This is the second in our series of unpacking the draft Professional Practice Guide (PPG) published by the Section 809 Panel to assist Government and commercial auditors in conducting audits of Government contracts. If you missed Part 1, click here. Yesterday's post discussed the risk assessment phase. Today we will look at the concept of 'materiality', and specifically, materiality as it relates to audits of incurred cost.
Contractors with flexibly priced contracts are required to submit annual incurred cost proposals (see FAR 52.216-7). The risk to the Government is that amounts are materially misstated due to contractors' noncompliance with contract terms or federal regulations (e.g. the Cost Principles in FAR Part 31).
The concept of materiality in the context of incurred cost audits expressly acknowledge that some degree of imperfection is acceptable to the users of financial information. There is an acceptable level of imprecision when determining or settling fair and reasonable contract prices. This concept is often foreign to DCAA auditors who feel that no level of imprecision is acceptable - they want to audit everything and try to achieve absolute assurance.
One significant concept that auditors will need to comprehend is 'quantified materiality'. This is the numeric representation of materiality that is calculated based on the total audit subject matter. It is used in planning to identify significant cost elements. So, for example, what is the threshold over which a misstatement will effect economic decisions. On a $100,000 contract, five percent ($5,000) will unlikely influence economic decisions whereas the same percentage on a $1 billion contract ($50 million) such a misstatement would likely influence economic decisions of users.
Tomorrow we will look at how 'quantified materiality' affects the scope of audit.