Materiality in Auditing - Literature review Example

Materiality in Auditing Introduction The main goal and objective of auditing a financial ment is so as to allow auditors to state opinions on the preparation of financial statements and whether, in material respects, the financial statement is prepared according to applicable frameworks of financial reporting (Vaujany & Mitev, 2013: p32). This decision and responsibility is separate from what the entity itself makes during the preparation of financial statements. Materiality in auditing refers not simply to quantified amounts, but also to the impact that the amount portends in different contexts. In the process of audit planning, the auditor takes the decision as to the level of materiality they will use, accounting for the entirety of financial statements that will be audited. This judgment is mainly done on the basis of the nature, size, and specific circumstances of omissions or misstatements that could influence the financial report’s user. Moreover, this judgment is also influenced by public expectations, regulatory requirements, and legislative requirements (Vaujany & Mitev, 2013: p32). This paper seeks to discuss the importance of materiality in the auditing context, as well as to assess the secrecy of materiality levels used by auditors. Importance of Materiality in the Auditing Context According to Porter et al (2014: p73), the term material is critically essential in the context of auditing. Materiality definitions in financial reporting are especially critical to auditors, financial statement preparers, and financial statement users. While only two of these stakeholders may be involved in making decisions on materiality, in this case the auditors and the preparers, the definition of materiality in auditing is oriented more towards the user. The user’s judgment of decisions on materiality is central to defining materiality, rather than the judgment of the financial statement preparer. Budescu et al (2012: p24) define materiality as one of the fundamental and essential auditing concept, noting that the Auditing and Assurance Standard-13 on audit materiality establishes the materiality concept’s standards, as well as how it relates with audit risk. A fair and true financial statement and how it is presented will depend on the materiality concept, among other things. Keune & Johnstone (2012: p1650) note the relative nature of the materiality concept, arguing that what is material in a specific situation may be immaterial in another circumstance and that consideration and judgment on materiality is a matter for the auditor’s experience and professional judgment. Thus, the auditor must make a serious consideration of the materiality concept prior to giving their opinion on the statements provided. The entity’s management or client is responsible for making sure that all relevant information is revealed by the financial statement. In case some material information is materially misstated or not disclosed, the statements do not give a fair and true picture. Consequently, not considering the materiality concept makes it impossible for the auditor to offer a clear opinion on the entity’s financial statements. As stated, it will be up to the auditor’s experience and professional judgment to assess what is material. In this case, information should be judged as material if erroneously stating the information or omitting it could affect the financial statement’s user’s economic decisions, which are specifically dependent on information from financial statements (Keune & Johnstone, 2012: p1651). Materiality, however, is not a primary qualitative characteristic and instead provides a cut-off point or threshold that the information should possess to be of use to the financial statement’s user (Arens et al, 2012: p70). All relevant financial information is a useful measure of a corporation’s overall performance. As part of the financial statement, this information is important in informing the interested entities of the significance of every day transactions, the value of liabilities and assets held by a company, and the overall worth of a company. The user of this information presumes that the creation of the financial statement was done in compliance with accounting principles. On the basis of prevailing conventions of accounting, the user is right as long as the benefit of applying the principles exceeds the cost of complying with the accounting principles (Arens et al, 2012: p70). Similarly, the concept of materiality allows a company to diverge from these accounting principles if the financial statement user would consider the size of a particular transaction as insufficient in the overall picture. At this point, it is clear that the materiality concept encompasses all information that is significant enough for their misstatement to deny the user of financial statements all relevant facts in making any economic decision (Arens et al, 2012: p71). Thus, the materiality concept shows the essential nature of erroneous presentation or omission of financial information for the decision-making of a reasonable person who is reliant on the information to make a different decision. Adopting of materiality will represent value in the statement that is used for its determination if the mistakes, omissions, and/or errors identified cumulatively or individually show if the accounts present an accurate, complete, and true image of the entity’s financial performance and position. Hingarh & Ahmed (2013: p45) identify materiality as representing the level of error under which interpretation and understanding of the financial accounts are not impacted significantly, as well as the admissible level of error that the auditor accepts in deciding the correctness of the financial accounts and statements. The company’s shareholders are the main consumers of financial audit reports, despite the fact that the company’s management is responsible for hiring the auditor. The auditor, therefore, should use the concept of materiality as the shareholder, based on the financial audit report, hope to understand how the business operations of the company are being conducted (Hingarh & Ahmed, 2013: p45). In addition, the auditor’s use of materiality in compiling their report enables the shareholder to interpret the company’s strategic decisions. Most importantly, perhaps, the shareholder makes the full assumption that the financial auditor has worked to observe and report the true picture provided by the financial statements and that the information not considered does not deviate significantly enough to influence their decisions otherwise. In identifying the materiality level of specific financial information and accounts, a financial auditor is expected to identify the addressed shareholders and the type of information they would be interested in knowing (Hingarh & Ahmed, 2013: p47). In addition, the auditor is expected to establish a link between the decision-making process and the provided information, as well as to know the type of decisions users are most likely to make using the audit reports (Houghton et al, 2011: p493). Moreover, the user expects the auditor to make a critical comment on the financial audit’s extent area that highlights the risk and materiality. The liability of the financial auditor is limited to information established as significant through materiality based on their professional reasoning and experience. Therefore, the financial audit report should seek to offer a reasonable, rather than absolute, assurance to the user regarding the financial statement’s fidelity. This should suggest that there is a certain level of risk even when there