Materiality in Auditing - Essay Example

Materiality in Auditing Materiality is one of the crucial elements in contemporary auditing. Particularly, it is a prominent component in the best practices in the field and in addressing risk. Loosely, it refers to the determination of the financial importance of an item or group of items in financial reporting (Dauber, Shim & Siegel, p 633). The Statements on Auditing Standards (SAS) referred to it as the “concept that recognizes that some matters, either individually or in aggregate, are important for fair presentation of financial statements in conformity with generally accepted accounting principles, while other matters are not important” (AICPA, 2006, pp. 1647). These definitions point to its relevance today especially in the recent drive for transparency, ethics and responsibility in the auditing process, which will be explored, among other things, in relation to materiality in auditing. Audit, Risk and Materiality Audit pertains to a review of financial data by an independent third-party auditor. The outcome of the process involves his or her financial statements, including his or her opinion regarding the legitimacy of the data reviewed. Materiality becomes relevant in auditing when risk emerges. This risk usually stems from errors or omissions in financial reporting. The impact is based on the degree by which it affects the decision making of those who use the information from the financial statements. For instance, a small error or omission in a periodic procedure could lead to a cumulative risk that could greatly influence the financial information since there is the possibility that it occurs on periodic basis. The importance of materiality can be demonstrated in the process by which it is conducted (see Fig. 1). Ideally, all audit procedures should undergo materiality considerations from the very first stage. According to Bragg (2011), as early as the identification of the nature, timing and extent of the audit procedure, materiality should already be determined. Specifically, it should be undertaken in: 1) the design of audit procedures for mechanisms to detect misstatements; the pursuit of the elimination of audit risk; and, the assessment of the risk of material misstatement as the basis for the audit procedures (Bragg, pp.25). These variables underscore how materiality forms part of the foundation of sound audit procedures, one that is capable of addressing errors and risks. The defined object of audit underscores this as auditors are expected “to carry out procedures designed to obtain sufficient appropriate audit evidence… [in order] to determine with reasonable confidence whether the financial statements are free of material misstatement” (Auditing Practices Board 1995, par. 2). A good analogy that could map out the relationship is that materiality is inversely related to risk: all other things being equal, as materiality goes up, audit risk goes down and vice versa (Kearns 2007, p. 4). Fig. 1: Audit-Materiality Process (Brennan & Gray, pp.10). The overall auditing framework that is achieved with a focus on materiality allows the auditor to identify, evaluate and address risks in the financial reporting as well as in determining whether additional audit is necessary. A review of literature on materiality and contemporary audit reveals the permeation of materiality as auditing practice and its role in efficacy of financial reporting. For instance, Brennan and Gray (2005, pp.1) outlined how it became imperative through the years such as after the 1990s period, when the US Securities and Exchange Commission (SEC) Chairman Arthur Levitt cited the need to reform “accounting hocus-pocus” and the misapplications of accounting principles. Materiality is critical when evaluating risks and uncertainties in the financial information. These are inevitable in preparing financial statements but materiality is able to inform the judgment of auditors in assessing whether the information is true and fair (Brennan & Gray, p. 2). Researchers such as Langevoort (2002) and Huang (2005) demonstrated how financial reporting using materiality is critical for stakeholders such as the investors because the decisions made based on financial documents rife with errors will inevitably impact organizational performance because of inappropriate economic decisions. An important aspect to the issue of risk in materiality-audit relationship is abuse. Materiality is largely relegated to the judgment of the auditor since the goal is to achieve a certain degree of flexibility when it comes to reporting financial data. Organizations could undermine materiality by reporting small errors so that they are considered immaterial. According to Brennan and Gray (pp.3), these errors or omissions can accumulate and mislead the stock market and other stakeholders such as lenders, employees and creditors. This dimension – though adverse – can further highlight the importance of materiality in the audit process. To illustrate this, one could turn the case of Enron. Oppel and Sorkin (2001) found that the company was able to manipulate its earnings from 1997 through 2000 “prior year