Mmateriality and Its Relevance in Auditing - Essay Example

MATERIALITY IN AUDITING 13th December Materiality in Auditing Materiality refers to the extent of a miss ment; wrong disclosure or wrongly classifying of accounting information that is likely to change the judgment of the user of the information. It is the last and most important test of the kind of information that is supposed to be provided in a particular set of financial statements. To increase the importance of the financial information, the test should ascertain if what is contained in the resulting information is significant so as to be included in the financial statements (Kwok 2005, p.145).This essay will discuss materiality and its relevance in auditing. Materiality is more of a limit point than a main qualitative feature that the information must have so as to be significant. It shows the need of omission or presentation of the accountancy information that defines the decision making of the users of that information. The materiality that is adopted should represent the value in the report with which it is being determined. It should indicate whether the miss-statements and omissions in the accounts, show whether the accounts offer a true, complete, accurate and fair view of the financial position and performance of an entity. Consequently, materiality represents the degree of error under which the understanding and interpretation of the financial statements will not be greatly affected. On the other hand, it represents the degree of error that is acceptable in order to make a decision on whether the accounts are true or false (Maria and Franca 2012, p.268). According to Maria and Franca 2012, p.268, the major users of the financial audit reports are the shareholders. The audit report gives a guidance to the shareholders on how they will go about their business and on coming up with strategic decisions. The financial auditor assesses whether the true image of financial statements is observed. The assessment by auditors is necessary so as to ensure that the decisions of the shareholders are not influenced. To determine materiality the financial auditor is supposed to determine the user of the financial information; establish how the information and the process of making decisions are connected. He is also supposed to identify what decisions the user will take on the grounds of the audited financial statements. The financial auditor should make important comments regarding the scope of the financial audit that show the materiality. His liability is fixed to the important information established by a materiality determined by the financial auditor on the grounds of the professional reasoning. Materiality is significant in the entire auditing process. It is especially important to the planning of the audit and in the evaluation of the results of audit testing. The assessment of what is material depends on the professional judgement.At the planning stage, the auditor determines an overall magnitude of materiality that is used to develop the area covered by the audit (Messier 2005).Auditors allocate a part of the planning materiality to account balances or various transactions. The allocated amount is referred to as the tolerable misstatement. It stands for the amount by which the account or the kind of transactions can be misstated and not be deemed material. Upon completing the audit, detected misstatements are compared to tolerable misstatements. This is done to ascertain whether the materiality in the misstatements warrants changes to the entity’s books of accounts .Auditing standard show that, planning materiality should be the same as evaluation materiality if based on the same information Audit issues related to materiality mostly involved evaluation materiality and not planning materiality. The application of appropriate audit judgment to the evaluation of the importance of the detected misstatements is the problem and not the level of materiality used to plan the extent of the audit (Auditing Practice Board 1995). According to Brody et al. (2003), a significant example of this issue is the $51 million adjusted that was waived by Arthur Andersen on Enron’s Audit of 1997.Andersen argued that this amount was not material using an average of annual reported earnings Several Government sources were critical of this materiality judgement.Nevertheless, Brody et al. (2003) indicates that the majority of professional materiality guidance are in support of Andersen’s decision to waive the adjustment as immaterial. It is a requirement by the Law on Audit (LA) that auditors should follow the general principles of professional ethics. These ethics include that of confidentiality and professional secrecy during the course of the audit. This principle requires that an auditor must keep secret the information that is provided to him by his client. He is not meant to tell it to a third party unless if required to disclose by a third party. The auditor also should not use the information of the entity he is auditing for his interests. An auditor must not transmit the materials collected to use for drawing up of an auditing plan. (OECD 2013, P.65). The new reporting requirements for auditors under ISA (UK $ I)700 ,affecting accounting periods starting on or after 1st October 2012,require the practitioners to report how the materiality concept has been applied in the planning and performance of the audit. The new requirements are to make the influence of materiality more visible on the audit work to investors and other users of the accounts and help them to engage directly with audit committees in relation to this area. The FRC will monitor how auditors are applying the new reporting requirements in practice during 2014.They should also consider the implications for other initiatives designed to enhance the quality and value of auditing and the effectiveness of auditors’ communications with stakeholders (The Financial Reporting Council Limited 2013). In the recent past, there has been a tendency of firms making changes to their guidance of materiality to be set at a higher level. Materiality levels should show the perceived financial information needs of users of the financial statements; this indicates that auditors believe the needs and expectations of users have changed. These changes may result in the amount of audit work performed. Audit committees are meant to seek to understand the reasons for and the effect of any increase in the materiality levels. They should