Materiality in Auditing of the Financial Statements - Essay Example

Materiality in auditing Introduction The main objective of auditing of the financial ments is to enable the auditing team to determine whether the financial records have been prepared in material respects. The complete financial statements must take into account all requirements and be in conformity with certified financial reporting framework (Australian Accounting Research Foundation, 2001, pp. 5). Anything less than this may mean that the information represented in these records could easily influence the economic decision of the users of these statements. Thus, information represented in the financial statements can be termed to be material if its omission or misrepresentation can have an effect on the decision-making process among the users of these records (Ndreca, 2013, pp 350). In simple definition, materiality in financial accounting is the intolerable misstatements that are embedded in the financial statements with the intention of justifying a non-existent transaction (Dodaro, 2013, pp419). In other words, materiality is the intolerable or unacceptable errors which cannot be ignored because they have a greater effect on the financial information represented in the records (Brannan & Gray, 2005, pp26). These errors are huge hence, when neglected; they may lead to big losses of the firm’s resources. This paper explores the concept of materiality in the financial accounting showing the importance of materiality in auditing process, the main development of the concepts of materiality over time. Materiality can be categorized into two; quantitative materiality and qualitative materiality. Quantitative materiality is the actual financial value that a certain misstatement can cause to the organization. On the other hand, qualitative materiality can be just a mere statement that has either misled certain transaction (Brannan & Gray, 2005, pp41). Accountants and management teams in most cases misstate the financial information to conceal particular information not to be known by the shareholders for their own benefits. Sometimes, certain information may qualify to be material without the intention or knowledge of the accountants and the management (Brannan & Gray, 2005, pp26). Therefore, the auditors have the task of exploring all the financial records and scrutinize them to establish, justify and certify that the information represented in them is quite relevant to the true status of the organization (Dodaro, 2013, pp419). Any deviation should be investigated to establish whether it can amount to the material or can have an effect on the decision. Normally, every financial record tends to have errors. There are some errors that have an insignificant effect on the information represented. However, other errors are quite pronounced in that when they are not rectified; they may impact the organization negatively; the big errors amount to materiality (Dodaro, 2013, pp419). Materiality in the accounting process is very much related to the significance of the transaction, balances and errors that are found in the financial statements. When auditors plan their auditing process, they calculate the level of material that can be tolerated. In the case during their auditing process they find materials that exceed their established levels (Leslie, 1985, pp17). Then they would qualify their audit report by notifying the users that certain information represented in the records cannot be accounted for. There is a time when the auditor may give unfit or unfair opinion for the irregularities and errors in the financial statements (Brannan & Gray, 2005, pp26). So many reasons can results to this unfit opinion, therefore, before the auditor starts the process of auditing, they must dig assemble all the information need and dig thoroughly into this information and even seek clarification from the management and the accountants about certain conflicting issues. Auditors have to do this to avoid auditing risks (Dodaro, 2013, pp419). The difference between the materiality and auditing risk is that the materiality is the measurement of the magnitude of the error. Audit risk, on the other hand, is a measurement of uncertainty. Therefore, it is advisable to auditors that before they start their auditing task, they should conduct a preliminary audit risk assessment (Ndreca, 2013, pp351). This assessment would help the auditor to avoid giving false opinion to the shareholders and the other users of the financial statements. In most cases, the auditors consider materiality when trying to determine the nature, timing and scope of the auditing procedures. This is the time prior to the auditing process. The auditor cannot start the process of auditing without knowing where to start and where to end (Ndreca, 2013, pp351). Another time when the auditors require the materiality is when evaluating the effect of misstatements in the financial statements available (Brannan & Gray, 2005, pp26). At this point, the audit tries to compare the extent of the irregularities and errors to the effects these errors have to the financial information. If the auditing team finds out that the irregularities are of many effects, them they give a qualified report to the shareholders. There are two types of materiality judgment used by the auditors; we have preliminary materiality judgment and final reporting materiality judgment (McKee &Eilifsen, 2000, pp12). The aim of preliminary materiality judgment is to guide the auditor in determining the nature, timing and the scope of the auditing exercise. In this type of judgment, the auditor may consider the financial statements provided by the management but the judgment may either be higher or lower (Brannan & Gray, 2005, pp25). Final reporting materiality judgment assists the auditor in the evaluation of the influence of the misstatements (Leslie, 1985, pp26). There are chances that the two kinds of judgment may arrive at the same level of materiality although in most cases, they do not. Importance of materiality in auditing Materiality concept is quite important in the auditing process. First, materiality assures the standard to determine the tolerable or acceptable level of irregularities together with the risk involved (Brannan & Gray, 2005, pp31). As mentioned earlier, materiality is closely related to the significance of the transaction and the magnitude of the errors. Therefore, when the size of the transaction is known and the errors involved can be calculated, then materiality can easily help in setting the standard to which these irregularities can be allowed. Secondly, materiality together with the audit risk determines the extent and the direction of the audit work (McKee &Eilifsen, 2000, 11pp). As discussed earlier, the