Seminar-Workshop on Integrated Results and Risk-Based Audit Materiality Template

MATERIALITY TEMPLATE
MATERIALITY AND TOLERABLE ERROR COMPUTATION

Auditee

Audit Date

Prepared By

Reviewed By

Approved By

A. COMPUTATION OF MATERIALITY
1. Understand the Auditees Views on Materiality
Describe the Auditees view on materiality and the underlying
rationale/computation.

2. Determine the sensitivity of the accounts.

Generally, the more sensitive the account, the lower the materiality level.
Very Sensitive, Sensitive and Not Sensitive accounts should be selected for
accounts identified as High, Moderate and Low Risk, respectively.
3. Identify the Most Appropriate Materiality Benchmark
a. Select the most relevant materiality benchmark (check one):

Measurement Percentage
Degree of Sensitivity
Very Not
Base Figure Sensitive Sensitive Sensitive

Total expenditures % -2% 2%

Total revenues % -2% 2%

Turnover (Sales) % -2% 2%

Normalized operations surplus % %-% %

Total assets % -1% 1%

Net Assets or Equity 1% 1-2% 2%

b. Indicate the benchmark amount (monetary value).

c. Indicate the source of the benchmark (check one):

Prior year financial statements
Current year projection (indicate date below)
Computation (show below)
Other (describe below)

d. Indicate the reason for the benchmark selection (check one):

Agency is operating under normal circumstances

Agency with volatile operating surplus

Agency is operating at breakeven levels

Agency is a non-profit entity

Agency has significant one-time (unusual) revenue or expenditure during the

audit year

Agency operating losses

 Agency does not report earnings ( non-profit organizations and government
entities )

Employee benefit plans

Others (please indicate)

4. Determine the Measurement Percentage

a. Materiality measurement percentage:

b. Indicate the reason for the percentage.

5. Calculate Materiality
Measurement
Benchmark Amount Percentage Materiality
(from Step 3.b.) (from Step 3.a.) Amount

X =
B. COMPUTATION OF TOLERABLE ERROR
1. Determine the Number of PAJEs and PRJEs Based on Prior Year
Experience

2. Determine the Total Monetary Amount of PAJEs and PRJEs Based on

Prior Year Experience

Include support for Steps 2 and 3

3. Calculate the Total Expected Error as a Percentage of Materiality

Expected Error Materiality

(from Step 2) Amount Percentage

/ =

4. Determine the Tolerable Error Percentage

Tolerable Error Matrix
Column 1 Column 2 Column 3
Expected Number of Total Expected Error as % of
PAJEs Based on Prior Year Materiality (from Step 3) Tolerable Error %
Experience (from Step 1)
02 Not applicable

35 up to 40%
over 40% 25%

6 or more up to 40% 25%

over 40% 15%

5. Calculate Tolerable Error

Tolerable Error % Materiality Tolerable Error
(from Step 4 Column 3) Amount Amount

X
 MATERIALITY TEMPLATE
Part III GUIDANCE
A. COMPUTATION OF MATERIALITY
The five steps that should be undertaken by the audit team in computing the
materiality are the following:
1. Understand the Auditees Views on Materiality
2. Determine the sensitivity of the accounts.
3. Identify the Most Appropriate Materiality Benchmark
4. Determine the Measurement Percentage
5. Calculate Materiality

B. COMPUTATION OF TOLERABLE ERROR

Tolerable error is the threshold of misstatement that we seek to detect when
applying a test to an individual account or group of related accounts (e.g.,
inventory). It is established to coordinate the scopes of the various tests so they
provide reasonable assurance that a material misstatement, if it exists, will be
detected. That is, each test is designed to search for errors, which in the
aggregate, exceed tolerable error.
Tolerable error usually is smaller than materiality because multiple errors may
exist whose total could exceed materiality. Generally, tolerable error decreases
as the number and magnitude of expected errors increase. The concept of
tolerable error also contemplates a cushion for errors that may exist but will
remain undetected or underestimated.
Many auditors decompose materiality into smaller pieces applicable to specific
audit areas or accounts. The amount of materiality assigned to individual
accounts is called tolerable error, which refers to the amount of error that an
auditor can tolerate in a specific account before it is considered to be materially
misstated. Tolerable error can differ for each account because some accounts
are more susceptible to error or are more significant to the overall financial
results of the organization.
In general, increasing the sum of allocated tolerable error means that the auditor
is willing to tolerate large errors in some accounts, which would increase the
overall risk that a material misstatement will remain undetected.
Some auditors do not distinguish between materiality and tolerable error, they
are essentially setting them equal. This strategy is not advisable. The resultant
audit may result in more audit risk than the auditor desired.
Individual accounts do not have the same risk concerns, thus, the actual
assessment of tolerable error is a matter for careful exercise of judgment by the
auditor.
We compute tolerable error as a percentage of materiality. That percentage is a
function of the extent to which we expect the financial statements to contain
errors. For example, if we expect errors based on several years of positive
experience, we could set tolerable error at a maximum amount of 80% of
materiality. Alternatively, if we expect to find substantial amounts of error in
several different areas, we set tolerable error at a small percentage (say, 15%).
The tolerable error amount is used to plan the tests in each area (i.e., it is not
divided between various tests).