are no reservations in the financial auditor’s report. To the financial statement user, however, there is an expectation of a clear image for decision-making, and the concept of materiality is indispensible in enabling the auditor fulfill these expectations (Houghton et al, 2011: p493). Secrecy of Materiality in Auditing As noted in the discussion above, it is up to the auditor’s discretion to decide on information that crosses the materiality threshold, which raises some criticisms regarding the transparency of materiality as used in auditing of financial statements. Indeed, Mock et al (2009: p4) argue that the levels of materiality are more secret than the Coca-Cola formula. Auditors and accountants in recent financial scandals may have resulted in this criticism, especially in the Enron scandal where materiality decisions seem to have been made on a materialistic basis rather than truth. In this case, the financial omission and misstatements, while deemed immaterial by the auditors and accountants, proved significant enough to cause the demise of Enron and the involved auditors. Such institutionalized focus in auditing and accounting regarding materiality has been criticized, with Bachert (2012: p39) terming materiality as the “best kept secret” in materiality due to the partial absence of disclosure or transparency about the threshold of materiality. In fact, there is little transparency in how corporations, even those that have been certified as transparent in material impact reporting, determine how the process of materiality actually works. Thus, the entire process is more of a black-box, in which there is limited information published about how materiality decisions were weighted or quantified. Materiality has been variously defined as referring to the entity, to which the concept is being used, including the decision-making body, the information’s recipient, the financial statement’s user, the auditor’s addressee, a reasonable investor, and the average prudent investor. (Bachert, 2012: p39) questions this decision, however, noting that there is need for additional clarity regarding what a reasonable investor is defined as, prior to teasing out the information of materiality. This secrecy as to the weighting and quantification of materiality decisions should, therefore, be tied to what is common place or normal, rather than to the idealized investor. For example, small earnings adjustments could cause irrational over-reactions to the market that may act as a wake-up call for the market to correct irrational distortions in the market (Bachert, 2012: p40). Therefore, secrecy in materiality should be viewed as tied to likely reactions of the market, rather than to reasonable investors. However, Gazzaway et al (2010: p51) call for changes to secrecy in the process of materiality in relation to what a reasonable investor constitutes, as well as what is required for information to be classed as material. Indeed, investing in capital markets is not a rational behavior at all times, which requires that materiality is given a new definition with regards to its secrecy that takes the emotional and presentation content into account, as well as its impact on shareholders and investors. In considering the effects of secrecy to the financial statement user, the auditor should consider a reasonable investor in terms of a realistic imagination of their behavior, instead of a standardized and normative idealized behavior. Moreover, the secrecy aspect of materiality must take into account how the financial information is presented regarding emotional content, form of presentation, and imagery. This will allow the audit report to present what the shareholder considers a truer picture of the corporation’s financial outlook, especially in the absence of information on how the information not included in the report was judged as inconsequential (Gazzaway et al, 2010: p51). On the other hand, Houghton et al (2011: p495) argue that enhancing the amount of information that is publicized by audit reports could aid in ending the secrecy culture and distrust by the public that involves corporate behavior. Stakeholders, who are concerned with the organization’s wider economic and social impacts, as well as those responsible for making sure that investments are performing financially, demand more and better financial information. Still, moving towards the completely doing away with secrecy and adopting a “take-the-lot” approach to financial information is not desirable or feasible. Indeed, completely unveiling the secrecy concept could be complex and complicated for competitive and legal reasons. In addition, an approach that removes the lack of disclosure around materiality and results in overload of information may not affect or inform the stakeholders or the company, who are the most important study group for effective communication. This may result in audit reporting becoming an expensive process that fails to influence the economic outcomes of the organization’s financial performance (Houghton et al, 2011: p495). In fact, more disclosure may actually reduce the stakeholder’s trust by enhancing their perception that the auditors are disguising important information by providing too much information. Collings (2011: p61) makes the point that effective audit reporting must always communicate what the target users of information consider important for them to make coherent and rational decisions. However, these arguments have been made against the background of calls increased transparency in how materiality is used in auditing financial statements. Yet, in spite of the apparent need for comparability, consistency, and transparency of materiality in auditing financial accounts, auditors continuously maintain secrecy around their materiality threshold. Because the auditor’s choice in materiality is not disclosed anywhere for the user of the audit report, the comparability and consistency of financial statements is impacted significantly, which may require a reevaluation of materiality guidelines on the basis of contemporary circumstances. Still, secrecy remains important in making audit reports, especially where the decision for not including some information may be related to competitive threats and the need to retain some transactions a secret (Collings, 2011: p61). Indeed, secrecy over how information has been left out may end up being beneficial to the investor majority of the time. Conclusion In conclusion, it is clear that materiality has become one of the most important aspects of financial audit reporting, although it has come under increased scrutiny after the Enron scandal where materiality was used subjectively. Materiality has been held up as an important aspect of auditing, especially for those using financial statements to make economic decisions on an organization’s financial future. Indeed, most users use financial statements in decision-making on the assumption that auditors have followed due diligence by applying the concept of materiality strictly. Thus, the auditor is expected to ensure that all relevant or material information is provided to the financial statement user. However, secrecy surrounding the threshold used to determine the materiality of information has come under some criticism, especially regarding disclosure and transparency. Still, this secrecy has proven essential in cases where information cannot be disclosed for competitive or legal reasons. References Arens, A. A., Elder, R. J., & Beasley, M. S. (2012). Auditing and assurance services: An integrated approach. Upper Saddle River: Prentice Hall Bachert, K. (2012). 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