2334 Optional component materiality framework

Jun-2018

OAG Guidance

Group financial statements are generally disaggregated to enable the performance of an audit. This disaggregation is achieved by identifying separate components for the purpose of planning and performing audit procedures while obtaining an understanding of the group, its components and their environments (OAG Audit 2331).

Components could include a head office, parent, division, location, business unit, branch, subsidiary, activity, shared service centre, joint venture, associated company, agency, department, Crown corporation, fund, non-governmental organizations, or other entity whose financial information is included in the group financial statements. Determining the number of components for purposes of component materiality requires professional judgment. The final determination is guided by the structure of the group, including the flow of the financial information, and the audit approach.

In the Framework, the number of components is used in the development of total component overall materiality (i.e., the maximum amount of combined component overall materiality that can be distributed to individual components). Accordingly, components that could overstate total component overall materiality are excluded from the number of components.

Generally, three types of components will be excluded from the number of components for purposes of determining component materiality as they could overstate total component overall materiality:

1. Shared Service Centres
   Shared service centres typically would not be counted as a component for purposes of determining component materiality because the financial data that they generate is included in the other components.

2. Components with No or Very Limited Audit or Review Procedures
   In determining the number of components to be used in the development of total component overall materiality, the group engagement team generally would not include components where there will be no, or very limited, audit or review procedures performed (e.g., consider components for which only group level controls and analytics will be performed).

3. Components that are Financially Inconsequential
   Components that are financially inconsequential (e.g., aggregate to less than three to five percent of group pre-tax income/loss and assets) generally would not be included for purposes of determining overall component materiality (although this exclusion does not dictate the audit approach at these smaller components). For example:

If three components comprise 95 percent of the group pre-tax income and assets and 100 components comprise the remaining 5 percent, then for purposes of determining overall component materiality there would be three components. The result would be the same regardless of whether or not audit procedures will be performed at these 100 small components.

However, small components may not be financially inconsequential where there are a large number of components and, as a result, many of the components are small (e.g., one percent or two percent of group pre-tax income/loss and assets) and, therefore, such components are important contributors to audit evidence. For example:

Five components comprise 35 percent of the group pre-tax income and assets and 50 components, ranging from 1 percent to 2 percent, comprise the remaining 65 percent. The group engagement team elects to audit the five large components and 20 of the remaining smaller components. The vast majority of the audit evidence comes from the audit of these 25 components. Accordingly, for purposes of determining overall component materiality there would be 25 components. In this circumstance, all 20 of the smaller audited components are counted even though some are individually 1 percent or 2 percent and some of these components would aggregate to less than 3 percent to 5 percent of the group's pre-tax income/loss and assets.

Materiality for Excluded Components

The group engagement team may determine that components that are excluded from the “number of components for purposes of component materiality” may still require audit or review procedures for purposes of the group financial statement audit. Where such audit or review procedures require materiality (i.e., overall, performance, or specific materialities), the materiality amounts are determined through professional judgment.

For example, shared service centres are typically not counted as a component in the Framework and, therefore, excluded from the Framework's materiality allocation. Accordingly, if audit procedures are to be performed on shared service centres, then relevant materiality amounts would be determined based on our understanding of the risks inherent to the component and using the engagement team's professional judgment.

These materiality amounts are either determined by the group engagement team, or evaluated by the group engagement team if determined by the component auditor.

Limitations on the Number of Components

While it is possible that large group engagements would have many hundreds of management or operating units, in general the number of components for purposes of determining component materiality is expected to be much lower (see OAG Audit 2323). If the group engagement team initially concludes that there are many hundreds of components, the group engagement leader needs to reconsider the definition of a component to determine if some aggregation would be appropriate.

OAG Guidance

To reduce the risk that the aggregate of identified and unidentified misstatements in the group financial statements exceeds the materiality for the group financial statements as a whole, the group engagement team determines a component overall materiality for each individual component that is lower than group overall materiality (i.e., the maximum materiality that can be distributed to any one component is less than 100 percent of group overall materiality). To guide the determination, it is useful to consider the extreme end points in the possible range of component overall materiality, as follows:

• On one end of the range, a pro-rata share of the group overall materiality is allocated to each component. For example, if group materiality was $10 million and there were 10 equal components, then the pro-rata share for each component would be $1 million. However, this approach may result in an inefficient audit because more audit work is performed than is necessary to maintain an acceptable level of audit risk at the group level.

