Standards on Auditing

1. SA 320 (Revised) Materiality in Planning and Performing an Audit

2. SA 530 (Revised) Audit Sampling

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SA 320 (Revised) Materiality in Planning and Performing an Audit

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Scope: SA 320 deals with the auditor’s responsibility to apply the concept of materiality in planning and performing an audit of financial statements

Objective: Auditor to apply the concept of materiality appropriately in planning and performing the audit.

Materiality in the Context of an Audit:

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the

financial statements and in forming the opinion in the auditor’s report. Auditor uses materiality when planning and performing an audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. It is one of the key judgments on the audit, This judgment provide a basis for:

• Determining the nature, timing and extent of risk assessment procedures;

• Identifying and assessing the risks of material misstatement; and

• Determining the nature, timing and extent of further audit procedures

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Materiality, from an entity’s point of view:

is the threshold at which the subject matter information becomes important enough to be reported

includes consideration of whether the reported subject matter information is free from misstatements that would affect the decisions of users taken on the basis of that information.

Materiality, from our perspective, helps us to:

determine the nature, timing and extent of our evidence gathering procedures

evaluate whether the subject matter information is free from misstatement.

Materiality from the user’s perspective:

A misstatement or the aggregate effect of misstatements is material when, in the context of the surrounding circumstances, it is probable that the decision of a user who is relying on the reported subject matter information and who has a reasonable knowledge of entity and its activities, would be changed or influenced by such misstatement or the aggregate effect.

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Materiality for the financial statements as a whole (OM) and performance materiality (PM)

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Materiality for financial statement as a whole

(OM)

When establishing the overall audit strategy, the auditor shall determine OM.

Materiality for particular class of transactions, account balances or disclosures

Auditor to determine separate materiality if misstatements of lesser amount than OM could

reasonably be expected to influence the economic decisions of users taken on the basis of the

financial statements

Performance materiality

(PM)

Amounts set by the auditor at less than OM to reduce to an appropriately low level the

probability that the aggregate of uncorrected and undetected misstatements exceeds OM

PM also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions,

account balances or disclosures.

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Determining materiality for the financial statements as a whole and performance materiality

Determining materiality involves the exercise of professional judgment.

A percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial statements as a whole.

Examples of benchmarks that may be appropriate, depending on the circumstances of the entity, include:

Profit before tax

total revenue

gross profit

total expenses

total equity or net asset value etc.

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Factors that may affect the identification of an appropriate benchmark include the following:

Whether there are items on which the attention of the users of the particular entity’s financial statements tends to be focused (for example, for the purpose of evaluating financial performance users may tend to focus on profit, revenue or net assets)

The nature of the entity, where the entity is at in its life cycle, and the industry and economic environment in which the entity operates

The entity’s ownership structure and the way it is financed (for example, if an entity is financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity’s earnings)

Scenario:

Profit before tax from continuing operations is often used for profit-oriented entities.

When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues

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Factors that may affect the percentage to be applied to a chosen benchmark include the following:

Determining a percentage to be applied involves the exercise of professional judgment.

There is a relationship between the percentage and the chosen benchmark, such that a percentage applied to profit before tax from continuing operations will normally be higher than a percentage applied to total revenue. 5% of PBT vis-à-vis 1% of total revenue or expenses.

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Considerations when selecting benchmarks Scenario Benchmark

Profit before tax is nominal Profit before tax and remuneration

Entities doing public utility programs/projects

Total Cost or Expenses Less Revenues

Current Year Profits are Low Average of the Past three years

Profit oriented entity with break-even results

Revenue

Private Equity Firm primary focus on EBITDA

EBIDTA

Production Costs recharged to Group Production Costs

Mutual Funds Net Assets

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1 2 3

Law, regulations or the applicable financial reporting framework affect users’ expectations regarding the measurement or disclosure of certain items (for example, related party transactions, and the remuneration of management and those charged with governance).

The key disclosures in relation to the industry in which the entity operates (for example, research and development costs for a pharmaceutical company).

Whether attention is focused on a particular aspect of the entity’s business that is separately disclosed in the financial statements (for example, a newly acquired business).

Materiality Level or Levels for Particular Classes of Transactions, Account Balances or Disclosures

Some of the factors to consider:

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Revision as the Audit Progresses: The auditor shall revise materiality in the event of becoming aware of new information or a change in the auditor’s understanding of the entity and its operations as a result of performing further audit procedures

Documentation: The audit documentation shall include the following amounts and the factors considered in their determination

Materiality for the financial statements as a whole

If applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures

Performance materiality and

Any revision of above as the audit progressed

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SA 530 (Revised) Audit Sampling

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Scope

• SA 530 deals with the auditor’s use of statistical and non-statistical sampling when designing and selecting the audit sample, performing tests of controls and tests of details, and evaluating the results from the sample.

