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FRC publishes the results of its audit quality thematic review on materiality

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13 Dec 2017

The Financial Reporting Council (FRC) has published the results of its audit quality thematic review on materiality.

The FRC’s Audit Quality Review team visited eight audit firms to review their audit methodology and guidance in respect of materiality. They also reviewed relevant aspects of the audit procedures performed on 32 audits in a variety of sectors during those visits.

Additionally the FRC gathered the views of Audit Committee Chairs and of investors with respect to materiality. The FRC held discussions with a sample of Audit Committee Chairs to both seek their views on materiality and also understand their interaction with auditors or prospective auditors on materiality at various stages of the audit and, where relevant, the tender process. With respect to investors the FRC held roundtables to understand their views on materiality and whether it informs their investment decisions.

The FRC assessed how:

  • materiality is assessed across the financial statements as a whole (overall materiality);
  • the auditor reduces to an appropriately low level the probability that the aggregate of misstatements identified through their audit work exceeds overall materiality (performance materiality);
  • materiality is assessed for entities or business activities included within the financial statements (component materiality); and
  • materiality is assessed for particular classes of transactions, account balances or disclosures (also performance materiality).

While the review does indicate that the majority of key messages from their last review have been addressed, the report includes an updated overview of findings and key messages for both audit firms and audit committees.

Key findings and messages for audit firms include:

  • Audit firms have taken on board the messages from the last report demonstrated by an increased the emphasis within their methodologies on the application of judgement when determining overall materiality and performance materiality, developing industry-specific guidance for many sectors and consideration of risk in setting performance materiality.
  • Audit firms should ensure that if adjusted profit is used as a benchmark, they explain why the adjustments were made and how the benchmark selected better responds to the needs of the users of the financial statements.
  • Audit firms should provide audit teams with guidance on setting component materiality including how to incorporate size of the component and risk within the assessment.
  • Performance materiality should be better explained by audit firms in their reports.
  • Audit firms should include guidance in their methodologies to audit teams regarding materiality judgments when an entity is loss making as there is little or no guidance in this area.
  • Audit firms should consider whether a lower performance materiality is appropriate for first year audits, given the increased risks associated with these audits and determine whether guidance in this area should be mandated.

Key findings and messages for audit committees include:

  • Audit committees should understand and challenge the judgments underlying the setting of materiality and how it affects the audit work performed.
  • Ensure the component materiality is properly explained and justified to them by the auditor.
  • Consider how best to engage with investors on materiality and adjusted and unadjusted differences.

The report also raises areas for standard setters and investors to consider. With respect to standard setters the report indicates that they should “be aware” of the recent developments in the practice of setting materiality including the use of forecasts as benchmarks. The report indicates that standard setters might wish to develop some guidance in this area for auditors.   The report also highlights that standard setters should also consider whether auditors would benefit from guidance regarding setting component materiality and how it relates to overall materiality and the impact that it has on the audit work performed.

The press release and full thematic review are available on the FRC website.

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