What Is Materiality - Essay Example

Materiality in Auditing The term material is of critical importance in the auditing context (Porter et al., p.73). Materiality levels are moresecret than the Coca Cola formula (Mock et al., 2009, p.4). Discuss these abstracts in the context of academic research and recent developments in audit regulation and practice. Introduction Accounting relates to information about business activity, and financial reporting relates to information  about business results during a specific period. An audit report contains a kind of guarantee certificate pertaining to the information contained in the non-financial and financial statements of a business. The audit process involves a study of a determination method of materiality,and of its significance in the audit process, and it offers a linkage between the audit risk and the materiality. The main aim of this research essay is to analyse the critical significance of materiality in the auditing context and its secrecy levels in the audit process. What Is Materiality? As per IASB, the term ‘materiality’ refers to the information that are is important if their its exclusion or inaccurate presentation could shape the economic decision of the users of the financial statement of a business. The Materiality rests upon the magnitude of the evaluated element or error in some scenario of the auditor’s omission or inaccurate presentation. The Materiality depicts the significance of an exclusion or of an incorrect presentation of an accountancy data or information which will impact the decision of a user of such accountancy information. As per ISA (UK&I) 320 , materiality in planning and carrying over out an audit means that the auditor employs the notion of materiality in planning and carrying over out the audit to identify material misstatements. Moreover, at the final  end of the auditing, the auditor will decide whether the unrectified misstatements recognised are either in aggregate or individually material to the financial statements or not. Thus, in deciding the materiality, auditor has to exercise his judgment. An omission or misstatement can be evaluated to be material or immaterial by virtue of their its nature or size or a mixture of both (FRC 2013:7). The Materiality concept is of critical importance in Auditing The auditor is anticipated to design and carry out an audit that offers a reasonable promise that materials’ misstatements will be exposed. Both materiality and audit risk are interconnected in that audit risk is explained in terms of materiality. If there is a material misstatement present in the financial statement even after the audit has been executed , in such case auditor will be held responsile for not highlighting the materiality (Rittenberg, Johnstone & Gramming 2011:135). The notion of materiality offers flexibility to financial reporting, and this can result in abuse. Corporations may record “small” errors intentionally within a distinct percentage range ceiling so that auditors will not evaluate such errors. It is the practice of the management to offer an excuse to these errors by arguing that it is immaterial. However, these small errors can pile up later and may misinform the creditors, lenders, employees and stock market .This was evidenced in the Enron audit. As per Oppel and Sorking (2001), Enron reported the earnings reductions of $92 m from 1997 to 2000 which Enron termed it as earlier year audit reclassifications and adjustments, Though, Enron’s auditor had recommended the same but was not made into effect during the above period of 1997 to 2000 due to the fact that Arthur Anderson was persuaded by the Enron management that the amounts were negligible or were immaterial. Bates, Ingram and Reckers (1982) found that there existed a link between materiality and auditor rotation and concluded that long-run association with an audit client can destabilise the judgments of auditors’. Chewning, Pany and Wheeler (1989) found that income is the chief factor regarded by auditors in deciding about what is material. Another study found that Big 8 auditors had lower materiality thresholds as compared to non-Big 8 auditors (Brennan & Gray 2005:19). Example of Auditor Materiality reporting Keller Group Plc is an UK based engineering specialist company, which offers cost-effective and technically advanced foundation solutions. Keller Group Plc is having offices in 40 nations around the world thereby employing 9000 employees, and its annual turnover is around £1.5bn. KPMG Audit Plc is the auditor for the Keller Group Plc and in their audit report dated 31 March 2014, they observed that the materiality for the financial statements was fixed at £ 4 mn. The group’s profit before taxation was taken by the auditor as the yardstick for materiality . They also reported that materiality symbolises 6.7% of Group revenue before tax and 4.7% of the Group revenue after the tax and any exceptional transactions were disseminated in the income statement itself. Further, KPMG also disclosed that they brought to the notice of the audit committee of the company all the unrectified misstatements recognised during the course of the audit by them, which were then rectified by the management. KPMG was of the view that audit committee should be aware of all these developments in accomplishing its governance accountabilities, and KPMG is of the view that any audit misstatements below the thresholds should also be reported on qualitative grounds (Kellergroupplc 2014). Are the materiality levels used by auditors been secret? If so, why? An auditor should disseminate the major information as it pertains to materiality. Materiality here connotes the information which would have transformed the outcomes of the business, if it would have been divulged. It does not connote that auditing should be saddled with information. Some insignificant information may be eluded, and others may be integrated with the other significant information. Certain information can be furnished in the auditor’s report. As per DeZoort et al (2006), higher magnitude of accountability pressure may exert pressure on auditors to give more emphasis on qualitative materiality judgment. The materiality levels used by the auditors, whether to be keep it as a secret or not will be determined by the following factors: Whether any present regulation , law or the applicable financial reporting standards impact the user’s anticipations as regards to the disclosure or the evaluation of some items like remuneration of managers , related-party transactions and those concerned with the administration. The major and key dissemination of information as regards to the industry in which such business functions like research and development expenses for a pharmaceutical company. Whether the devotion is centred upon a specific feature of the business that is distinctly disseminated in the financial statement as in the case of a newly acquired business. A gullible investor has the right to know the materiality level as applied by the auditors. However, auditors argue that if the materiality levels are increased, then, it would end up in an increase in the cost of audit. Thus, the cost of audit and its linkage to the selection of materiality, is an issue which the shareholders