Objective

• The objective of the auditor when using audit sampling is to provide a reasonable basis for the auditor to draw conclusions about the population from which the sample is selected

Need for audit

sampling

• Audit sampling refers to the application of audit procedures to less than 100% of items within a population of audit relevance such that all sampling units have a chance of selection in order to provide the auditor with a reasonable basis on which to draw conclusions about the entire population.

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Process Flow

Evaluating Results of Audit Sampling

Projecting misstatements

Investigate nature and cause of deviation

Performing audit procedures

Selection of items for testing

Determination of sample size

Sample design

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Sample design:

In considering the characteristics of the population from which the sample will be drawn, the auditor may determine that stratification or value-weighted selection is appropriate.

The decision whether to use a statistical or non-statistical sampling approach is a matter for the auditor’s judgment

Sample size:

The level of sampling risk that the auditor is willing to accept affects the sample size required. The lower the risk the auditor is willing to accept, the greater the sample size will need to be.

The sample size can be determined by the application of a statistically-based formula or through the exercise of professional judgment

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Examples of Factors influencing Sample Size:

Factor Effect on sample size

Remarks

An increase in the auditor’s assessment of the risk of material misstatement

Increase The higher the auditor’s assessment of the risk of material misstatement, the larger the sample size needs to be

An increase in the use of other substantive procedures directed at the same assertion

Decrease The more the auditor is relying on other substantive procedures to reduce to an acceptable level the detection risk regarding a particular population, the less assurance the auditor will require from sampling

An increase in tolerable misstatement Decrease The lower the tolerable misstatement, the larger the sample size needs to be.

An increase in the amount of misstatement the auditor expects to find in the population

Increase The greater the amount of misstatement the auditor expects to find in the population, the larger the sample size needs to be in order to make a reasonable estimate of the actual amount of misstatement in the population

Stratification of the population when appropriate Decrease When a population can be appropriately stratified, the aggregate of the sample sizes from the strata generally will be less than the sample size that would have been required to attain a given level of sampling risk, had one sample been drawn from the whole population.

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Selection of items for testing:

With statistical sampling, sample items are selected in a way that each sampling unit has a known probability of being selected. With non-statistical sampling, judgment is used to select sample items.

Methods of sample selection:

Random

Systematic

Monetary unit sampling

Haphazard

Block selection

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• Random number tables are used to determine sample Random Sampling

• Selection of Every nth Item Systematic selection

• Type of value weighted selection focusing on monetary amounts Monetary Unit Sampling

• Sample items are selected without any conscious bias or predictability and thus attempt to allow all items in the population to have a chance of selection

Haphazard Selection

• Block selection involves selection of a block(s) of contiguous items from within the population.

Block selection

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Performing Audit Procedures:

The auditor shall perform audit procedures, appropriate to the purpose, on each item selected.

An example of when the auditor is unable to apply the designed audit procedures to a selected item is when documentation relating to that item has been lost.

An example of a suitable alternative procedure might be the examination of subsequent cash receipts together with evidence of their source and the items they are intended to settle when no reply has been received in response to a positive confirmation request.

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Nature and Cause of Deviations and Misstatements:

The auditor shall investigate the nature and cause of any deviations or misstatements identified, and evaluate their possible effect on the purpose of the audit procedure and on other areas of the audit.

In analyzing the deviations and misstatements identified, the auditor may observe that many have a common feature, for example, type of transaction, location, product line or period of time. In such circumstances, the auditor may decide to identify all items in the population that possess the common feature, and extend audit procedures to those items

Projecting Misstatements:

The auditor is required to project misstatements for the population to obtain a broad view of the scale of misstatement but this projection may not be sufficient to determine an amount to be recorded.

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Evaluating Results of Audit Sampling: The auditor shall evaluate:

(a) The results of the sample; and

(b) Whether the use of audit sampling has provided a reasonable basis for conclusions about the population that has been tested.

For tests of controls, an unexpectedly high sample deviation rate may lead to an increase in the assessed risk of material misstatement, unless further audit evidence substantiating the initial assessment is obtained.

For tests of details, an unexpectedly high misstatement amount in a sample may cause the auditor to believe that a class of transactions or account balance is materially misstated, in the absence of further audit evidence that no material misstatement exists.

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If the auditor concludes that audit sampling has not provided a reasonable basis for conclusions about the population that has been tested, the auditor may:

Request management to investigate misstatements that have been identified and the potential for further misstatements and to make any necessary adjustments

Tailor the nature, timing and extent of those further audit procedures to best achieve the required assurance. For example, in the case of tests of controls, the auditor might extend the sample size, test an alternative control etc.

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Stratification and Value-Weighted Selection

Stratification:

Audit efficiency may be improved if the auditor stratifies a population by dividing it into discrete sub-populations which have an identifying characteristic.

For example, 20% of the items in a population may make up 90% of the value of an account balance. The auditor may decide to examine a sample of these items.

Value-Weighted Selection:

One benefit of this approach to defining the sampling unit is that audit effort is directed to the larger value items because they have a greater chance of selection, and can result in smaller sample sizes

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Thank you

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