Meaning of Materiality in Auditing - Essay Example

Materiality in Auditing Introduction Materiality is a concept that guides auditors in auditing the financial ments of an organization. This concept is the backbone of the auditing profession because it is a guide to carrying out auditing activities, and it is the most critical factor in an audit report. Materiality is critical in auditing because it helps auditors to reduce the risk of overlooking misstatements in the financial records, which may mislead users such as investors and the management. The concept also helps auditors in planning their audit and carrying out their functions swiftly. Materiality levels of organization are often undisclosed to avoid fraud that may be conducted by the parties involved in preparing financial statements. Analysis of the fundamentalism and the secrecy of materiality are essential in understanding how this concept is applicable in the auditing profession. Meaning of Materiality Materiality is a concept that describes discrepancies in the financial statements that may mislead the decision making process of users of those records (Stuart, 2012). The discrepancies may be included or omitted in the financial statements intentionally or as a result of errors in recording. If users of accounting records would not change their decision after the correction of the discrepancies, the misstatement are said to be immaterial. However, if users of financial statements would change their decisions after the corrections, then the discrepancies are said to be material (Messier, Martinov-Bennie, & Eilifsen, 2005, p. 5). Materiality in the financial statements may be individual or collective. Individual materiality is the one that occurs when a record in an account is recorded wrongly. Collective materiality, on the other hand, is the one that arises when the total discrepancies in two or more accounts of a similar classification mislead decision makers (FRC, 2013). Significance of Materiality in Auditing Materiality in Audit Planning Auditors have to determine the level of discrepancies that they will find to be immaterial and those that are material at the planning stage. The materiality level is usually stated in quantitative figures such as percentages. For example, the auditors may state that a misstatement of the income before tax by 5% and below is immaterial while the error is material of it exceeds this allowance (Lessambo, 2013). Examiners use professional judgement to determine the materiality allowances because there is no formula of calculating the amount. Auditors make their judgements based on their understanding of the factors that influence the decisions of users of financial reports (IAASB, 2009). The level of materiality allowance that auditors formulate is based on the balance of accounts either individually or in totality. The total materiality level is the one that is set on a class of accounts, for example, total debts. The materiality level of classes of transactions is known as performance materiality. The effect of performance materiality may be disastrous even if the single discrepancies in specific accounts seem harmless when they are evaluated single-handedly (Messier, Martinov-Bennie, & Eilifsen, 2005). Although materiality is usually stated in quantitative terms, auditors may also state this factor using qualitative measurements. The qualitative statements of materiality act as a support to the quantitative level of materiality in financial statements. Materiality in Concluding an Audit Materiality is also essential in auditing when making conclusions about whether financial statements are true and fair. The auditor conducts substantive tests on the records of transactions in a sample of the accounts of an organization (Taylor, & Osborne, 2013). The professionals then compare the discrepancies in the accounts with the materiality levels that were stated during the planning stage. If the discrepancies exceed the predetermined percentages, then the auditor concludes that there are material misstatements in the financial records. However, if the discrepancies are within the pre-determined limit, then auditors conclude that financial records are true and fair. The auditor writes a letter to the managers of an organization asking them to correct material errors in the records to avoid the qualification of the final audit report (Schmitt, 2012). Materiality and Audit Risk There is an immense relationship between audit risk and materiality because they have to be pronounced together in any situation; there is no single factor among the two that may be considered solely. Audit risk is the likelihood that an auditor may give the wrong opinion about the truth and fairness of the financial records of an organization (Mock, Turner, Gray, & Coram, 2009). The risk is divided into three sub-risks that include control, inherent, and detection risk. The professionals reduce audit risk when they determine the level of materiality that is acceptable in the accounts of a company. This is because the materiality levels act as a guide in helping the professionals to detect errors and frauds in account balances and in the total balances of various classes of transactions (Trussel, Frazer, & Hoyle, 2012). The levels guide auditors in that they help them to determine the accounts that are highly risky and to choose procedures that are efficient in discovering discrepancies in