Note that a similar result is achieved if materiality for each component is determined on a stand-alone basis. For example, if the 10 components each have $20 million of pre-tax income, based on 5 percent of pre-tax income, the stand-alone materiality would be $1 million.

• On the other end of the range, the group engagement team allocates the entire group materiality to each component. For example, if group overall materiality was $10 million and there were 10 equal components, then the allocation for each component would be $10 million. However, this approach will generally result in an ineffective audit as there would be an unacceptable risk of unidentified misstatements aggregating to more than group materiality.

In most cases neither of these end-points yields the best approach to determining component materiality. As there are considerable variations unique to each group audit there is no single “correct” solution or formula to determine component materiality. Therefore, the group engagement team applies professional judgment and may consider steps A and B of the approach below to guide their professional judgment when determining the overall materiality levels for the components.

Regardless of the group engagement team's individual component overall materiality decisions, sufficient appropriate audit evidence to reduce audit risk for the group financial statements to an acceptably low level needs to be obtained.

A—Determine Total Component Overall Materiality (the maximum amount of combined component overall materiality that can be distributed to components)

The following table provides the group engagement team with an approach that may provide a useful point of reference for determining total materiality available for distribution to individual components while maintaining acceptable audit risk at the group level.

Using the number of components determined, the group engagement team follows the table below to determine a group overall materiality multiple. Determined through probability theory, this multiple is applied to group overall materiality to determine “total component overall materiality.” This total component overall materiality is the maximum amount that can be distributed to the components to establish each individual component's overall materiality.

We determine the appropriate multiple to use within the table above based on the number of components identified and the performance materiality haircut that was assessed at the group level. The total component overall materiality derived from the multiple table above is a maximum amount available for distribution to components. Using different multiples for different group performance materiality haircuts reflects varying levels of engagement risk and facilitates more targeted application of the framework, depending on the group engagement circumstances. For example, the group using a 10 percent or 25 percent performance materiality haircut would generally have lower engagement risk and therefore it could use a higher materiality multiple than the group with a 50 percent haircut. See OAG Audit 2103 for guidance on determining performance materiality haircuts.

As stated previously, component overall materiality for each individual component is at or lower than group overall materiality.

The following example illustrates how the total component overall materiality is determined and used:

Group overall materiality is $1,000,000, the group has factors supporting 25 percent performance materiality haircut, which has been applied to group overall materiality, and there are 10 equal-sized components. Therefore, the multiple from the table above is 400 percent and the total component overall materiality is $4,000,000. This is the maximum amount that could be distributed to the 10 components to determine their individual component materiality.

If we use a group performance materiality haircut that is different from 10 percent, 25 percent and 50 percent, we pro-rate the multiples, as appropriate. For example, if the group has 10 components and we use a haircut of 30 percent at the group level, we select a multiple from between 300 percent and 400 percent (i.e., 380 percent that would be a pro-rated multiple corresponding to the 30 percent haircut).

B—Distribute Total Component Overall Materiality to Individual Components Within the Group

Group overall materiality reflects the needs of the group financial statement users. In contrast, component overall materiality is an audit planning decision. Accordingly, individual components may or may not have the same overall materiality.

The group engagement team applies professional judgment when determining the distribution of the overall materiality levels to the components. As a starting point for distributing total component overall materiality, the group engagement team considers their understanding of the group, its components, and their environments to determine an appropriate basis for distribution.

The group engagement team considers the judgment applied and the conclusions reached in initially determining the work to be performed at components. Components with an increased risk of material misstatement would typically be allocated a lower component materiality than components that do not represent an increased risk. When the group engagement team intends to perform procedures at components that are not individually significant in order to obtain sufficient evidence on the financial statements as a whole, judgment is applied to allocate an amount that is less than overall materiality to the components and to verify that the component materiality is reasonable in relation to the factor that led the group engagement team to conclude it was necessary to perform procedures at these components. For example, if a component that is not significant is included in the planned procedures because there is a concentration of a specific account at that component, the materiality allocated to the component needs to be reasonable in relation to the specific account over which procedures are to be performed.

