Materiality in Auditing and Materiality Disclosure - Essay Example

Materiality in Auditing and In recent years, the issue of materiality has been receiving a lot of attention mainly because of the controversial surrounding accounting scandals that have been witnessed in financial reports. Auditing standards as stipulated by the AICPA and PCAOB urge an auditor to develop a maiden level of materiality at the initial stage of an audit engagement. This level of materiality is usually used to determine the rate of audit conducted. The range changes when basic financial statement figures change. In the current standards final materiality and preliminary numbers are not disclosed. The auditor is the only person who knows about the numbers (Bates, 2012). The paper explains the reasons why materiality levels are highly concealed. It also shows the benefits users would enjoy if auditors used materiality levels when disclosing financial statements and reports. Introduction When an audit is conducted, there must be a carefully designed plan which is meant to ensure the audit execution process gathers competent, sufficient and evidential matter to support the auditor’s ultimate financial judgment. Risk assessment is what really matters in an auditors plan as the auditor can easily understand the business, client, policies set by the client and the environment where the client operates. The auditor assesses financial statements and pinpoints key client assertions that require evidence. The assertions of completeness, existence, obligations, allocation, valuation, disclosure and presentation should be weighed in order to detect risks. Risk assessment has huge impact on an auditor’s time allocation (Stein, 2010). An audit risk is a term that refers to the danger that encompasses an audit failure. Auditing has associated risks caused by its complexity and the environment. These risks have consequences on the audit process. An audit risk in other words refers to the likelihood of an auditor making an incorrect judgment on financial statements which are materially misstated. That definition automatically links the terms materiality and audit risk. Talking of audit risks without mentioning the level of materiality would sound rather awkward. Actually, materiality is inversely related to risks. With the other factors being constant, as the audit risk drops down the materiality rises up and vice versa. Materiality simply plays a very big role when matters of assessing audit risks are mentioned. Materiality is very essential as it assists auditors identify information needed for analysis (Wheeler, 2013). Auditors usually reinforce materiality in order to detect irregularities and errors that need adjustments. Materiality secrecy Many auditors insist that materiality figures should not be disclosed and should remain confidential. A lot of red flags are raised when disclosure of materiality levels is mentioned. One of the reasons why secrecy is maintained is because disclosure will disrupt users of the financial statements. If materiality figures are made public then a variety of earnings emerge automatically replacing the relaxed single earnings. This new format might confuse some users of the financial statements. Disclosure will also increase the risk of liability the auditors are exposed to (Messie, 2014). Revealing materiality also results in development of measurement standards which sets principles for earnings misstatements and other financial reporting advances .This are just opportunities to nail the auditor through litigation for failing to identify misstatements. On the other hand critics are continuously advocating for materiality disclosure especially those that are conducted by independent auditors. One CFO was once quoted saying that “materiality levels are more secret than the Coca Cola formula.” Auditors are very confidential and do not reveal a single detail about their audits. They claim that materiality disclosure views the earnings concept as a wide topic. Disclosure assists the financial statement users to see earnings as types of ranges rather than precise amounts. People are so keen to hit analytical forecasts made about the market. If a company fails to meet the analysts’ expectations which are about $0.01 per share then the company is punished (Hillison, 2009). There is another perception that disclosure increases an auditors transparency level in the decision making process. This is continuously supported by standard setters in the financial accounting fields who are working tirelessly to ensure financial statements are transparent. Materiality level calculation is a very critical procedure in auditing and ensures anauditor’s decision is transparent. There is another ideology that disclosure improves and refines materiality calculation in the auditing profession. If each auditor conducts materiality estimation openly then auditors will easily learn from each other. As auditors mingle they also share their audit reports and their diverse methods of calculating materiality then new practices emerge on how to improve audits. Some of the most common methods of disclosing materiality are introduction of a new phrase in the standard audit reports and also a new paragraph in the present standard audit report (Jennings, 2008). Scholars insinuate that the advantages of disclosure outweigh the advantages of secrecy in materiality when conducting audits of financial statements. Academic research In academic literature materiality has also been given a lot of attention. The literature can be divided into four areas. I. Audit engagement materiality The research mainly focuses on the methods used by the auditor to get a quantitative materiality figure of an audit engagement. This might involve the application of an algorithm centered measure applied at an assertion level. They include the effects of unique audit company judgment consensus and audit firm structures. Also, the current period approach versus the cumulative approach has effects on the methods used by auditors. (Martin, 2009). Finally we have the use of differing materiality levels based on recognition issues instead of disclosure issues. II. Auditing theory This method uses a theoretical approach when dealing with materiality or when establishing a model which might be used to assess suitable levels of materiality in specific situations. Examples include the use of expert