Materiality in Auditing - Research Paper Example

MATERIALITY IN AUDITING Contents MATERIALITY IN AUDITING Contents What is Materiality Importance of Materiality in the audit: 2 Materiality Level Should be Secret: 3 The Academic Research on Materiality 3 Changes in Audit Practice: 6 Recent Example: 7 Bibliography 9 What is Materiality? Materiality refers to the significance of an amount or transaction. It can also be explained in terms of discrepancy or an amount of transaction i.e. if the discrepancy is large or the amount is big enough to have significance or importance for the company then the discrepancy and amount are considered as material from the perspective of the audit (Bragg, 2011). The major objective of an audit is to help and enable the auditor to evaluate whether the financial data that is financial stamen is prepared in accordance with the required framework of financial reporting or not (Graham, 2012) . In other words, whether the reports are prepared in conformity to all the material respects or not. The information is considered material if it has significant impact on the decision making process. If the omission of the information from the financial report can influence economic decision then the information is believed to be material (Williams, 2002). Materiality in auditing is the key concept to understand and evaluate for all the auditors. The job of auditors, whether internal or external, is to identify the materiality while making the audit report of the company. Materiality can be determined using qualitative aspects of the business. The qualitative aspect refers to the significance of a particular transaction which may not look big in size but may have importance because of the nature of the transaction (Zadek & Merme, 2003). There are various qualitative factors that are approached by the auditors to make realistic and authentic decisions. Some of the factors are (1) Likelihood of earning management, (2) Misstatement of share price, (3) Misstatement on projected earnings, (4) Likelihood of financial statement fraud, (5) Ineffective audit control culture, (6) Litigation risk, (7) Fraud detection or its symptoms etc. (Zabihollah & Riley, 2009) The nature of transaction can also be explained in terms of the disclosure regarding the financial transaction, which may not be significant in terms of size but lack of proper disclosure may have significant impact on the presentation of the business structure (Gupta, 2004). Importance of Materiality in the audit: Now the question arises, how much the concept of materiality is important in audit process? The answer is explained using the literature review on materiality. The increase in requirement of information in more civilized financial market requires that more stringent audit process must be conducted to identify the facts on which the quality of the business process can be judged (Puncel, 2007). Therefore, all the factors that contribute significantly towards the business decision making process are referred as material information. The material information has dominance in the business cycle, as well as, economic cycle of the organization. The access of such material information is considered important for the business to identify and rectify the loopholes, which may ultimately leads to success (Moraru & Franca, 2012). The audit report includes the materiality in terms of number, which represents the value in the report. The value is reported in the reports because auditor observes that the value is wrong and if the value were reported correctly then the performance results of the company would have been different (Rittenberg,, et al., 2011). Therefore, reporting materiality always play one of the most important role in the audit process. In most cases, if the materiality is not reported in the audit report then the report may be considered as unqualified report. The unqualified report is referred to as the report with no requirement of qualified opinion. In other words, an unqualified report is the one in which an auditors has made no reservations regarding the reporting of financial information of the company (Ndreca, 2013). Materiality Level Should be Secret: The Materiality level and indicators, which are being used by auditors, should be kept secret. The companies can very smartly manipulate the material information, if they know in advance the perspective of the auditors regarding materiality. Disclosed criteria of materiality may lead the auditor’s report to the wrong results. Therefore, it is considered better that the materiality level should not be disclosed (Cannon, n.d.). There are different perspectives regarding the secrecy of materiality level by auditors. One view says that the materiality levels should be clearly disclosed in advance so that the companies can understand the importance, as well as, the significance of specific transactions or discrepancies. This results in the better management of the financial information. In addition to this, rather than putting more efforts in the areas of business, which may not add value to the business. It is better to emphasize those areas which are considered to be more important and significant both from business