2.6 Materiality, Planning & Risk Assessment (Including Climate-Related Implications)

Materiality, Planning & Risk Assessment (Including Climate-Related Implications)

Two outcomes in ICAB Syllabus 2023 are examined together in practice: "identify the process of planning an assurance engagement, including risk assessment and the implications of climate change for an entity's financial statements" and "define materiality and identify its role in the assurance engagement."

1. Defining materiality

Materiality is defined by reference to users. Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the economic decisions that users of the financial statements take on the basis of those statements.

Three features of that definition carry marks:

• It is judged from the users' perspective, not the auditor's convenience or the client's preference.
• It concerns decisions, so it is about influence, not arithmetic tidiness.
• It covers obscuring as well as omitting or misstating — burying a material item in an undifferentiated note can itself be a material failure.

Quantitative materiality

Auditors set an overall materiality figure for the financial statements as a whole by applying a percentage to an appropriate benchmark. Common benchmark ranges used in practice are:

These are professional conventions to guide judgement, not rules in a standard. Choosing the benchmark is itself a judgement: for a loss-making textile mill, 5% of a small or negative profit before tax would produce an absurdly low figure, so revenue or total assets is used instead.

Qualitative materiality

An amount well below the quantitative threshold can still be material by nature. Classic examples:

• Transactions with directors or other related parties, however small.
• A misstatement that turns a reported loss into a reported profit, or that causes a debt covenant to be met.
• Amounts affecting directors' remuneration disclosures.
• Any item that is unlawful, or that conceals unlawful conduct.
• A misstatement in a figure that management has drawn attention to in the narrative report.

Performance materiality

Performance materiality is set at an amount lower than overall materiality. Its purpose is to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality. It is commonly set at 50% to 75% of overall materiality, with the lower end used where control risk is higher or where prior-year audits found many errors.

Worked illustration. A trading company reports revenue of BDT 1,200 million and profit before tax of BDT 90 million. The auditor selects profit before tax at 5%:

• Overall materiality = 5% × BDT 90m = BDT 4.5 million
• Performance materiality at 60% = 60% × BDT 4.5m = BDT 2.7 million
• A clearly trivial threshold, below which misstatements need not be accumulated, might be set at 5% of overall materiality = BDT 225,000

2. The role of materiality across the engagement

Materiality is not a planning-stage number that is then forgotten. It operates at four points:

Materiality is also revised during the engagement if circumstances change: if the draft profit before tax falls sharply between planning and year-end, materiality must be reassessed and procedures extended if necessary.

3. Planning and risk assessment

Planning is a continuous process, not a discrete phase. Its purpose is to direct effort towards the areas where material misstatement is most likely.

The core steps:

1. Understand the entity and its environment — industry conditions, the regulatory framework (for example Bangladesh Bank prudential rules for a bank, or BSEC requirements for a listed issuer), ownership, financing, operations and accounting policies.
2. Understand the entity's system of internal control — the five components, and whether controls relevant to the audit are designed effectively and implemented.
3. Perform risk assessment procedures — inquiry of management and others, analytical procedures on draft figures, observation and inspection.
4. Identify and assess the risks of material misstatement at the financial statement level and the assertion level, and identify any significant risks.
5. Set materiality and performance materiality.
6. Develop the overall audit strategy and the detailed plan, deciding where to seek control reliance and where to go straight to substantive work.

Continuous risk assessment matters: risk is reassessed as evidence emerges. If control testing reveals a high deviation rate, the assessed risk rises and the substantive plan must expand.

4. Climate-related implications for the financial statements

The syllabus specifically flags climate change at the planning and risk assessment stage. There is no separate "climate accounting standard" that creates new line items; the point is that climate-related matters feed into existing recognition, measurement and disclosure requirements, and the practitioner must consider them when assessing risk.

The practical audit responses are ordinary ones: inquire of management about climate-related risks, read board minutes and buyer correspondence, challenge impairment and useful-life assumptions, evaluate provisions, and read the other information for inconsistency with the financial statements.

5. Common traps

• Treating materiality as only a percentage. Qualitative materiality is examined frequently.
• Confusing overall materiality with performance materiality — performance materiality is always the lower figure and exists to absorb aggregation risk.
• Assuming climate change creates a new standard or a new opinion. It changes estimates, provisions, going concern and disclosure within the existing framework.
• Forgetting that materiality is revised if the underlying benchmark moves materially during the engagement.