Materiality in Auditing - Essay Example

Materiality in Audit Location Materiality in Audit The independent auditors have the duty to plan and perform financial audits that will provide assurance of detecting irregularities and errors that are material in nature. According to the Financial Accounting Standard Board, the misstatement or omission of an item or items is considered to be material if the magnitude of the item in light of the surrounding circumstances would have made a person relying on the report make another decision if the item had been included (RITTENBERG, 2012). In other words, information is material if its inclusion or omission can influence the economic decisions of users which are based on the financial statements. It is hard to quantify materiality because this is determined by individual situation. However, accounting firms have been able to come up with ways of establishing the materiality threshold. This is by establishing the maximum amount that they believe could be misstated in the statements and still not affect the decisions made by reasonable users. An amount can be considered to be material if it is one pound more than the amount that is required by users of the financial statement to change their decision. Materiality can be qualitative or quantitative. Quantitative materiality is economic in nature and usually depends on its effect on facts about the financial performance of a company, for example, total assets. Qualitative materiality on the other hand, considers the reliability and relevance of facts to determine its effects on the financial statements. Body Importance of materiality in audit Materiality concept is crucial for auditors when they are planning for an audit. This needs to be considered even before they look at the financial statements. Materiality has no set rules for all companies and depends on the auditors judgment and experience in the company’s industry sector. Materiality is crucial because it assures a standard to determine an allowable level of irregularities and risks. This also helps in determining the direction and extent of the audit work. It is a fact that the financial statements cannot be completely accurate and if it is possible, there are very few users who require this level of accuracy. Therefore, the level of accuracy is acceptable with a certain degree of tolerance. This tolerance is referred as materiality, and represents the significance of an item in the financial statement. The concept of materiality is also crucial because it assures the company that decisions made are based on true financial statements. However, materiality is considered when it is large enough. For example, an inventory figure of £ 100 may not be material if the company has a turnover of £ 1,000,000. It would be a waste of time to concentrate on such a small figure in the financial statement. This amount represents a small risk in the financial statement. However, if small misstated figures keep appearing in the financial statement then the figures can be material because the sum of all the figures will be big enough to influence the decisions of users, which they would have not made if there were no misstated figures. Items that are disclosed in the financial statement are usually determined by their level of materiality. The contents of the financial statements are partly as a result of judgments that have been exercised around materiality (RITTENBERG, 2012). Materiality is crucial in auditing, both in planning and designing the audit procedures to be used. This is also useful in evaluating if the financial statements are fair and if they are in compliance with the accounting principles. Auditing involves sampling some transactions in order to come up with an acceptable level of assurance. The extent to which transactions are tested depends on the choice of materiality level that a company will apply in audit. The concept of materiality is also crucial in determining the level of audit risk. Audit risk is hard to manage because some materials which have been misstated can remain undetected as auditors are usually not in a position to check everything. Materiality can give auditors an idea of the level of risk before they begin the audit work so that they can be able to check items in the financial statement that they suspect their implication if misstated will be material (BARNES, 1990). Finally, materiality is crucial in professional accounting in making decisions on whether or not to adjust a misstatement or an error, or whether to disclose an item that has been published in the financial statements. Materiality is also crucial in determining the amount of work that has been done during audit. This influences the audit opinion provided in cases where another opinion other than a clean one is required. Materiality Level There is very little guidance provided in the auditing standards and the financial accounting standards on how to determine the materiality level. Auditors must set the materiality level during the planning stage of an audit. This is referred to as the preliminary materiality because it is based on the company’s unaudited accounts and can be adjusted (WRIGHT, 2013). Materiality is adjusted when the financial statements are adjusted after the audit and is later referred as the final materiality. The materiality level should be a secret because there is a high risk that if there is disclosure, the financial statements will be manipulated (DAVIES, 2008). Manipulation might occur in areas where audit tests will be conducted in order to get favorable audit report. Materiality level should also not be disclosed because this will confuse users of the financial statements who are mostly people with no accounting background, that is, shareholders. When figures related to materiality are made public, a range of figures emerge which can confuse users of financial statements. When materiality calculations or level are disclosed, the company gets a clear exposure of the measurement standards used to measure misstatements and omissions in the financial statements (MOELLER, 2008). The chances of the auditors to find misstatements and adverse financial reporting are low. This exposes them to litigation expenses where they are held accountable for failing to find issues in the financial statements (GREAT BRITAIN, 2011). On the other hand, it can be argued that disclosure improves the transparency of the audit. This is the extent to which a company’s financial information is understandable and visible to investors and other stakeholders (GRAMLING, 2012). It is argued that the decision of materiality taken by auditors needs to be transparent. This is because the level of materiality is crucial as it determines the amount of testing that auditors will perform in various stages of audit (PUNCEL, 2007). As long as auditors keep the calculations on materiality a secret, there cannot be an outside check on the reasonableness