Alternatively, we may consider it appropriate to allocate materiality to components proportionately using a benchmark. This approach may be appropriate when components are homogeneous and there are no distinct risk factors that vary among the components within the group structure. Benchmarks to consider may include:

• contribution to group pre-tax income,
• percentage of group assets, or
• contribution to operating cash flows.

In the example above, a proportional allocation based on a benchmark may result in individual components within the group structure being allocated a component materiality amount marginally below $1,000,000, while other components within the group structure are allocated a component materiality amount less than $400,000. However the total amount of materiality allocated to the 10 components would not exceed $4,000,000.

(Additional examples of other benchmarks can be found in (OAG Audit 2102.)

Inter-company balances and/or transactions and statutory audits may impact the distribution. Further information related to these situations is provided in the Additional Considerations section, below.

Subsequent to the distribution, the individual component overall materialities may then be adjusted, based on the group engagement team's experience and professional judgment, to reflect the overall audit approach or specific attributes of certain components. After any such positive and negative adjustments are made, the group engagement team determines whether the sum total of component overall materialities after such adjustments remains within a reasonable margin of the total component overall materiality and documents the rationale for significant adjustments, as appropriate.

In complex group structures where components are initially identified as business units that are comprised of many stand-alone subcomponents, the group engagement team may be able to apply a similar multiple concept at the segment or business unit level. However, in no case is the sum total of all component overall materialities to exceed 1,100 percent of group overall materiality.

For the example above, distribution of the $4,000,000 total overall component materiality ($1,000,000 overall group materiality X 400 percent allocation multiplier) based on a proportional share of pre-tax income is as follows:

Another option is that the group engagement team may decide to distribute the total component overall materiality equally to the components which would result in overall component materiality of $400,000 for each of the 10 components in the example above.

Additional Considerations

Inter-company accounts

In distributing total component overall materialities, the group engagement team considers whether the results are inappropriately affected by inter-company balances and transactions. If this is the case, the group engagement team reconsiders the distribution, for example, by:

• Using experience and professional judgment to make adjustments to the component overall materialities.

• Selecting a different benchmark for distributing total component overall materiality that is not significantly influenced by inter-company balances or transactions.

Regardless of the group engagement team's approach, the requirements provided by the component materiality guidance (OAG Audit 2333) still apply.

Statutory audits

In the determination of component overall materiality, component(s) may have statutory reporting requirements that require component materiality(ies) lower than that which would have been determined absent the statutory requirement. Under such circumstances, the group engagement team may need to consider the impact, if any, on the determination of all components' overall materiality.

If the group engagement team uses the approach outlined in this Framework, they may consider redistributing some of the effect of the lower statutory audit materiality(ies) to the other components. As stated previously, component overall materiality for each individual component is at or lower than group overall materiality.

Importantly, there may be no impact from statutory audits unless the statutory audit fieldwork is (a) performed at the statutory materiality level and (b) completed with results communicated to the group engagement team prior to the issuance of the group financial statements.

OAG Guidance

Once the individual component overall materiality has been determined, it will be necessary to determine performance materiality for each component (i.e., apply a “haircut” to the individual component overall materiality). An amount lower than the individual component overall materiality is determined for audit planning purposes to provide an allowance for the aggregation of misstatements across the individual component's accounts and for detection risk at the component level. This individual component performance materiality is useful when assessing the risks of material misstatement, designing component level audit procedures, and as a basis to determine significant account balances, classes of transactions, and disclosures at the component level. See OAG Audit 2333 for guidance.

If the de minimis SUM amount exceeds the performance materiality at one or more components (other than in the circumstances referenced (OAG Audit 2333), the group engagement team first reconsiders the component materiality distribution from the second step of the Framework. If the distribution is considered to be reasonable, then the group engagement team reconsiders and appropriately adjusts the de minimis amount. This would be done by lowering the percentage applied to group overall materiality to determine an appropriate de minimis amount (e.g., lower the percentage from five percent to three percent).