Materiality in Auditing - Essay Example

Materiality in Auditing Economic growth is now opening wide roads for investors to invest in booming businesses. After the recent economic shock, investors and shareholders started to make cautious investment decisions that led businesses to focus on the credibility and accuracy of financial documents. The main purpose behind is that financial statements are the main drivers for investment decisions in a firm, and the accuracy of the information is vital to satisfy stakeholders of the process. If the interpretation of data reveals mistakes in financial statement will not only lead to errors and losses but also aggravate the business image in financial markets. Financial mistakes are not always unintentional instead there is a culture of making misstatements in accounting due many reasons including unexpected errors, mistakes or negligence level of misstatement and/or fraud cases. Pointing out and examining the level of misstatement and its impact on the whole financial performance is one of the major concerns of auditors. Rittenberg, Johnstone, and Grambling (2011) suggested that the point or level of misstatements or materiality in data possess high concerns of auditors’ judgments and experience. The term “materiality” refers to the acceptable level of misstatement according to the experience and judgments of the auditors that do not affect the decisions of financial statement readers (Financial Accounting Standard Board). It sounds vague that a highly sensitive document and its materiality issues are left only to the judgments and knowledge of the auditors. Unfortunately, it is widely practiced and kept secret by the auditors as stated by Mock, at el (2009). The gaps in the phenomena are vital and should be covered with identifiable measures. It is necessary to develop a level of understanding for establishing accurate measures to address the problem. For the purpose of getting deep insight of the matter of materiality in auditing, the piece of writing is crafted to define and discuss wider aspects of materiality. The importance of materiality is apparent in the making of financial statement. International Accounting Standard board’s conceptual framework for preparing financial statements defined materiality as the data become “material” if its alteration or omission affects the stakeholders’ decisions (Todea, Joldos, and Cioca, 2013). To elaborate materiality is the cut-off point of accepting material data to the level up to which it does not impact in decision-making via financial statement drivers. Although, IASB and other responsible institutions defined the phenomenon and suggested guidelines to be followed, but it is difficult to impose quantifiable measure for the significance of the matter. Accepting the significance, role and need of materiality, it even cannot be determined that what level of materiality is viable in pertaining situation or up to what level it will not be intervene in the decision-makers’ perception. Instead of pre-built strong measures for identifying and adding materiality, it is the concern of financial reporters and auditors only and dependent on the understanding and given importance of both of the stakeholders. Determining materiality level by revealing the materials misstated by reporters is the concern of auditors. Auditors according to their experience and judgment define a tolerable degree of materiality for a certain situation that will according to them not affect the decisions. Materiality in financial reporting intentional or unintentional, small or may be very small lead to enhance material data. Auditors should take strict notice of materiality even of a small amount as it finally leads to misstated affecting materials. Rittenberg, Johnstone, and Grambling (2011) suggest that materiality exhibit high risks are associated with the impact of misstated information in the financial document. Mainly the risks produced due to misstated information are categorized as three classes including financial statement level risk, Audit risk, and detection risk and affect the quality of the audit report. It is to mention here that inherent and control risks fall in the financial statement level risk are controlled by clients during preparation of financial statement. According to international Standards on Auditing (2009), an audit risk refers to the risk associated because of biased or incautious verdict on the material misstatements. On the other hand, detection risk accounts for the matter that auditors’ set standards for materiality misstatements are insufficient in finding materials in the report. Inherent and control risks if not controlled during production of the financial report augment audit risks of misstatement as well as detection. The key for producing quality document is maintaining standards imposed, showing cautious behavior and having wide understanding of the matter. Another factor that favor the existence of materiality and hurt the quality of audit is the level of secrecy that is maintained about the degree of materiality present in the audit report. Some of the cut-off point acceptable level are disclosed for the relaxation of matter but in practice, there is no any vital implication that suggests the application of the