Materiality in Auditing - Literature review Example

School: Topic: Materiality in auditing Lecturer: Introduction Auditing is generally known to a professional practice involving the systematic and independent examination of financial and other non-financial data, records or statements (Huang, 2005). Vorhies (2005) however noted that an important aspect of auditing is for the auditor to have the professional competence to decide on which figures or variables is material to the auditing process. This is because it is based on this that the auditor is able to express an opinion whether the statements, records or data being audited have been prepared in all professional material respect. It is based on this doctrine that the importance of materiality has evolved over the years in accounting discourse. There are several recent developments in the audit regulation and practice which highlight the importance of materiality in the auditing context, as well as current levels of materiality and how it affects auditing practice. This paper is written with the aim of constructing a sustained academic argument out of which a stand is taken on the importance of materiality and the benefits that could possibly be gained if auditor materiality level were to be disclosed to key stakeholders in the auditor’s report. Critical importance of materiality in auditing The International Accounting Standards Board (IASB) defines material information in its framework for the preparation and presentation of financial statements as information which could influence the economic decisions of users of a financial statement if such information is omitted or misstated (International Federation of Accountants (IFAC), 2004). This means that materiality can be explained from the context of the combination of quantity which is determined by amount and nature which is determined by quality of misstatement in a given financial statement (Nelson, Palmrose and Smith, 2005). Based on this explanation, materiality can be noted to be a very important and critical concept in auditing as it helps to explain not just the relevance of quantified amount but also the impact that the quantification has on various contexts of the data, statements or records that are prepared. In the light of this that the IASB emphasised that materiality provides a threshold based on which information found in the financial statement can be considered to be useful. By implication, in the absence of materiality, it would virtually not be possible to determine the extent of attention to place on a given quantity and quality in a financial statement when making economic decisions. Also writing on why materiality is of critical importance in auditing, Gleason and Mills (2002) observed that it is based on materiality that auditors are able to determine what a tolerable misstatement is and what an intolerable misstatement is. But to do this effectively, it is important that the right materiality levels are set by the auditor based on any available information that ensures that the levels are well estimated. In effect, the ability of the auditor to not understate or overstate the materiality levels is an important determinant in realising the critical importance of materiality in determining tolerable misstatement. This is because when the wrong materiality level is selected, chances are that a particular item or misstatement or omission may be regarded as tolerable when in actual fact it is not. Meanwhile, such outcome with the auditing process is what audit risk is all about (Patterson and Smith, 2013). To a very large extent therefore, one may argue that materiality is critically important in the work of the auditor in ensuring that audit risk which arises from an auditor’s inability to detect material misstatement is avoided. It is not surprising that for a very long time, materiality has remained an important professional context in both auditing and accounting. Secrecy with materiality level and reasons for it In current auditing practice, materiality levels used by auditors have been highly concealed. Huang (2005) found that both the preliminary level of materiality which is often given as a dollar value used to identify the extent of audit testing and the final materiality levels of auditors are kept in high secret and not disclosed in the auditor’s report. Using the example of Morrison’s 2013 audit report, it would be seen that auditors refused to declare in explicit terms what their materiality levels used were. They however go ahead to make reference to estimates and assumptions used in the preparation of the financial statements of the company which they felt could pose significant risk of causing a material adjustment. In the report, some of these were noted to include property provisions, pension scheme assumptions and mortality table (Morrison Auditor’s Report, 2013). There are a number of reasons behind the need not to disclose materiality level. Podgor (2005) for example explained that disclosure of materiality level would lead to a situation where there is an increase in the liability exposure of the auditor involved in the auditing process. This is because any form of disclosure will give a basis for setting very clear measurement standards that may be used to measure the severity of earnings misstatement (Kearns, 2011). In another development, Vorhies (2005) argued that disclosure of materiality