proposed audit adjustments and reclassifications”… which was recommended by Enron’s auditors who were persuaded to declare certain amounts were immaterial because of their small value. The impact is best depicted in the effect of the inappropriate data to the stock market and the company’s lenders. A more recent case involve the latest audit report released by Tesco. The UK’s Serious Fraud Office has launched an investigation on allegations of fraud and misstatements in Tesco’s audit report for 2014 (TESCO 2014). It was claimed that the company grossly misstated up to £118 million of its profits, an outcome attributed to the lack of standards in determining how factors such as errors in accounts are considered material (Butler, 2014). Secrecy As previously stated, materiality considerations rest on the discretion and judgment of auditors. For this reason, the concept and its practice became shrouded in secrecy. This can be explained by citing the ambiguities in current auditing standards. According to Riadh, Hassan and Najoua (2011, pp.232), professional standards such as the NEP 320, ISA 320, HER 107 are not precise enough with respect to the criteria involved, making it ambiguous and subject to a big margin of interpretation and auditor evaluation. In addition, it was also stressed that individual audits are unique, not only depending on personal and intrinsic auditor characteristics but also on the various situational contexts according to the organization involved. The offshoot is that auditors can follow their own methodologies and materiality framework only informed and guided by their personal moral compass. There are several arguments behind secrecy of materiality. Kearns outlined two of the most important: 1. Disclosure will confuse the users of the financial statements because a range of earnings emerges in place of the single earning number of old. 2. Disclosure will increase the liability exposure of the auditor as it will provide a measurement standard against which to measure the severity of misstatements and errors (Kearns, p. 13). The first argument above is also known as the “Buried Facts” doctrine, which holds that too much information could be misleading, particularly those material information that is inaccessible or hard to assemble (Palmiter, 2008, pp.86). The modern auditing standards, hence, allow non-disclosure of materiality. In the United States, there are only two conditions where disclosure is mandated: the SEC filing obligation and the duty of honesty. The first requires publicly listed companies to include in their filings material information necessary to make line-tem disclosure not misleading whereas the latter requires companies to disclose material information as defined by antifraud provisions of the federal securities laws (Palmiter, pp.76). In the UK, issues of disclosure are governed by the United Kingdom’s Financial Reporting Council, an independent regulator that promotes confidence in corporate reporting and governance. In two white papers, it upheld the position of secrecy since information clutter supposedly makes it difficult for users to assess a company’s progress (FRC 2009; FRC, 2011). A guideline on materiality and disclosure is also being developed by the European Banking Authority but it is still nonbinding presently. Its recommendations regarding secrecy for materiality in auditing are undergoing its consultative stage. In the UK, auditors follow organizational templates for setting materiality but these do not require auditors to explain their judgments (FRC 2013, pp.5). All in all, Palmiter noted that all financial information is contextual and that it can be tempered or disclaimed in parts. The current regulatory environment allows a good amount of financial data to be kept confidential long as they do not violate established regulations, which for their part do not consider full disclosure an imperative. No less than the US Supreme Court supported such contextual nature as something that is according to the law. This is depicted in the case TSC Industries, Inc. v. Northway, Inc., where the court ruled that certain omissions are permitted and the omitted permission could be subject to nondisclosure as well. Audit Regulation One of the critical turning points for materiality in auditing occurred with Levitt’s pronouncement calling for reforms in the way auditors report financial statements. A series of rules and policies were drafted afterwards such as the Staff Accounting Bulletin No. 99 and the Big Five Audit Materiality Task Force, which was responsible for the creation of the Statements on Auditing Standards (Messier, Martinov-Bennie & Eilifsen, 2005, pp. 3). The trajectory of the regulatory changes has been geared towards three important areas: the increased focus on materiality as part of the best practices in auditing and financial reporting; an increasing drive to reform current guidance and standards on materiality; and current call for transparency. These developments are reflected in the review of academic literature by Bennie and Eilifsen (pp.8) from 1982 to the present. They found that the concept has been integrated in