Tolerable error is computed in six steps:

1. Determine materiality.
2. Estimate the number of PAJEs and PRJEs based on prior year experience.
3. Determine the total monetary amount of PAJEs and PRJEs based on prior
year experience.
4. Calculate the total expected error as a percentage of materiality.
5. Determine the tolerable error percentage.
6. Calculate tolerable error

1. Determine Materiality

For example, if the materiality benchmark is Php 35,000,000 and the

applicable measurement percentage is 0.5%, materiality would be Php
175,000.

2. Estimate the Number of PAJEs and PRJEs Based on Prior Year

Experience

Determine the number of PAJEs and PRJES that we expect will result from
our work using prior year experience as our basis. A group of entries
resulting from related audit tests addressing the same risk should be
counted as a single adjustment.

These PAJEs and PRJEs represent errors (either anticipated or known to

exist) that will not be eliminated from the financial statements. Regardless of
their location, such errors reduce our tolerance for undiscovered errors in all
audit areas, so we need to reflect them in the tolerable error calculation.

The number (and monetary amount) of PAJEs and PRJEs might be

estimated from prior results and from a consideration of recent changes in
conditions (see below). To illustrate this estimate, assume that in the prior
year we posted the following PAJEs and PRJEs, and we expect similar
results in the current year:
 Prior Year
Overstatement of
Income

1. Import Duty Application Php 35,000

2. Salaries and wages Unpaid 20,000
3. Office Supplies Utilized 10,000
Total Monetary Value Php 65,000
Total Number of PAJEs 3

In this example, the current years expected number of PAJEs is three (3).
Recent changes in conditions may influence our expectations. For example,
if we have strong evidence that the auditee has improved the processes and
systems where errors historically occurred, the likelihood of error might be
reduced; conversely, the introduction of new operating activities or personnel
turnover may increase the expectation for error. If only a general range of
error can be predicted, the safest approach is to use an amount near the
high end of the expected range. Underestimating the number and amount of
error (i.e., being overly-optimistic) can result in setting Tolerable Error at too
high a level, which could require revision of testing scopes during the audit.

3. Determine the Total Monetary Amount of PAJEs and PRJEs Based on

Prior Year Experience
Determine the total monetary amount of PAJEs and PRJEs related to the
PAJEs and PRJEs identified in Step 2 above. In the above example, this
amount is Php 65,000.

4. Calculate the Total Expected Error as a Percentage of Materiality

Determine whether the total expected error exceeds 40% of materiality.
Note:
Testing scopes need to be increased in response to increased risk of errors. As a
rule, a suitable trigger point for this decision is the expectation that total error will
exceed this 40% threshold.

5. Determine the Tolerable Error Percentage

Based on the number of expected PAJEs and PRJEs (Step 2) and the
expected error percentage (Step 4), refer to Column 3 of the Tolerable Error
Matrix to determine the appropriate tolerable error percentage (tolerable
error expressed as a percentage of the materiality).
In the above example of three (3) PAJEs, the expected error (Php65,000) is
less than 40% of materiality ( Php175,000), so the tolerable error percentage
is 40%.
 6. Calculate Tolerable Error
Multiply the appropriate tolerable error percentage (Step 5) by the materiality
(Step 1) to determinate the monetary amount of tolerable error (40% x Php
175,000 = Php 70,000).

C. DETERMINATION OF PAJE AND PRJE

Proposed adjusting entries (PAJEs) generally are entries to correct
misstatements of net income or net worth. Proposed reclassification entries
(PRJEs) transfer balances among financial statement captions but do not affect
net income or net worth.