levels has the potential of confusing users of the financial statements. The basis for this argument is that materiality is taken from the context of both quantity, which is determined by amounts and quality which is determined by value or nature. In effect, even though the quantitative component may be easily understood because it makes use of empirical numbers, the qualitative component may not be understood as it is highly subjective in nature even though it is guided by standards and principles of auditing practice. Academic research on importance and secrecy of materiality There are recent academic researches that have argued about the importance and secrecy of materiality. One of such lines of academic research has to do with the determination of materiality for an audit engagement (Brown, 2005). This line of research is considered very relevant to the auditing profession given the fact that is helps in setting the basis for pegging the right materiality levels which can set the basis for judging an audit report as being either accurate or filled with audit risk. But given the fact that the quantitative component of materiality is subjective, the line of academic research which have focused on the determination of materiality for an audit engagement have largely looked at methodologies that may be used in arriving at quantitative materiality figure for an audit engagement (Kinney, Burgstahler and Martin, 2012). The argument for this line of research is that once there is an acceptable quantitative materiality methodology or formula, the issue of materiality secrecy would not have to be an issue of concern to stakeholders who do not have background in auditing. This is because they can have the trust that even when materiality levels are not disclosed and that auditing takes place in independence, the outcomes can still be trusted as being in line and comforming to what is universally accepted. In a study by Gleason and Mills (2002), the use of algorithm-based methodologies was suggested for this purpose. There are other studies that also make use of cumulative approach as against the current period approach (Patterson and Smith, 2013). In terms of academic research on secrecy of materiality, there is generally a divided front in literature. This is because whereas the first school of thought holds that secrecy should be promoted due to most of the reasons stated in earlier section of the essay, the second school of thought argues that the best way to effective economic decision is for there to be disclosure of materiality. In a study by Nelson, Palmrose and Smith (2005) where the need to disclose materiality was researched, the major component of argument used in the research was that corporate governance principles acknowledges both shareholder stakeholders and non-shareholder stakeholders as having a central role to play in the management of corporations. If this is the case then it is expected that there will be disclosure which will make decision making by users of the financial statement a well informed one. IFAC (2004) however advised that even if such relationship will be expected to be built between auditors and stakeholders, it is important to consider the place of auditing theory in the process. This is because auditing theory sets a basis for the development of game-theoretic used to develop a model which assesses the appropriateness of given levels of materiality in an audit report (Podgor, 2005). Recent audit regulation for change in materiality disclosure In the past few years, there have been a number of changes that have taken place and those that have been proposed from audit regulations on disclosure of materiality (Financial Reporting Council (FRC), 2013). For example as much as the Financial Accounting Standards Board (FASB) has refrained from setting any clear-cut quantitative guidelines that should be used in calculating materiality, the body has also advocated for possible communication between auditors and users of financial statements in making disclosure under Auditing Standards No 47. Already, under the provisions of the Auditing Standards No. 47 which touches on “audit risk and materiality in conducting audit”, there have been a number of common rules that have been devised for their possible use in the quantification of materiality. The idea has been that if there is a universal method for quantifying materiality, then there would not even be the need for disclosure because the materiality can be calculated by anyone with an idea on how to use the method (Kinney, Burgstahler and Martin, 2012). The International Standard on Auditing for UK and Ireland has also given regulations on the communication of errors which partly supports a change for materiality disclosure. The argument of the body is that disclosure helps to clearl evaluate misstatement and make decisions on audit risk (ISA, 2013) Argument for change towards materiality secrecy There have been several arguments made on the need to lessen the extent of secrecy with materiality levels used in audit reports. Some of these arguments have come from the conclusions of academic research whiles others have come from audit regulations. On the whole, a position can be taken in this paper that the changes that are being championed are for the better of audit practice. This is because there are several advantages or merits which can be associated with