Hey, today I want to talk to you about materiality guidance and get really real world with you and help you understand how real accounting firms go about setting materiality guidance when they do audits. Keep in mind that the ultimate objective for the auditor is to obtain reasonable assurance about whether the financial statements are free of material misstatement, and so that's the magic word. What is a material misstatement? You would perhaps be amazed that the auditor's report that we've talked about on several occasions, when it talks about the auditor's opinion in what an audit entails, it really doesn't describe how the auditors, historically, has not described how auditors went about setting materiality. Now the good news, in my opinion at least, in some parts of the world, that has already changed in United Kingdom, for example. But I want to talk to you about a really cool research paper that inner...for academics interface with practitioners. So in this very accessible paper by Eilifsen and Messier, here's a summary of the paper, and I'll just read this to you. Our results show a high level of consistency across the firms in terms of quantitative benchmarks used to determine overall materiality, that's one level of materiality, the related percentages applied to those benchmarks, the percentages applied to overall materiality for determining what's called tolerable misstatement, and what constitutes a trivial misstatement. So let me help you a little bit here. Overall materiality is the materiality level that pertains to the financial statements taken as a whole. That often will be set with regard to some quantitative benchmark. Let's say 5% of net income before taxes. But overall materiality doesn't really help the auditor know what would be material for individual account balances on the balance sheet or line items on the income statement. So what the auditors then do, is they decide, let's take some percentage of overall materiality, multiply that percentage times overall materiality, and that will yield something called tolerable misstatement. That tolerable misstatement is how much, it's sort of like materiality applied at the account balance level. Then the next thing that we're talking about here is this clearly trivial misstatement. They have to decide, you know the auditors can't aggregate every little minuscule error that they find. And so some they choose to ignore because of efficiency considerations, knowing that it's not going to also infringe on the effectiveness of the audit. So, that's what they're talking about there. So, the paper gives us some proprietary insight into what the materiality guidance of these firms are. As we'll talk about in just a second, materiality is used in three ways. I'll come back to these again, but these are important for you to understand. It helps you plan the audit. It helps you also decide whether what you have found, in terms of misstatement, is something that will matter to investors and other users of the financial statements. We'll talk about that in just a second too. So, what you also need to remember is that materiality is not just a function of quantitative factors. So, the auditor, using professional judgement, needs to figure out the interaction, the tradeoff between quantitative and qualitative factors that would make a misstatement capable of changing the decisions of a reasonable user. So, in this paper, the authors were excited to look at how do you determine multiple levels of quantitative materiality. And sometimes you will determine multiple levels, again, for overall financial statement level, account balance level, and down sometimes to even the assertion level within account balances. How do you go about incorporating these qualitative factors? Now there is a list of qualitative factors in both PCAOB Audit Standards, and International Audit Standards, and also in the AICPA's Audit Standards. Remember, the PCAOB, they're the standard setters for the audits of public companies in the United States. International Accounting Standards are for worldwide standards, public and private. AICPA continues to be the audit standard setter for private company auditing in the United States. The paper looks at the firm's guidance for looking at qualitative factors and also their guidance for handling detected and then there's a funny little phrase here, undetected misstatements. Now, what might that mean? Well that pertains to when the audit uses sampling looking at a subset of the population. When the auditor looks at, say, 100 transactions out of millions that have occurred in a large organization, the auditor realizes that if they have found, let's say, 4 misstatements out of that 100, it is utterly unrealistic to think that there's only four in the rest of the population at large. And so the auditor would project how many misstatements are likely under the assumption that that sample they've drawn is representative. But then, they usually go a step further and say, there's some chance that sample we drew is not in fact representative of the population. That's called a fudge factor. That's not the technical term. The technical term is an allowance for sampling risk. So the auditor sometimes does worry that, not just about misstatements they've located, but also about misstatements that are likely, but something that they can't really show management, hey, you have to correct this misstatement. Those sometimes lead to interesting conversations with client management in terms of adjusting their books. Then there's also a bit in the paper about group audits, which we're not as worried about for this course, is more of an advanced topic.