financial records. IAASB (2009) argue that the relationship between the level of materiality and audit risk is converse (p. 5). This means that when the level of materiality is low, audit risk is high, and when the level of materiality is high, audit risk is low. This relationship between these factors acts as a guide in helping auditors to plan their engagements. For example, when the materiality level of an account is low and audit risk is high, the professionals choose a large sample of transactions from which to gather evidence in this account. However, when the materiality level of high and audit risk is low, auditors choose less complex procedures and smaller samples for gathering evidence (McLean, & Elkind, 2004). The other relationship between audit risk and materiality is that both factors may be stated quantitatively; the two may also be stated in qualitative terms. The last significance of materiality in auditing is that it helps auditors in advising the managements of organization on how they may prevent errors (Lessambo, 2013). This is because the level of materiality sheds light on the auditor about how the control system may prevent misstatements. The auditor also understands the likelihood of employees of conducting fraudulent activities. This then helps managers in installing systems that are able to detect the errors and frauds even before the auditor discovers them; this is beneficial to the examiner because it reduces audit risk. Secrecy of Materiality Levels Mock et al. (2009) argue that materiality levels are too secretive that they exceed the secrecy of Coca Cola’s secret formula (P. 4). This is because these authors believe that if materiality did not exist, the Coca Cola secret formula would be the most reserved. The auditing profession requires auditors to maintain the confidentiality of the information of their clients. This means that auditors have to ensure that they do not expose any piece of information to other parties apart from the client. Since materiality is one of the factors in the financial statements of a client, it means that auditors need not to inform anyone about this information. The exposure of such information to parties other than the client may cause liability on the auditors towards their client (Messier, Martinov-Bennie, & Eilifsen, 2005). Secrecy of Materiality Information prevents Fraud Materiality is also a secretive factor in auditing because the exposure of this factor may lead to fraud, which an intentional inclusion or omission of critical information in the financial records of a company (FRC, 2013). For example, if the auditor informs workers of a client about the acceptable level of materiality, these employees may start manipulating accounts by including discrepancies that are within the acceptable level of materiality. This is because the workers presume that auditors may ignore misstatements that are within the acceptable level of materiality because these are said to be immaterial (Stuart, 2012). The management of an organization may also cause discrepancies that are within the acceptable level of materiality if they know this amount in advance. Therefore, auditors maintain the secrecy of the materiality levels of a client to avoid intentional discrepancy caused by employees and the management. Secrecy of Materiality Information prevents Audit Risk The secrecy of materiality information helps to reduce the audit risk that auditors face when they investigate the statements of a company. When auditors refrain from exposing information about the materiality levels of accounts of a company, they reduce the risk of expressing wrong audit opinions (FRC, 2013). This is because the confidentiality of this piece of information motivates organizations to promote efficiency at all levels because they are not aware of the acceptable level of misstatements. The maintenance of accuracy in the records also saves time for auditors because they examine only few sample records of their client’s accounts. Secrecy of Materiality Level and Code of Ethics of Auditors The code of ethics of auditors requires them to maintain confidentiality and independence when carrying out their activities (Mock, Turner, Gray, & Coram, 2009). This means that auditors who break this rule face the possibility of being punished by the audit regulatory bodies of their countries. Auditors who fail to adhere to this requirement also risk their profession because their regulatory bodies may seize their operations by invalidating their certificate (Taylor, & Osborne, 2013). This would have an effect of leading to the joblessness of the auditors and their assistants, which may then force examiners to change their profession. Although auditors should preserve the confidentiality of materiality levels of their client’s account balances, this secrecy may be disadvantageous at times. This is because auditors use realistic judgements to determine the materiality levels of various accounts in companies (IAASB, 2009). Whatever is realistic to one auditor may be unrealistic to another. This means that auditors need to discuss various issues so that their techniques of determining materiality levels may match. However, since the profession prevents examiners from discussing about the financial statements of their clients, this creates a risk of determining incorrect materiality levels of an account balance. The wrong determination of a materiality