The Term Material Is of Critical Importance in the Auditing Context - Essay Example

The term ‘material’ is of critical importance in the auditing context” (Porter et al., p.73 Introduction Materiality is of critical importancewithin auditing background (Porter et al, 2014). Materiality levels are mostly determined by auditors who are assigned to carry out the process of audit. In this process, they are required to take into account certain benchmarks which enable the auditor to ascertain and determine the materiality level. This process is of higher importance as this will directly influence on the audit procedure that will be conducted throughout the audit period. In this regard, it is important to mention that the materiality is separately determined for different classes of accounts, transactions and each has its own material significance and impact for the audit process. In the following parts of this essay, first definition of materiality has been provided in which well established and recognised authors have been used so as to increase the validity of the materiality definition. It is followed by the part highlighting the significance of materiality. This part is centrally important to this essay as it highlights the crux of the essay through describing the significance of materiality in a critical manner. Subsequently, materiality secrecy part has been included in which both positive and negative reasons relating to the secrecy of materiality have been included. Before the conclusion part, audit regulation and disclosure of materiality: Tesco plc and impact of audit regulation change on materiality have been incorporated. Definition of Materiality Materiality is a central auditing activity. Materiality has been defined as “Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements” (Ernst & Young, 2008, p. 227). In this regard, it is important to highlight that the definition includes both absence and incorrect representations of items. At the same time, that absence or misstatement becomes material in both situations whether the item or information individually or collectively impact the economic decisions based on the information included in the financial statements. However, this definition has certain limitations. First, it does not specify any practical framework that can be used for judging materiality of items. Under the absence of any such framework, it will be very challenging to even rely on the audit report because the auditor has been fully authorised to use his will and wish to determine the audit sample size for ascertaining the materiality level. Significance of materiality Without any doubt, materiality is of a paramount importance for carrying out the audit process (Messier et al., 2005). And this determination of materiality is crucially significant at the planning stage when an auditor is required to assess and ascertain an overall magnitude of materiality for developing the scope of the audit (Messier et al., 2005). And for developing and determining the materiality level, the role of auditor is of central prominence as the auditor uses due care and professional judgement for ascertaining the materiality level (Vallabhaneni, 2013). This reflects that the entire process of audit is fundamentally reliant on the use and efficacy of materiality and without effectively using the subjective judgements, the chances of judgemental errors will certainly affect the audit opinion which will subsequently increases chances of inappropriate audit procedure and audit opinion which will have damaging effect not only for the audit firm but also for the client as well. Both amount and nature of item under scrutiny should have both qualitative and quantitative significance for assessing and establishing the materiality (Kwok, 2005; Gibson, 2011). this aspect clearly highlights the significance of materiality in the field of audit as it emphasises that both qualitative and quantitative aspects are highly essential for determining materiality. For example, sale of $3 million has been reported in the financial statement which is highly material for the auditor because the normal transaction takes place in the range of $50,000 to $100,000. However, if this amount is only reported once and the company management provides understandable and valid reason, the amount may not be counted as material. This happens for two important reasons. First, the company management has clearly provided valid reason; second, the amount has been reported once and is clearly traceable as well. on the other hand, if the same amount or higher than this amount are present in the financial statement, it would highly essential for the auditor to apply audit procedure as such amounts are material and clearly put effect on the decisions of the users of the financial statements. In order to assess this amount, it is also necessary that the auditor should take into account the perspective of the client before applying the related audit procedures. For example, the auditor should ask the client to express in clear terms that the amount ($3 million) is material for them. This clarity is very much important as this will enable the auditor to record the perspective of the management on this issue. Consequently, this will be useful for the auditor for constructing audit opinion. At the same time, if the auditor disagrees with the management explanation about the amount, under this situation, the auditor can use the clause ‘except for’ in which the auditor is fully authorised to express his audit opinion and provide the auditor perspective on this unusual item in the financial statements. All these factors represent the importance of materiality for the entire audit process in which the auditor’s role is largely reliant on the use of materiality. Materiality secrecy Materiality levels have remained secret (Independent Audit Limit, 2013). And there are positive and negative reasons behind disclosing the materiality level. The positive reasons encompass that the materiality disclosure will highlight the concept of earnings range; it will enhance transparency relating to the auditor’s decision making process; it also increases the evaluation