point of view and audit point of view (Brennan & Gray, 2005). Moreover, the disclosure of materiality levels the companies from the auditors may also help the auditors to more easily educate the companies regarding the disclosures of financial information. On the other hand, the challengers of the view claim that the materiality levels should be secret say that the materiality levels must not be disclosed by the auditors, so the auditors can clearly identify the business process and mitigate the wrong results of audit (Cannon, n.d.). The Academic Research on Materiality There are number of different academic researches that are conducted regarding the importance of materiality and maintenance of secrecy level in the audit report. Moraru Maria and Dumitru Franca in their research report on the “Importance of Materiality in Audit” (2012) identified and explained the materiality in audit from the perspective and references of different research reports including their own evaluation of the importance of materiality in audit. The research report indicates the major objective of the financial audit is that the auditor must provide assurance regarding the reporting of financial information by the company (Moraru & Franca, 2012). In addition to this, auditor must also provide assurance that the reported financial information is complete and accurate. If the information is not complete or inaccurate then it must be reported in the audit report and the report will be considered as the qualified report. Moreover, if the misrepresentation is based on that transaction, which is considered as material then the auditor must report it separately and provide detailed qualified advice regarding the rectification (Needles & Powers, 2013). The auditor has the authority to ask from the company executive to justify the material misstatements and may impose penalties on the company. The auditor can also downgrade the credit rating of the company and the company may have to face problems in raising further capital in the shape of debt because the company will be considered as more risky and creditors may demand higher rates against lending to the company (Anson, et al., 2004). Another research article by James Brady Vorhies on the “The New Importance of Materiality” (2005) identifies that the reasonable investment may not affected or influenced in investment decision making process if the fluctuation of the profitability is within the range of 5. The research indicates that on the basis of numbers, the profitability determines the materiality if the volatility of net income moves beyond the range of 5% (Vorhies, 2005). The assumption of 5 % range is based on the fundamental estimates for the materiality. The fundamental estimates of materiality can also be explained in terms of sales figure fluctuation, if the fluctuation, which may also define the volatility of 10% fluctuation range of sales figure per year. If the fluctuation moves out of the specified range then the movement will be considered material otherwise, the audit report will give positive remarks regarding the performance of the company. Niamh Brenan and Sydney J Grey in their research report on “The Impact of Materiality: Accounting Best Kept Secret” (2005) identifies both the importance of materiality in audit and Secrecy level of materiality in audit report. The research report elaborates and identifies the context in which materiality is important in the audit process. The relevancy of materiality is considered an important factor in the audit process along with the issues that may arise that may arise in the audit process regarding the identification of materiality. The research reports clearly explains that concept of materiality one of the most important and critical aspect of audit in accounting. The importance is explained both in terms of accounting of items and auditing of the financial statements (Kwok, 2005). This implies that the without materiality the quality of the audit report cannot be justified. Moreover, regarding the secrecy of the materiality in audit, the report indicates that the best kept secret of materiality should be reported to all the shareholders so that they can be able to understand the actual performance of the organization. In addition to this, the secrecy regarding materiality must be disclosed after the audit. In addition to this, the research also identifies that there is no need of the preparers of the accounts or for auditors to disclose their approach on the materiality decisions (Previts, 2008). They suggested that the disclosure of materiality decisions may only be made when there is a requirement in relevant accounting policy. The research also indicated the method of disclosure of material decision making (Houghton, 2010). The materiality decisions must not be disclosed in the shape of detailed calculations but should be disclosed in the form of results. In other words, the materiality levels should only be disclosed in terms of final numbers not in terms of how the numbers were calculated. The reason is that the users of the report may not be concerned with the calculations of the results or it may be cumbersome for the readers to understand the calculations