the disclosure of materiality levels. In the first place, disclosure can be seen as a way of improving transparency with the auditor’s decision process. This is because the independence and subjective nature of the auditor’s work would now be subjected to open empirical scrutiny (Brown, 2005). Already, it is known that there are calls for transparency in financial statements so as to better realise the principles of corporate governance which seeks to make the running of companies an open-ended and integrated process. When there is disclosure, it will set the pace for improving transparency in the financial statements through transparency with the auditor’s decisions on materiality. Until now, auditors seem to be lords of their own who are only accountable to regulatory bodies and not stakeholders of the companies they work for. Another reason that can be used to argue that changes being made are for the better is the fact that disclosure of materiality will improve the understanding associated with qualitative factors used in materiality computations as well as help in refining the materiality calculations for the auditing profession (Kearns, 2011). Already, it has been said that materiality is made up of quality and quantity. But even as academic research tries to find common methodologies to calculating materiality, they only look to the quantitative component of materiality. Through disclosure, the credibility associated with the subjective aspect of qualitative factors used in materiality computation will now be made known to stakeholders who can critique the extent of critical qualitative factors that were used in the final determination of materiality (Kearn, 2011). Meanwhile, as auditors become aware that their qualitative decisions are to be criticised, they will become more cautious in using their subjective powers in determining qualitative factors that should be used in setting materiality level. Conclusion As explained by the IASB in its framework for the preparation and presentation of financial statements, it is important for auditors to identify and clearly define what constitutes a material while undertaking their professional roles so that they can avoid audit risk as much as possible. The position of the IASB has clearly been agreed with in the paper because the paper through its review of existing works of literature has helped in establishing that audit risks come about when the auditor’s report is considered unqualified because it fails to clearly identify material misstatement. As material is central in audit risk, it can be expected that one’s approach to materiality will define or determine the extent of risk that may be associated with audit report produced. In terms of materiality level, the paper has helped in identifying that the extent to which the auditor is able to set materiality level that is considered acceptable goes a long way to help the auditor detect misstatements that needs to be considered from both the perspectives of the amount which is expressed as quantity and the nature, which is expressed as quality. References Brown, C. A. (2005). Auditors Use of Qualitative Information in Materiality Judgments, Paper presented at the American Accounting Association Annual Meeting, San Francisco, August. Financial Reporting Council (FRC) (2013). Example of a UK auditor’s report. [Online] Available at https://www.frc.org.uk/Our-Work/Publications/Audit-and-Assurance-Team/ISA-700-(UK-and-Ireland)-700-(Revised)/Illustrative-example-of-a-UK-auditor-s-report.aspx. [December 15, 2014] Gleason, C. A. and Mills, L. F. (2002). Materiality and contingent tax liability reporting. The Accounting Review, 77(1), 317–342. Huang, P. H. (2005). Moody investing and the Supreme Court: Rethinking the materiality of information and the reasonableness of investors, Supreme Court Economic Review 13(1), 99–131. International Federation of Accountants (IFAC). (2004). Materiality in the Identification and Evaluation of Misstatements. International Auditing Standard No. 320, IFAC, New York, NY. ISA (2013). Audit Maeriality. [Online] Available at https://www.frc.org.uk/Our-Work/Publications/APB/320-Audit-materiality.pdf [December 14, 2014] Kearns F. E. (2011). Materiality and the audit report. It’s time for disclosure. [Online] Available at https://ritdml.rit.edu/bitstream/handle/1850/8790/FKearnsArticle2007.pdf?sequence=1 [December 14, 2014] Kinney, W., Burgstahler, D. and Martin, R. (2012). Earnings surprise "materiality" as measured by stock returns. Journal of Accounting Research, vol. 40 no. 5, pp. 1297–1329. Morrison Auditor’s Report (2013). Annual Report and Financial Statement 2012/2013. [Online] Available at http://www.morrisons-corporate.com/2013/annualreport/downloads/Morrisons_Group_financial_statements_2013.pdf [December 15, 2014] Nelson, M. W., Palmrose, Z. V. and Smith, S. D. (2005). Effect of quantitative materiality approach on auditors adjustment decisions. The Accounting Review, vol. 80 no. 3, pp. 897–920. Patterson, E. and Smith, R. (2013). Materiality uncertainty and earnings misstatement, The Accounting Review, vol. 78 no. 3, pp. 819-846. Podgor, E. S. (2005). Arthur Andersen, LLP and Martha Stewart: Should materiality be an element of obstruction of justice? Washburn Law Journal, vol. 44 no. 3, pp. 301-319. Vorhies, J. B. (2005). Importance of materiality. Journal of Accountancy, vol. 199 no. 5, pp. 53–59. Read More