systems which can set preliminary levels of materiality and also observe the results of the rule which is under changing circumstances (Bates, 2012). Another example is the establishment of the game theoretic which is also used where there is some uncertainty surrounding materiality and occasionally describes possible relations between the manager and the auditor. III. Laboratory experiments This research method sets up artificial or virtual situations that are very similar to real life situations. Normally, individuals are thrown into a cautiously constructed virtual environment and are then asked to react to information offered to them or react to stimuli. The investigator keenly observes the behavior. An example of an experiment that is related to materiality is the Myers –Briggs experiment. Which became very famous and people actually adopted it to learn how materiality levels were determined. Another experiment was conducted that mainly dealt with policy factors involving materiality judgment (Wheeler, 2013). The experiment used over thirty hypothetical cases and nineteen associates of CPA corporations to make materiality resolutions under changing forms of risks and uncertainty. IV. Field tests In this research the issue of materiality is experimented using a set of financial statements found in the field of GAAP. For instance, a study of how materiality is used in reporting contingent tax liabilities by over 100 industries reveals that many firms do not disclose their IRS claims that have deficiencies and errors of material tax. Another example is about a research conducted on disclosures of retirees’ health care costs within the jurisdiction of SFAS. Results indicated that disclosures were consistent with the figures the author had estimated on the specific materiality. The major drawback affecting the research efforts is the lack of accurate information on specific materiality levels utilized by auditors (Jennings, 2008). The fact that reasonable levels of materiality are assumed means that the estimates are not accurate and no hard facts are available. Disclosure of materiality Recent professional and legal auditing regulations have been very keen to show the difference between material and nonmaterial objects and their requirements, approaches and rules. The distinction is vital in order to determine what content should be disclosed in financial statements. For instance, auditing standards advice companies to only disclose accounting policies that are linked with material items. For example, auditing regulations only need the disclosure of material contingent liabilities (Stein, 2010). The methods used to disclose materiality simply enlighten the public on procedures used to compute materiality levels. Disclosure also shares information within the auditing community to boost their level of experience. Materiality disclosure has simply improved the auditing profession and simplified duties of the users of the financial statements. Materiality disclosure is important to regulators, investors, the public and companies. Disclosure really assists investors especially material issues disclosed in the form of 20-F and 10-K as stipulated by the SEC. Institutional investors also need materiality disclosure due to the fiduciary duty bestowed upon them that demands a lot of keenness on scrutinizing material issues. Companies usually have limited resources and they must therefore concentrate on managing and disclosing the performance of material issues (Martin, 2009). The likely hood of a negative environmental and social impact occurring on a specific operation may lead to huge operational losses on companies, societies and investors. Supported by the fact that its advantages outweigh its disadvantages, materiality disclosure is undoubtedly the right move in financial auditing. In the near future there might be controversy relating to the legality of disclosure materiality thresholds. This is because auditor materiality might increase the rate of auditor litigation or the legal liability as other third parties have access to the financial statements and can easily assess the auditor’s faults. The research will also be conducted to investigate whether disclosure of materiality of auditor might increase the number of lawsuits filed against auditors and the mount auditors would be penalized (Stein, 2010). There are also other concerns that managers are of late biasing stated earnings in the auditor materiality thresholds. If these concerns are true then reviewing public disclosure of materiality on a manager’s duty to conduct earning management will also be weighed. Conclusion There is a huge urge from members of the public to increase the rate at which materiality calculations are disclosed by independent auditors. This move will not only benefit the users of the financial records but also the whole auditing field. Materiality disclosure seems to have more advantages over materiality secrecy. The first drawback predicted to bar the change is the usual fear of the unknown as a result of the prolonged usage of an established protocol and will seem to contradict the auditor’s code of conduct at first. With the current urge for transparency however, one can easily predict that in the near future concealing materiality among auditors will be a thing of the past. References Bates, H. 2012, “Auditor-client affiliation: The impact on materiality”, Journal of Accountancy, vol. 60, no.2, pp.60–63 Stein, M.2010.“Factors affecting auditors assessmentsof planning materiality Auditing”, A Journal of Practice & Theory,vol. 67, pp. 297–307 Wheeler, S. 2013,“Auditor reporting decisions involving accounting principles changes:Some evidence on materiality thresholds”, Journal of Accounting Research, vol.27, no.10, pp. 78–96. Messie, W. 2014,“A review and integrationof Empiricalresearch on materiality”, Auditing, A Journal of Practice & Theory, vol.2, no.2, pp. 45–63. Hillison, W 2009,“Disposition of audit-detected errors – Some evidence on evaluative materiality Auditing”, Journal of Practice &Theory, vol.58,no.20, pp. 22–34 Jennings,L 2008,“A reexamination of the concept of materiality: Views of auditors, users and officers of the courtsAuditing”, A Journal of Practice &Theory, vol.6, no. 1, pp.104–115. Martin, R. 2009,“Earnings surprise "materiality" as measured by stock returns”, Journal of Accounting Research, vol.40, no.5,pp.1297–1329. Read More