level may then ruin the image of an auditing organization. Case Study of Arthur Anderson Auditing Company and Enron Arthur Anderson auditing company was in charge of examining the books of Enron Corporation before the time of the company’s collapse. The organization had often realized various misstatements in the records of Enron; for example, in 1997, the profit of the organization was $51 million, but it had been recorded as $105 million (McLean, & Elkind, 2004). The misstatement in the profits of the organization was a result of factors such as false salaries and bonuses to the management. Although Arthur Anderson had identified some of these discrepancies, the auditing firm had concluded that they were not material. However, when the company became bankrupt in 2002, a close examination of the records of Enron indicated that the misstatements were material (Trussel, Frazer, & Hoyle, 2012). The company collapsed because of bankruptcy and the truth came to light that some members of the management were defrauding the company of its funds. This also had an effect on Arthur Anderson, the auditing company of Enron in that its clients lost confidence in the organization’s proficiency. The public image of the organization was also ruined because it was discovered that some employees of the firm colluded with the workers of Enron (McLean, & Elkind, 2004). This made it easy for Enron’s management to swindle the company’s records. New Materiality Disclosure Regulations IAASB has recently developed a regulation that requires organizations to include auditor’s statements of materiality disclosures in financial statements (Smith, 2014). The board argues that the inclusion of components of materiality disclosures in financial statements may enable interested stakeholders to comment about these factors. These stakeholders, therefore, guide auditors in determining materiality levels when they comment on the disclosures in the financial statements. Although this regulation helps auditors to become efficient, it dilutes their independence (Smith, 2014). This also creates room for organizations to manipulate financial statements by including errors. Therefore, it is not possible to determine whether this regulation improves financial reporting or not. Conclusion Materiality is an auditing concept that guides auditors in the planning, execution, and analysis of audit activities. The idea refers to the discrepancies that exist in the financial records of organizations and their effects on the decisions made by users of financial statements. Auditors determine materiality using their own judgement. Materiality is critical in auditing because it enhances audit planning and conclusion, and it helps to prevent audit risk. This is because the acceptable level of materiality enables auditors to choose efficient samples and determine procedures that are efficient in discovering misstatements. Materiality concept remains a secret of auditors because their professional code of ethics requires them to maintain confidentiality of information. The secrecy of materiality also enables auditors to prevent fraud that would result by exposing the figures. Some auditors may be unable to determine materiality levels of errors in financial statements, for example, Arthur Anderson Company was unable to discover the materiality of discrepancies in the financial statements of Enron Corporation. This means that the secrecy of the figure may be disadvantageous because what one considers to be immaterial may be material to another person. References Financial reporting council (FRC), 2013. Audit quality thematic review: materiality. FRC. [Online]. Available at < https://frc.org.uk/Our-Work/Publications/Audit-Quality-Review/Audit-Quality-Thematic-Review-Materiality.pdf> [Accessed 10th Dec 2014]. IAASB, 2009. Materiality in planning and performing an audit. International standard on auditing (ISA) 320. Pp 322-331. Lessambo, F. I., 2013. The international corporate governance system: Audit roles and board oversight. Hampshire: Palgrave Macmillan. McLean, B., & Elkind, P., 2004. The smartest guys in the room: The amazing rise and scandalous fall of Enron. New York: Portfolio. Messier, W.F., Martinov-Bennie, N., & Eilifsen, A., 2005. A review and integration of empirical research on materiality: two decades later. A journal of practice and theory. pp 1-51. Mock T., Turner, J.L., Gray, G.L., & Coram, P.J., 2009. The unqualified auditor’s report: a study of user perceptions, effects on user decisions and decision processes, and directions for further research. [Online]. Available at < http://www.ifac.org/sites/default/files/downloads/Study__1_ASB_Summary_Report.pdf> [Accessed 10th Dec 2014]. Schmitt, D. B., 2012. Advances in accounting behavioral research: Vol. 15. Bingley: Emerald. Smith, S., 2014. Exposure draft, proposed changes to ISA’s- addressing disclosures in the audit of financial statements. IFAC. [Online]. Available at https://www.ifac.org/sites/default/files/publications/exposure-drafts/comments/KPMGCommentLetter-EDAddressingDisclosuresintheAuditofFinancialStatements.pdf [Accessed 16th Dec 2014]. Stuart, I., 2012. Auditing and assurance services: An applied approach. New York: McGraw-Hill. Taylor, J. R., & Osborne, J., 2013. Auditing. Worcester: Osborne Books Limited. Trussel, J., Frazer, J. D., & Hoyle, J. B., 2012. The Lakeside Company: Case studies in auditing. Boston: Pearson. Read More