auditing methodologies and standards as well as in the auditing manuals that guide practices in individual firms. Their investigation also outlined several issues the differences in practices, guidance and chosen variables in determining materiality thresholds. These underpin the current movement for more investigation, evaluations and reforms given the established importance of the concept in ideal auditing procedure. The changes that has been transpiring with respect to how materiality is viewed and implemented is necessary because it indicates a growing recognition for the concept as a determinant of the quality of financial information. What this means is that universal guidelines and standards on this aspect in the auditing process could finally emerge. This is critical considering the risks in the process of determining and evaluating materiality thresholds, which currently relies largely on the auditors judgment. This is further aggravated by the fact that the process is allowed to remain secret. Ethical problems, abuse and low quality of reported financial information are just some of the adverse outcomes. These can be addressed by mechanisms of control and evaluation. There are a number of authors in the extant body of literature that already argue for disclosure because its advantages supposedly outweigh the benefits of keeping materiality information secret. Conclusion The current focus on materiality concept and the series of changes being instituted on auditing around the world ensures a more in-depth examination of process in order to finally determine the best practices and standards that would guide not only the accurate but also the ethical reporting of financial information. Clearly, materiality is inherent in all aspect of the process in which auditors examine financial information. Also, it is critical in determining whether the outcome yields high quality financial data. The body of academic literature supports this, including an imperative to further develop and address weaknesses and risks. All in all, the recent changes being made appear to be for the better. They are steps in the right direction if only for the fact that they can become cornerstones of accurate and ethical financial reporting. In this issue, it is important to remember the stakeholders who peruse financial data and how inaccurate information affects their decisions and, by extension, firm performance and the health of the market. Transparency is another key factor here. This dimension to disclosure addresses the issues of abuse and ethics as well as an opportunity for accountability. References AICPA, 2006. AU Section 312: Audit Risk and Materiality in Conducting an Audit. [online]. Available at: . [Accessed 9 December 2014]. Auditing Practices Board (APB), 1995. Objective and General Principles Governing the Audit of Financial Statements. Statement of Auditing Standards No. 100. London: Auditing Practices Board. Brennan, N. and Gray, S., 2005. The impact of materiality: Accountings best kept secret. Asian Academy of Management Journal, 1(2005), pp.1-31. Butler, S., 2014. Criminal investigation launched into Tesco’s accounting. The Guardian. [online]. Available at: . [Accessed 14 December 2014]. Financial Reporting council (FRC), 2009. Louder than words. UKFRC. Available at: https://frc.org.uk/getattachment/7d952925-74ea-4deb-b659-e9242b09f2fa/Louder-than-words.aspx. Financial Reporting council (FRC), 2011. Cutting Clutter. [online]. Available at ,https://www.frc.org.uk/Our-Work/Publications/FRC-Board/Cutting-Clutter-Combating-clutter-in-annual-report.pdf>. [Accessed 8 December 2014].. Financial Reporting Council, 2013. Audit quality thematic review: Materiality. [online]. Available at: .[Accessed 8 December 2014]. Huang, P., 2005. Moody investing and the Supreme Court: Rethinking the materiality of information and the reasonableness of investors, Supreme Court Economic Review, 13(1),99–131. Gupta, K., 2004. Contemporary Auditing. New Delhi: Tata McGraw-Hill Education. Kearns, F., 2007. Materiality and the audit report: Its time for disclosure. Rocherster Institute of Technology. Langevoort, D., 2002. Taming theanimal spirits of the stock market: Abehavioral approach to securities regulation. Northwestern University Law Review, 97, pp.135–191. Messier, W., Martinov-Bennie, N. and Eilifsen, A., 2005. A review and integration of empirical research on materiality: Two decades later.Auditing: A Journal of Practice & Theory, November 2005. [online]. Available at SSRN: . [Accessed 10 December 2014]. Oppel, R.A. and Sorkin, A.R., 2001. Enron admits to overstating profits by about $600 million. New York Times, 9 November 2001. Palmiter, A., 2008. Securities Regulation: Examples and Explanations. New York: Aspen Publishers. Riadh, M., Hassan, L. and Njoua, E., 2011. The Impact of Qualitative Factors on Ethical Judgments of Materiality: An Experimental Study with Auditors. International Journal of Business, 16(3), pp.232-243. Tesco, 2014. Tesco Plc: Annual Report and Financial Statements 2014. [online]. Available at: . [Accessed 15 December 2014]. TSC Industries, Inc. v. Northway, Inc. 426 US. 438 (1976). Read More