standards. For instance, (CFRR, 2013) imposed that alteration in pre-tax income up to 5% to 10% while 1% to 1.5% in total asset or revenue is acceptable. Rittenberg, Johnstone, and Grambling (2011) maintains that there are opinion differences of auditors and management of the firm about the materiality that lead to maintain secrecy. Ownership and consent of firms matters in the transparency of audit reporting. For instance, management can persuade auditor to manipulate the information by adding materiality in interest of the firm and keep the facts secret. Deep insight of the matter provide evidence that auditor is the authority itself that can control materiality, judge the suitable measures to be imposed in a particular case, and maintain the level of transparency by revealing relevant matters to the management and auditor teams (Butler, Leone, and Willenborg, 2004). The matter of transparency of the public document is also taken into account by the chief accountant of SEC in 2001, where he mentioned in a speech that transparency of public interest financial document plays a fundamental role in making efficient markets (Turner, 2003). Secrecy level is also concerned for the matter of detecting frauds in information, where fraud is accounted for intentional manipulation in the data for the sake of personal benefit or omitting errors. Information dissemination in the matter is also important to reveal the adultery at the level as well as safeguarding future transactions. Materiality is a wide concern of auditors and researchers from decades and measures for improving the matter is continuously enhancing. To develop practical standards for the improving the quality of auditing report, many auditors augmented the field by reviewing and adding valuable considerations. For instance, Jennings, Reckers and Kneer (1991) presented auditor’s dilemma of differences in real practice and the stated measures of the field. The research was focused to find out the level of difference in between described and practiced measures of the profession. From the perspective of investors, (Huang, 2005) augmented the viewpoint of the intervention of materiality in the investment decision-making and suggested that materiality definition should wider its scope via taking into account investors’ ability to extract information from the report. Further, many of the researches are conducted, and papers are produced to address the issue of secrecy in materiality. Kearns (2007) in his paper stated that it is viable to mention the level of materiality maintained in the document to reduce the impact of secrecy on the information presented. In addition to this, (Hope et al., 2008) taken into account the cultural implication on the matter and suggested that the societies with less openness can influence toward keeping secrets and can show reluctance towards hiring quality audit firms. Some of the researchers argued that there is a lack of rules about materiality is present that the augment the issue arising because of materiality of audit practices. For instance, Scharfman (2012) claimed that it is useless to consider the information of financial statements in order to make decisions as there are no rules regarding materiality so financial statement are the product of auditors’ writing. Audit regulatory authorities in the interest of producing quality and comprehensive information, are changing the regulations about the materiality to a higher level of concern continuously. For the purpose, international standard of auditing (ISA-320) developed a plan for the assistance of auditors in applying and disclosing the matter of materiality and made effective from 2009. Recently PCAOB (public company of accounting of the oversight board) has imposed a standard of materiality consideration for the purpose of planning and performing in the audits (PCAOB, 2010). Auditor will have to follow the standards in planning and conducting an audit and by setting required level of materiality acceptable in the situation for particular reporting. Regulation imposed by PCAOB also employs auditors to take implications of standards at multiple areas of the audit report PCAOB, 2010). Some of the other regulatory committees and authorities are developing set of conducts for the purpose. However, finally, it is to accept that the level of materiality and secrecy issues are still on the consent of auditors and can be manipulated by their instinct intervention or because of the requirement of the situation. The gap mentioned decreases the ability of regulations to control the matter of materiality application and secrecy. For instance, UK Financial Reporting Council in 2013 presented a report on the auditors conducts based on the performance of many top audit service provider companies. This report revealed that financial reports are mostly outcomes of errors and misstatements detected instead of credible information. The reason behind that is firms can set their standards for acceptability of materiality and lack of giving justification for taking the measure. The report and other evidence lead to the insight that developing and imposing regulation are not enough to control the auditors’ authority in the matter instead there must be some measurable tools to get control of the matter. As