of earnings restatement besides enhancing understanding relating to the qualitative factors involved for computing the materiality levels (Kearns, n.d.). Based on these positive reasons, it can be deduced that the disclosure of materiality levels provides benefits in the shape of increased transparency in the entire audit procedure which is carried out. And through this disclosure, a critical evaluation can be easily carried out to ascertain whether the adopted audit procedures were sustentative to satisfy the requirements of the audit objectives. On the other hand, there are shortcomings for disclosing the materiality levels. For example, disclosure will not be helpful for the user of the financial statement as the many users do not understand such complex words and their application in the audit procedures; besides, disclosing the materiality levels will increase liability exposure of the auditor (Kearns, n.d.). In other words, the materiality disclosure will create issues for the shareholders and other related stakeholders as they may not be able to understand such terms and its significance and relevance for the financial statements. Audit regulation and disclosure of materiality: Tesco Plc Tesco plc uses materiality for carrying out the audit process. For example, “We set certain thresholds for materiality. These helped us to determine the nature, timing and extent of our audit procedures and to evaluate the effect of misstatements, both individually and on the financial statements as a whole” (Tesco Plc, 2014, p. 65). And Tesco uses 5% of profit before tax materiality level for carrying out the audit procedures based on the use of this threshold (Tesco Plc, 2014) Tesco has its own materiality thresholds. In this regard, it is important to mention that there is no universally accepted framework which is applicable to all audit firms complying with the requirements of the international auditing procedures. Instead, every firm has its own preferred materiality standards and levels. Under this situation, the audit firms are completely at their will to determine and apply those auditing and materiality standards that are preferred by them. This creates a threat of collusion in which audit firms and companies collude to massage and hide financial figures. And in the corporate history, such collusions have taken place and the most notorious example of the collapse of energy giant Enron scandal in which Arthur Andersen and the top executives of Enron colluded by continuously receiving clean audit report and audit opinion from the audit firm (Arthur Andersen) (Fernando, 2010; Klein et al., 2012). Impact of audit regulation change on materiality Recently, some changes have been introduced to audit regulation. For example, Financial Reporting Council (n.d) has updated ISA 700 in which they have added a new clause in the auditor’s report reflecting the audit quality of the publically traded companies. In the scope of the audit of the financial statement, an additional part is “ … and to identify any information that is apparently materially incorrect based on, or materially inconsistent with, the knowledge acquired by us in the course of performing the audit” (Financial Reporting Council, n.d p. 2). This addition in the audit scope statement is entirely based on the subjective judgement of the auditor. The new addition encourages auditor to remain more professional while discharging the services. In other words, it is expected that the auditor will be required to carry out the process of due diligence and professional judgement for satisfying the requirements. However, there are certain inbuilt limitations to the professional judgement. For example, an auditor will only apply all those audit procedures that he or she considers appropriate and are highly effective for satisfying the audit objectives. Under this situation, it is possible that the applied audit procedures may not be fully effective and may fail to generate the expected results. Consequently, the audit procedures would not satisfy the audit objectives. Similarly, the auditor would give a clean opinion whereas the ground reality is totally different from what has been provided in the audit opinion and in the audit report. At the same time, Financial Reporting Council (2013) highlights that some of its findings signify that the audit firms are updating their materiality guidance which will directly affect their materiality levels and the level of audit work as well. In other words, such changes are only carried out to reduce the chances of incorrect judgements and make more effective audit process. However, this finding still fails to take into account the issue of subjectivity which is a central shortcoming in the audit process. instead of providing and developing more objective measures, the report exhibits that the audit firms are only focusing on the subjective audit matters which will only increase audit quality under any circumstances. Conclusion Materiality is critically relevant and important for the audit procedures. In the auditing procedures, the auditor first determines the materiality levels, which normally remain hidden, during the planning stage. In other words, the entire auditing activity substantially relies on the use of materiality levels as they guide auditor about the type and size of sample that will be determined so as to carry out the process of audit. However, the determination of materiality level is highly subjective not objective. In other words, the auditor will have discretionary while developing materiality levels. References Ernst & Young, (2008). International GAAP 2008: Generally Accepted Accounting Practice under International Financial Reporting Standards. West Sussex: Wiley. Fernando, A.C. (2010). Business Ethics and Corporate Governance. New Delhi: Pearson. Independent Audit Limit, (2013). FRC Consultation on Changes to the Auditor’s Report. 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Available: http://www.tescoplc.com/files/pdf/reports/ar14/download_annual_report.pdf Accessed: 16 December, 2014. Vallabhaneni, S.R. (2013). Wiley CIA Exam Review 2013: Internal Audit Practice. New Jersey: Wiley. Read More