are entitled to be informed. It is not unjust to require auditors to disseminate in their audit report about how they planning the materiality which is being applied in the audit. Then, the shareholders will have the chance to evaluate the margin of error during the course of an audit. What has academic research shown about the importance and secrecy of materiality? As per Wong-On-Wing et al., (1989) the thresholds for materiality by auditors were significantly linked with their inference about management. As per Carpenter and Dirsmith (1992), the materiality judgments by the auditors’ were impacted by the size of an item, the effect on company’s earnings trends, and the nature of the transactions. As per “Carpenter et al. (1994)”, the audit firms’ experience and culture will determine the materiality procedures and judgments. As per Libby and Kinney (2000), misstatements are less likely to be adjusted if they result in earnings to drop well below the analyst’s forecasts. As per Braun (2001), whether to show or waive decision was not influenced by the client’s relative fees but was impacted by the financial health of the client. As per Na and Tan (2003), the auditor’s negotiation result as regards to the audit fine-tuning is jointly maneuvered by audit committee efficaciousness and by authoritative guidelines. As per Nelson et al (2005), factors like subjectivity , misstatement size , income impacts will have a direct influence on auditor’s decision to book the misstatement under the method by which the misstatement looks more material ( Messier & Martinov-Bennie 2005:46). The courts also came to help by providing some guidance on the threshold of uncertainty applicable in the materiality decision. In “SEC v. Texas Gulf Sulphur Co, 01 F.2d 833, 849 (2d Cir.1968)” held that materiality at any given time will foot upon upon the harmonisation of both the designated likelihood that the event will happen and the expected dimension of the event in the background of the aggregate of activities of the company (Brennan & Gray 2005:9). How has recent audit regulation, particularly in relation to audit reporting, changed audit practice in relation to the disclosure of materiality? Materiality is a vital part of an audit. As per ISA (UK&I) 320-‘Materiality in planning and performing an audit is that how the auditor employs the notion of materiality in planning and carrying out the audit to find out material misstatements if any. Moreover, at the final stage of an audit, the auditor should disseminate whether the uncorrected misstatements recognised are either in aggregate or individually material to the financial statements or not (FRC 2013:7). ISA (UK&I) 700 (revised) which is effective from 1 October 2012 need auditors to explain how they applied the notion of materiality in planning and carrying over the audit. Thus, this new requirement will offer an enhanced perceptibility of the effect of materiality on the demeanour of audit work to investors and other users of the accounting information of a company and facilitate them to communicate directly with Audit Committees in relation this materiality . Under the ISA (UK&I) 700 (revised) which is effective from June 2013, the auditor should state in their audit report under the heading “our application of materiality”, a clarification about how the auditor applied the notion of materiality in scheduling and carrying out the audit. The auditor’s explanation should cover the threshold employed by the auditor as being materiality for the company’s financial statement in its entirety. Further, the auditor’s report should state that auditor has taken earnest efforts to find out any material inconsistencies with the audited financial statements and to recognise any information that is not correct which is apparently footed upon or materially inconsistent with and the knowledge gathered by them in the course of carrying out the audit .Further, under ISAs (UK & Ireland), an auditor has to state in the annual report the following: That in his opinion , that the client’s financial statement consists of materially inconsistent or with materially not correct information footed upon , or materially not consistent with his knowledge gathered during the course of the audit or is otherwise deceptive (FRC 2013:3). Is it possible to conclude whether or not this change is for the better? As we have seen already that under the ISA (UK&I) 700 (revised) which is effective from June 2013, the auditor should state in their audit report under the heading “our application of materiality”, any materiality he witnessed during the audit. For instance, in Tesco’s 2013 audit report, Tesco’s auditor PWC disclosed £150 m as the level of materiality which symbolises about 5% of Tesco’s adjusted revenues. PWC also reported that it concurred with the audit committee’s findings and it would report misstatements materially recognised during the audit in excess of £7m and together misstatements less than that amount for qualitative reasons, which is required to be disseminated now in the auditor’s opinion under the above new rule (Penny 2014). Conclusion This research study recommends that the regulators should introduce more disclosure requirements to include about materiality thresholds to improve transparency of auditing and accounting process. As stakeholders, investors and shareholders are having every right to have this information about the company in which they have invested. Shareholders are authorised to have such vital information, and they should be informed about the inaccuracy underlying what otherwise seems very accurate. Had such disclosures were in place, it is not likely that $51 million as restatement which was 50% of Enron’s 1997 profit would have been regarded as immaterial? Auditors and management collusion makes materiality to be at stake. Thus, this research study strongly recommends that the auditor should not be allowed to keep the materiality as secret as Coca-Cola is keeping its formula as secret but it should be disseminated to all the stakeholders, especially to the shareholders. List of References Brennan N & Gray S J. (2005) The Impact of Materiality: Accounting’s Best Kept Secret. AAMJAF, Vol (1), 1-31 Financial Reporting Council. (2013) Illustrative Example of a UK auditor’s report reflecting requirements of ISA (UK and Ireland) 700 (Revised June 2013). [online] available from < https://www.frc.org.uk/Our-Work/Publications/Audit-and-Assurance-Team/ISA-700-%28UK-and-Ireland%29-700-%28Revised%29/Illustrative-example-of-a-UK-auditor-s-report.aspx> [accessed 4 December 2014] Keller Group Plc. (2014). Independent Auditor’s Report. [online] available from < http://www.keller.co.uk/good_gov/governance/independent-auditors-report.aspx> [accessed 9 December 2014] Messier, WF, Martinov-Bennie N & Eilifsen. A (2005). A Review and Integration of Empirical Research on Materiality: Two Decades Later. [online] available from < http://papers.ssrn.com/sol3/papers.cfm?abstract_id=786688> [accessed 4 December 2014] Penny, J. (2014) Tesco Mis-statement puts Audit materiality into focus. [online] available from [accessed 4 December 2014] Rittenberg L, Johnstone K, Gramming A. (2011) Auditing: A Business Risk Approach. 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