectively, are and . Jonathan T. Liljegren is a recent graduate of Brigham Young University. He works for PricewaterhouseCoopers in the Washington, D.C., Metro office. His e-mail address is . William F. Messier Jr., CPA, DBA, is a professor of accounting at the University of Nevada–Las Vegas. His e-mail address is . He is a former ASB member. How do auditors determine materiality?Auditors determine overall materiality at the planning stage of the audit, typically by applying a percentage to a chosen benchmark. Common benchmarks include profit before tax or normalised (ie. adjusted) profit before tax, total income or total expenses, gross profit, total assets or net assets.
Why is it important for audit firms to develop policies and procedures for establishing materiality?Why is materiality important? As the basis for the auditor's opinion, ISAs require auditors to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement. The concept of materiality is therefore fundamental to the audit.
Why does the auditor need to determine the materiality in a financial statement audit?DETERMINING OVERALL MATERIALITY
The primary purpose for setting overall materiality when planning the audit is that it is used to identify performance materiality (which is needed, for example, to help auditors design their audit procedures) and a clearly trivial threshold for accumulating misstatements.
Who determines component materiality?(d) Component materiality – The materiality for a component determined by the group engagement team. (e) Group – All the components whose financial information is included in the group financial statements. A group always has more than one component.
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