ascertain whether auditors believe that the needs and expectations of users of the entity’s financial statements have changed, and the likely impact on the level of audit work undertaken. According to the Audit Quality Thematic Review-Materiality of December 2013, the extent and quality of sector specific guidance varied between firms. There was a sector-specific direction in several firms covering industries where the judgments required may be more complex. Such sectors include pension funds, mutual funds, insurance companies, banks and building societies, mining companies and real estate companies. A more detailed qualitative guidance around the setting of component materiality and the reporting of unadjusted misstatements to audit committees has been issued to a number of entities. ISA (UK & I) 320 states that making a plan of the audit for the only purpose of detecting individual material misstatements is not enough. It ignores the fact that the total of individual immaterial misstatements may lead to material misstatement. It also leaves no margin for misstatements that have not been detected. Performance materiality is set to reduce to an appropriate low level the probability that the aggregate of uncorrected and undetected misstatements in the financial statements is greater than the materiality for the overall financial statements. Performance materiality relating to a materiality level determined for a particular class of transactions, account balance or disclosure is set to reduce to an appropriate low level. The determination of performance materiality is not a simple mechanical calculation and involves the exercise of professional judgement.It is the exercise of professional judgement.It is affected by the auditor’s understanding of the entity, updated during the performance of the risk assessment procedures; and the nature and the level of misstatements identified in previous audits and thereby the auditor’s expectation in relation to misstatements in the current period (ISA (UK & I) 320). An example reflecting the changes made to ISA (UK and Ireland) 700 made in October 2012 and June 2013 is as seen in the independent auditor’s report to the members of XYZ PLC as outlined by the Financial Reporting Council. The auditors by acknowledging that they have audited the financial statements for the year ended at a certain period. They explain on the financial reporting framework that has been applied in their preparation and state that it is applicable law and International Financial Reporting Standards (IFRSs) as adopted by the European Union. The report also includes the various responsibilities of directors and auditor.As explained more fully in the Directors’ Responsibilities Statement. The directors are responsible for the preparation of the group financial statements and for being satisfied that they give a true and fair view. The auditor’s responsibility is to audit and express an opinion on the group financial statements in accordance with applicable law and International Standards on Auditing (UK and Ireland). Those standards require the auditors to comply with the Auditing Practices Board’s (APB’s) Ethical Standards for Auditors. The auditors give their opinion those financial statements: give a true and fair view of the state of the group’s affairs as at a certain period and of its profit or for the year then ended; have been properly prepared in accordance with IFRSs as adopted by the European Union; and have been prepared in accordance with the requirements of the Companies Act 2006 and Article 4 of the IAS Regulation. The application of materiality, is supposed to explain how the auditors used the concept of materiality in planning and performing the audit. An overview of the scope of their audit is to give an overview of the scope of audit explaining how the scope addressed risks of material misstatement and how the auditor’s use of materiality affected it. Under the ISAs (UK and Ireland), the auditors are required to report to the entity if, in their opinion, information in the annual report is: materially inconsistent with the information in the audited financial statements; or apparently materially incorrect based on, or materially inconsistent with, our knowledge of the Group acquired in the course of performing our audit; or is otherwise misleading. Specifically the auditors are required to consider whether they have identified any inconsistencies between their knowledge acquired during the audit and the directors’ statement that they consider the annual report is fair, balanced and understandable and whether the annual report appropriately discloses those matters that they have communicated to the audit committee which they consider should have been disclosed. The materiality concept comprises the expression of materiality and expresses the maximum acceptable error level of the reported data in the financial statements in order to avoid the probability of influencing the decisions of the users. The materiality involves an important aspect in the process of making decisions of the financial audit in all stages of the auditing process beginning from the planning stage, execution stage and in the reporting of the conclusions of the financial audit. Works Cited Auditing Practices Board (APB) (1995a). Objective and General Principles Governing the Audit of Financial Statements. Statement of Auditing Standards No. 100, Auditing Practices Board, London. Brody et al 2003. Could $51 million be Immaterial When Enron Reports Income of $105 Million? Accounting Horizons, 17(2) Financial Reporting Council December 2013.Audit Thematic Review: Materiality.Retrieved from https://www.frc.org.uk/Our-Work/Publications/Audit-Quality-Review/Audit-Quality-Thematic-Review-Materiality.pdf Financial Reporting Council: Illustrative Example of a UK Auditor’s Report Reflecting the Requirements of ISA (UK and Ireland) 700 Revised June 2013 retrieved 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 Kwok, B.K.B 2005.Accounting Irregularities in Financial Statements: A definitive Guide for Litigators, Auditors and Fraud Investigators.England.Grower Publishing Company. Maria, M & Franca, D.The Importance of Materiality in Audit. Messier, W.F, Jr 2005.A Review of and Integration of Empirical Research on Materiality: Two Decades Later. Atlanta. OECD 2013.Global Forum on Transparency and Exchange of Information for Tax purposes Peer Reviews: Lithuania 2013: Phase 1: Legal and Regulatory Framework.OECD Publishing. Read More