mentioned in the beginning, the economic downturns, organizations’ fraud scandals and declining credibility of financial documents are imposing quality measures on provided information. The regulations discussed above are developed and imposed to serve for the quality development of audit reports. According to Zadek and Merme (2003), more information should be public in order to increase the credibility of the process and report. Audit quality of the public body is now widely becoming the concern of regulatory authorities and concerned governments. For the matter, European parliament in 2014 proposed that there should mandatory rotation of audit firms in order to improve the credibility and transparency of the audit reports going public. Despite having, sufficient guidelines and regulation, materiality misstatements and high secrecy level in the reporting are the outcome mutual consent and agreement of the stakeholders that are auditors and financial reporting officials. To make the regulations’ implications viable on the process, it is necessary to develop a process flow of information dissemination for the matter if materiality (Butler, Leone, and Willenborg, 2004). Here, the issue is to change the culture of secrecy on different levels including government institutions to auditors. The authority of judgment allow auditors to Safeguard mutual interests, ownership interests as well as government interests where applicable (Guedhami, Pittman, and Saffar, 2009). Although regulations imposed are gaining attention of stakeholders toward the matter but there is a need to embrace and develop a new culture via practicing impartiality. Investigating the phenomena of materiality, secrecy, and impact in context of auditing and financial reporting, it is revealed that economic downfall and occurrence of fraud cases imposed high pressures on the audit industry to reduce the amount of materiality from final documentation and increase the credibility and truthiness of the data in favor of stakeholders by increasing visibility (Zadek and Merme, 2003). Further, governments and regulatory bodies should cautiously develop quantitative and standardized tools to help auditors in producing quality reporting instead of only believing on the experience and judgments. Moreover, comprehensive measures in the form of code of conduct should be imposed regarding the secrecy maintenance about materiality. List of References Butler, M., Leone, A. J., & Willenborg, M. (2004). An empirical analysis of auditor reporting and its association with abnormal accruals. Journal of Accounting and Economics, vol.37, no. 2, pp. 139-165. CFRR. (2013). Materiality – Concepts And Approaches : Audit Training-of-Trainers Workshop . Available from http://siteresources.worldbank.org/EXTCENFINREPREF/Resources/4152117-1270824012230/6954188-1363857566454/Materiality_JT.pdf [Accessed 11 December 2014]. Guedhami, O., Pittman, J. A., & Saffar, W. (2009). Auditor choice in privatized firms: Empirical evidence on the role of state and foreign owners. Journal of Accounting and Economics, vol.48, no.2, pp.151-171. Hope, O. K., Kang, T., Thomas, W., & Yoo, Y. K. (2008). Culture and auditor choice: A test of the secrecy hypothesis. Journal of Accounting and Public Policy, vol. 27, no. 5, pp.357-373. Huang, P. H. (2005). Moody investing and the Supreme Court: Rethinking the materiality of information and the reasonableness of investors, Supreme Court Economic Review. Vol.13, no.1,pp 99–131. Jennings, M. M., Reckers, P. M., & Kneer, D. C. (1991). The auditors dilemma: The incongruous judicial notions of the auditing profession and actual auditor practice. American Business Law Journal, vol. 29. no.1, pp.99-126. Kearns, F. E. (2007). Materiality & the audit report: Its time for disclosure. Available from https://ritdml.rit.edu/bitstream/handle/1850/8790/FKearnsArticle2007.pdf?sequence=1 [Accessed 11 December 2014]. Mock, T., Turner, J., Gray, G., and Coram, P. (2009). The Unqualified Auditor’s Report: A Study of User Perceptions, Effects on User Decisions and Decision Processes, and Directions for Future Research. A Report to the Auditing Standards Board and the International Auditing and Assurance Standards Board (June). New York, NY. PCAOB. (2010). Auditing Standard No. 11 Consideration of Materiality in Planning and Performing an Audit. Available from http://pcaobus.org/Standards/Auditing/pages/auditing_standard_11.aspx [Accessed 11 December 2014] Rittenberg, L., Johnstone, K., & Gramling, A. (2011). Auditing: A business risk approach. Cengage Learning. Scharfman, J. A. (2012). Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation, and Documentation (Vol. 770). John Wiley & Sons Todea, N., Joldos, A., and Cioca,I. (2013). Considerations regarding materiality calculation and audit risk in the context of the guidelines for audit quality. Available from http://www.fse.tibiscus.ro/anale/Lucrari2013/Lucrari_vol_XIX_2013_117.pdf [Accessed 11 December 2014] Turner, J. L. (2003). Aligning auditor materiality choice and the needs of a reasonable person. Journal of Forensic Accounting, vol. 8, pp. 29-52. Zadek, S., & Merme, M. (2003). Redefining Materiality: Practice and Public Policy for Effective Corporate Reporting. Institute of Social and Ethical Accountability. Read More