of the calculations. Academic Research on importance and secrecy of materiality Academic research also shows that materiality issues are crucial to many users of financial statements. Materiality is crucial because it assures a standard to determine an allowable level of irregularities and risks. Study conducted by Messier analyzed materiality judgments. In the study they were 29 audit partners who were presented by 32 cases. They were then requested to make judgments on the probability of separate disclosure in the income statement and the materiality level of inventory write-down. The net income was varied at four levels while the total assets, current ratio, earning trend, and the total inventories were manipulated (Messier, 2005). The result showed that the materiality level determined the outcome of the audit procedure. However, this study also showed that different groups understand the concept of materiality differently. Recent Audit Changes Materiality is still a crucial topic for auditors. Recently there have been changes in company’s guidance and processes for setting materiality. There has been a general trend by firms to make their materiality level higher or to allow a lower sample size to be used when conducting audit tests. Due to the fact that the level of materiality is a reflection of the financial information that is needed by the users of financial statements, this change assumes that the expectations and the needs of users have changed (VALLABHANENI, 2013). This change is not for the better because it reduces the amount of audit work that is being performed. Even though, it is a fact that the financial statements cannot be completely accurate and if it is possible, there are very few users who require this level of accuracy; this change will reduce the accuracy of financial statements. Audit Regulations Because of the issue presented where companies set a higher materialistic level ISA (UK&I) 320 has come out to state that an auditor should determine the materiality level that will be used in transactions, disclosures, or account balances where misstatements are of lesser amounts than materiality for the whole financial statement which could influence or which could be expected to influence the decision of those using the financial statements (WHITTINGTON, 2010). This guideline is better because each firm has their own materiality level depending on their turnover, however, they will have guidance on the acceptable level of materiality (Financial Reporting Council, 2013). Conclusion The independent auditors have the duty to plan and perform financial audits that will provide assurance of detecting irregularities and errors that are material in nature. It is hard to quantify materiality because this is determined by individual situation. However, accounting firms have been able to come up with ways of establishing the materiality threshold. Materiality concept is crucial for auditors when they are planning for an audit (DAUBER, 1988). Materiality is crucial because it assures a standard to determine an allowable level of irregularities and risks. This also helps in determining the direction and extent of the audit work. The concept of materiality is also crucial because it assures the company that decisions made are based on true financial statements. Materiality is crucial in auditing, both in planning and designing the audit procedures to be used (LOUGHRAN, 2010). This is also useful in evaluating if the financial statements are fair and if they are in compliance with the accounting principles. The concept of materiality is also crucial in determining the level of audit risk. Finally, materiality is crucial in professional accounting in making decisions on whether or not to adjust a misstatement or an error, or whether to disclose an item that has been published in the financial statements. Materiality is also crucial in determining the amount of work that has been done during audit. There is very little guidance provided in the auditing standards and the financial accounting standards on how to determine the materiality level. Materiality level should also not be disclosed because this will confuse users of the financial statements who are mostly people with no accounting background, that is, shareholders. This exposes them to litigation expenses where they are held accountable for failing to find issues in the financial statements (RAWINDARA, 2011). On the other hand, it can be argued that disclosure improves the transparency of the audit. Materiality is still a crucial topic for auditors. Recently there have been changes in company’s guidance and processes for setting materiality. There has been a general trend by firms to make their materiality level higher or to allow a lower sample size to be used when conducting audit tests. This change is not for the better because it reduces the amount of audit work that is being performed and affects the accuracy of audit work. Because of the issue presented where companies set a higher materialistic level ISA (UK&I) 320 has come out to state that an auditor should determine the materiality level that will be used in transactions, disclosures, or account balances where misstatements are of lesser amounts than materiality for the whole financial statement which could influence or which could be expected to influence the decision of those using the financial statements. References List (2014). Accounting and Regulation New Insights on Governance, Markets and Institutions. Accounting and Regulation. New York, NY, Springer New York. AINAPURE, V., & AINAPURE, M. (2009). Auditing and assurance. BARNES, M. (1990). Financial control. London, Telford. DAUBER, N. A. (2009). The complete guide to auditing standards, and other professional standards for accountants, 2009. Somerset, N.J., Wiley. DAUBER, N. A., & PERSON, S. (1998). Barrons how to prepare for the CPA, certified public accountant examination. Hauppauge, N.Y., Barrons. DAVIES, H., & GREEN, D. (2008). Global financial regulation the essential guide. Cambridge, Polity.  FINANCIAL REPORTING COUNCIL, 2013. Audit Quality Thematic Review: Materiality. Aldwych: Financial Reporting Council. GRAMLING, A. A., JOHNSTONE, K. M., & RITTENBERG, L. E. (2012). Auditing: [a business risk approach]. [Mason, Ohio], South-Western Cengage Learning. GREAT BRITAIN. (2011). Auditors: market concentration and their role : 2nd report of session 2010-11. Vol. 2, Vol. 2. London, Stationery Office. LOUGHRAN, M. (2010). Auditing For Dummies. Hoboken, John Wiley & Sons.  MESSIER, W., MARTINOV, N., & EILIFSEN, A. 2005. A Review and Intergration of Empirical Research on Materiality: Two Decades Later. A Journal of Practice & Theory, pp. pg 3-40. MOELLER, R. R. (2008). Sarbanes-Oxley internal controls effective auditing with AS5, CobiT and ITIL. Hoboken, NJ, John Wiley & Sons.  PUNCEL, LUIS. (2007). Audit Procedures 2008. Cch Inc. 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