but it is easier to see the final results (Brennan & Gray, 2005). Changes in Audit Practice: The Securities and Exchange Commission, Sarbanes Oxley Act , Auditing Standards Board and International Auditing and Assurance standards board raised the concerns in 2004 regarding the materiality. The major concern that was expressed by the above mentioned bodies regarding materiality was the concept of materiality that was implied in financial reporting and auditing. The argument, which was raised at that time, was that most of the companies were misusing and abusing the meanings and concepts of materiality while reporting their financial information to auditors (Bennie , et al., 2005). The reason may be the disclosed criteria of materiality levels. In addition to this, the companies intentionally misreport some numbers in the financial information and assume the numbers were not material to the business process. Afterwards, the companies argue on these errors by saying that the transactions are too small to have impacts on the business process. However, as discussed in the beginning of the paper that the materiality does not only mean the discrepancies occurred because of the size of the transaction but materiality may also arise because of the nature of the transaction. After presenting the concerns on materiality, Commissioner Levit in 1998 instructed the Securities and Exchange Commission staff to evaluate the importance of the argument and examines the problem (Bennie , et al., 2005). The staff, after detailed examination of the problem, developed the guidance and standards for the determination of materiality in terms of the qualitative factors. The Staff Accounting Bulletin was then released, which is also called as SAB No. 99 (Bennie , et al., 2005) Other recent developments in the practice of materiality in audit includes the attestation standards In US, The standards include various subject matters. The examples of such subject matters include the internal control methods and management discussions. In addition to this, recently IAASB passed its framework for the sustainability reporting (Bennie , et al., 2005). Recent Example: In the audit report of TESCO PLC, it was identified that the financial information was proved to be reported correctly with no materiality. In the page 65 of the annual report of TESCO PLC the following point was mentioned (Tesco PLC, 2014): This indicates that the point that the auditors explain that if they do not receive the relevant information from the company then the auditors have the responsibility to report the issue without any exception. This clearly indicates the responsibility of the auditor regarding the audit process and materiality regarding the financial information of the company Conclusion: The detailed evaluation of materiality, its importance, secrecy levels and recent developments in standards identifies that the materiality is one of the most important factor in audit planning and designing of audit report. The secrecy levels must also be defined properly and it is better not to disclose the secrecy of the materiality to the company before the audit otherwise they may be able to manipulate the reporting process more smartly. In addition to this, the recent progresses in the audit practice standards regarding materiality serve the suitability of the audit process i.e inculcation of the attestation process and guidance regarding the determination of materiality in terms of qualitative factors can help improve the reporting quality of the financial information by the company and audit reports have improved the accuracy level regarding the identification of materiality. Therefore, the recent development is for the better. Bibliography 1. Anson, M. J. P., Fabozzi, F. J., Choudhry, M. & Raw Chen, R., 2004. Credit Derivatives: Instruments, Applications, and Pricing. 10th ed. s.l.:John Wiley & Sons. 2. Bennie , N. M., Messier Jr, W. F. & Eilifsen , A., 2005. A Review and Integration of Empirical Research on Materiality: Two Decades Later. Auditing: A Journal of Practice & Theory. 3. Bragg, S. . M., 2011. Wiley Practitioners Guide to GAAS 2012: Covering all SASs, SSAEs, SSARSs, and Interpretations. s.l.:John Wiley & Sons. 4. Brennan, N. & Gray, S. J., 2005. The Impact of Materiality:Accountings Best kept Secret. Asian Academy of Management Journal of Accounting and Finance, Volume 1, pp. 1-31. 5. Cannon, S., n.d. Bank Secrecy Act Auditing for Community Banks:A risk-based Approach, s.l.: Advancing Financial Crime Professionals worldwide. 6. Graham, L., 2012. Accountants Handbook, Financial Accounting and General Topics, Volume 1. s.l.:John Wiley & Sons. 7. Gupta, K., 2004. Contemporary Auditing. 6th ed. s.l.:Tata McGraw-Hill Education. 8. Houghton, K. A., 2010. The Future of Audit: Keeping Capital Markets Efficient. s.l.:ANU E Press. 9. Kwok, B. K. B., 2005. Accounting Irregularities in Financial Statements: A Definitive Guide for Litigators, Auditors, and Fraud Investigators. s.l.:Gower Publishing, Ltd.. 10. Moraru , M. & Franca, D., 2012. 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Redefining Materiality:Practice and public policy for effective corporate reporting, s.l.: AccountAbility. Read More