2107 Documenting Materiality

Jun-2018

OAG Guidance

Document materiality levels as part of documenting the overall audit strategy. We also document the de minimis SUM posting level and the factors considered in its determination.

The documentation includes

• how the individual circumstances of the entity were taken into account;

• the benchmark and rule of thumb percentage used (OAG Audit 2102). The documentation indicates the rationale for selecting the benchmark and the percentage used;

• the rationale for selecting the haircut percentage in determining performance materiality (OAG Audit 2103);

• the rationale for determining a different materiality for particular classes of transactions, account balances or disclosures (if determined) (OAG Audit 2104); and

• the rationale for determining a de minimis SUM posting level (if determined), i.e., percentage applied to overall materiality (OAG Audit 2105, OAG Audit 9016).

Because OAG recognizes the importance of using professional judgment in determining materiality, the documentation of the rationale needs to support the judgments made, and not just refer to OAG Audit guidance.

The engagement file evidences that overall materiality, performance materiality, materiality for particular classes of transactions, account balances or disclosures (if determined) and a de minimis SUM posting level (if determined) were discussed and agreed by the engagement team. This may be achieved by including a materiality discussion on the agenda of the team planning meeting(s) and by the engagement leader’s sign-off of planning (CAS 220.A14,  OAG Audit 4010).

OAG Guidance

IDEA provides a set of valuable tools for sample size estimation, sample selection, and evaluation that we will continue to use. The values to enter as sampling parameters in IDEA are in the following table and are elaborated in the explanations below.

Tolerable error. The appropriate input parameter is the performance materiality. Performance materiality is the difference between our overall materiality and a new error component referred to as the “haircut.” The haircut is an estimate, at the planning stage, of the errors expected from risks at the broader financial statement level. Such errors are not identifiable with specific assertions at a financial statement component or cycle but rather could affect many different assertions for any or all financial statement components or cycles. Examples of such haircut-related errors are those resulting from weak environmental controls leading to such occurrences as management override, fraud, poor or limited overall management and monitoring controls at the financial statement level, etc. As a result, such errors are not normally found through detailed tests of samples—this fact is a very important assumption that impacts on any sampling decisions we may later make. To allow for an estimate of such errors, you might determine that a haircut between 10 percent and 25 percent is appropriate in a well-controlled audit environment with relatively low risk of pervasive errors (performance materiality is appropriate between 90 percent and 75 percent of overall materiality). In the reverse situation, you would determine that a haircut higher than 25 percent (30 percent, 35 percent, 40 percent, etc.) of overall materiality is needed in a weak control environment where there have typically been errors throughout the financial statements—not just within one particular financial statement component or cycle. Again, this overall assessment is based on your prior audit experience and will impact on the extent of your audit testing.

Expected error. Given the fact that such haircut errors are not normally found through detailed tests of samples, under OAG Audit, the appropriate IDEA input parameter is limited to the expected error for the population that you are sampling. This is based on the risk factors you analyzed in your planning work. So, for example, there may be, and in fact will likely be, different expected errors whether you are sampling a payroll cycle or inventory cycle. The expected error for the audit cycle being sampled is based on your prior audit experience, including, we recommend, the findings from the prior year.

Engagement leaders are reminded to consult with Audit Services when the aggregate of the haircut and expected misstatements for a particular sample population in the context of substantive tests of details is greater than 50 percent of overall materiality. Refer to the OAG Policy at OAG Audit 7044.

Documentation. It is critical that you document in your file your rationale for your choice of the degree of the haircut leading to the determination of the amount of performance materiality (in the Materiality template) and your rationale for the expected error for every cycle you are sampling. This will provide the necessary support for the decisions you have made and the professional judgment you have exercised.

We expect that this sampling approach will lead to efficiencies, especially where there are different factors surrounding the expected error based on the financial statement component or cycle population you are sampling. In our pre-CAS methodology, it has been common practice to use the same value of expected errors for different financial statement components or cycles, regardless of the expected error results or risk factors present in those different cycles. This approach penalized those samples of financial statement components or cycles where there were good controls and few expected errors. Our preliminary analysis has revealed sampling reductions as high as 40 percent in populations with larger error incidence.

Please contact Audit Services for further assistance as required.