main goal of auditing process is to investigate and determine whether the financial statements are credible. Moreover, the auditing work aims to reveal the irregularities engraved in the financial statements (Ndreca, 2013, pp354). Thus, setting the level of acceptable materiality before the auditing process identifies some critical and suspicious areas where the auditor needs to scrutinize thoroughly. Thus, setting the materiality levels notifies the auditor on which direction should the auditing process take in order to investigate the certain information that seems to be attracting attention. Thirdly, materiality also helps in setting the accuracy of the financial statements (Dodaro, 2013, pp419). When the auditors determine what levels of materiality should be allowed, and then these levels set the levels of acceptable accuracy of the financial statements (Brannan & Gray, 2005, pp27). Once these levels of accuracy are established, the auditors inform the users the levels of information they should expect from the financial statements prepared by their accountants (Leslie, 1985, pp26). Thus, the shareholders and other users of the financial statements are notified by the auditors in advance on the range at which the financial information in the statements should lie. Another importance of materiality in the auditing process is that it assists the auditors to prepare the audit tests (Brannan & Gray, 2005, pp29). After gauging the extent at which the irregularities can be tolerated, the auditors can now develop audit tests in areas that seem to be raising concern where the errors exceed the standards set (McKee &Eilifsen, 2000, pp13). Audit test is simple, but specific questions the audit set and strives to find the answers from the financial statements provided by the management. Audit tests do not cover the entire aspects of the financial statements, but they randomly question some of the issues in the statements (Ndreca, 2013, pp356). Good audit tests tend to be accurate and assist the auditors to conduct the process in a more comprehensive and efficient manner. Therefore, to come up with quality audit tests, the auditors base their development from the materiality. The materiality levels used by the auditors in most cases are kept secret. The reason behind the secrecy of the materiality is that the process of auditing is a form of investigation of the anomalies (Dodaro, 2013, pp419). Therefore, materiality is a weapon used by the auditor to pin down the fraudulent officers in the organization. Therefore, when the materials are not kept confidential, the officers would try to manipulate the financial statements to conceal certain items that may reveal their fraudulent dealings (Brannan & Gray, 2005, pp25). Other officers would even go to some extent of trying to correct the anomalies in the financial statements; a fact tat may lead to more confusion. Therefore, it is an accounting policy for the auditors not to disclose the materiality they are going to use during the auditing exercise (Ndreca, 2013, pp351). However, after the auditing process, the auditors should now disclose the materiality they used to make their judgments over the financial information represented in the financial statements (McKee &Eilifsen, 2000, pp9). The purpose of the disclosure of this materiality after the auditing exercise is to make the financial statements more understandable by the users such as the shareholders and the government agencies (Leslie, 1985, pp26). The auditors should show the calculation they used to make it easier to disclose the absolute amount of the materiality level (Brannan & Gray, 2005, pp26). In addition, the auditors in most cases do not disclose the materiality levels applied in the auditing task. They just give the materiality they used which and the materiality guidelines aimed at providing the investor with relevant and necessary information that would enable them to make their informed decisions (Brannan & Gray, 2005, pp27). Recent audit regulation on materiality Materiality concepts has been in use for many years, however, the regulation surrounding this concept tend to change over time and this change is attributed to the changing nature of the society where new technologies have become an integral part of our society (Ndreca, 2013, pp355). One of the notable developments on the issue of materiality is that the courts have recently provided some guidance on the level of uncertainty applicable in the materiality decision (McKee &Eilifsen, 2000, pp8). The United States courts have provided that materiality will have to depend on the time upon the indicated probability that the event will have to occur and the expected magnitude of the occurrence (Ndreca, 2013, pp351). Therefore, auditors should consider both the chances that the event will occur. Right from the past, the auditing exercise was much based on a single rule or the “rule of the thumb” and the variable or size rules (Dodaro, 2013, pp421). However, in recent times, more regulation have been developed which requires that for auditors to carry out credible materiality judgment, they should use blends or average method and formula method (MCKee &Eilifsen, 2005, pp4). These two methods are quite comprehensive hence fewer audit risks. Thus, an international auditor must use a blend or formula approach in judging the materiality during the auditing exercise (Ndreca, 2013, pp351). Another regulation surrounding g the materiality issue is that when the auditors are evaluating the results, they must consider both quantitative and qualitative factors to find the actual materiality (Pcaobus.org, 2010, PP1). Initially, auditors just consider either quantitative factors or qualitative factors, and they make their opinion. This has been leading to making of false opinions because some information can be left when the auditor relies on one aspect. Conclusion The concept of materiality in auditing is not new but an old concept that has been used by auditors to carry out their function of auditing. It is a tool that the auditors prepare and use it in guiding them when making the judgment of the financial statements. Therefore, materiality is quite important during this exercise since it gives the auditor the direction to which the auditing process should take. Materiality also assists in the designing the auditing tests which the auditors use to carry out the auditing exercise; thus it makes the auditing work easier. The fact that the concept of materiality has been in existence for a long time, the regulations about it has been changing too over time. In the modern corporate world, some new regulations are being drafted to bring more light when dealing with materiality during the auditing task. 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