Public vs. Investors Perception on Materiality - Term Paper Example

? Materiality Materiality Materiality is a term that refers to a considerable usefulness or utility of an item which highly relies on the perception of the person to the general status of a firm. Data materiality and cost-benefit connection enforce limits on the importance of accounting data or information (Miller, 2005). The main purpose of performing an audit on financial statements is to help the auditor to put forth an instant judgment as to whether the financial statements are duly organized in accordance with the recognized financial reporting systems like the GAAP (Generally Accepted Accounting Principle). The perception of materiality assessment is highly dependent on the expatriate opinion. According to FASB (1975), "material information is that whose omission or misstatement could influence the economic decision of stakeholders to the financial statements. Materiality is dependent on the size of the item or error judged in the particular scenario of its omission or misstatement. Materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic whose information must have if it is to be useful." Public vs. Investors Perception on Materiality The public and the private investors have different perceptions on materiality. The entry of auditor’s materiality is perceived as proprietary data by numerous certified public accounting companies as they are not normally reported to the public (Ryan, 2004). Numerous regulators and scholars have suggested that the auditors must be asked to give a report on materiality entry to the users of the financial statements in their report of audit. The concept of materiality has been researched by various scholars with the aim of finding substantial information in regard to the view by both the private investors and the general public on the same concept (Riahi-Belkaoui, 2005). The debate on public perception against the investors’ perception has been researched by the FASB (1975) by taking the position that “no general standards of materiality could be formulated to take into account all the considerations that enter into an experienced human judgment,” and thus, decisions on materiality must be abandoned in the hands of auditor’s opinion (FASB, 1975). This stand by FASB regarding materiality has compelled scholars to investigate the opinion of organizers, users and auditors of the statements of finance where most of these researches uncover that there is an anticipation break amongst the users and auditors of the statements of finance as to what that amount to a material misstatement. The expectation break has the implication that the criterion of materiality entirely used by auditors to describe and perform materiality is essentially unique from that used by the users of buyer financial statements. The absence of consistency in materiality opinion limits the users from being knowledgeable in regard to misstatements or omission of items they feel to be material in the financial statements. In this regard, the position taken by the FASB and the “expectation void” in materiality opinion consequently made scholars and regulators suggest that materiality by auditor’s entry to be reported to the public. The normal allegation is that revealing of the auditor materiality entry would give the users the information of the extent of suitable error or misstatement in the buyer statements of finance and finally, minimize the disparity of materiality decisions by the users and auditors (Fields, 2011). The users of the public financial statements would also be in a position to substantially make use of the auditor materiality entry to evaluate the degree of dependence they can allocate on the audit to ascertain that public financial statements are independent from material misrepresentation. Therefore, it is claimed that the revelation of auditor materiality entry might assist in creating a high agreement amidst the public anticipation of the auditor, including its judgment of the performance by the auditor and the standards of auditing. The claim by the securities exchange commission (SEC) is perhaps similar to the above reasoning is that materiality that is based on historical measures might not be relevant in the current structure of the capital markets since some auditors and their customers might wrongly be using the terminology of materiality (Porter & Norton, 2011). In SEC’s judgment their concerns are that there might be excess auditor lenience for misrepresentation by the management where the objective to control the earnings due to materiality entry as applied by the auditor. In this respect, the exposure of auditor materiality entry may reduce the prejudice in the determinations by the auditor of the level of threshold and avert the administrators from purposefully entering errors within the bounds of the auditor threshold on materiality in case such practices are in existence. Is Materiality Based On Policy or "Feelings?" The principle of materiality must be based on auditor’s professional opinion which is found on the some predetermined set of procedures that must be followed in making that professional opinion. The idea of “personal feeling” must not arise in the sense that such side of view has resulted into the downfall of great companies globally. A good example is the Enron failure in the year 2001. FASB (1975) notes that there are numerous items that might be felt to be immaterial by an auditor due to personal judgments as opposed to the policy of the company and the regulators. Such items might involve where thee occurs some misstatements which might: i. Emanate from an entry which might not be measurable accurately, or from an intrinsically inaccurate approximate; ii. Hide a variation in the nature of earnings; iii. Conceal the inadequacy to fulfill the expectations of the analysts; iv. Modify a loss into a profit or income or the other way round; v. Involve a considerable department of the company; vi. Have an effect on the conformity with debt agreements or other contractual arrangements; vii. Have an impact on the legal necessities; viii. Raise the compensation of management via bonus plans schemes or; ix. Concern hiding of illegal activities within the company’s normal operations In this point of view FASB (1975) identifies that the quoting the volatility of the firm’s price in reaction to a considerably small misrepresentation as material might not be the only point of consideration for the auditors, but relevant due procedures must be followed to enhance the principle of materiality. Furthermore, the auditors might be wrong to personally assume international misrepresentation to declare some earnings as immaterial. The objective to misrepresent based on personal ‘feelings’ does not essentially result into the misrepresentation being declared immaterial. On the contrary, international misrepresentation in management of earnings might give substantial proof of materiality since the managers might have varied the reported figures in the perception that the users of financial information would consider the figures as considerable in their own opinion. Moreover, the quantitative and qualitative elements of every misrepresentation must be taken as distinctively and consolidated with other omissions to establish if the financial information in entirely are misrepresented (Kwok, 2005). Permission of small purposeful GAAP variations to be entered in the opinion that the intentional misrepresentation are immaterial may be in violation of the sections 13 (b) (2)-(7) of the 1934 Securities Exchange Act which regard hiding the “reasonableness” of the facts and guarantee given by the records of accounting (Kwok, 2005). Failing to rectify an identified misrepresentation might therefore be unlawful, found on the importance of the misstatement, the manner in which the misstatement came about, the cost involved in rectifying the misstatement and the preciseness of the involved reliable accounting policy. Is Materiality Consistent from Year to Year? There is a common mistake in every stage of the frequent financial statements preparations that they are not in a position to measure the principle of materiality on the foundation of consistency with the requirements of the users of the financial information. It might not be strange at all that management is at times tempted to assume the vigilant advance in regard to materiality to obtain personal or corporate objectives. One the most prevalent instances is the case of Enron where a $1.2 billion was written down of the shareholder’s equity in 2001 (Ryan, 2004). In this case professional consistency was not followed as the standards connected to materiality found on the presumed requirements of an optimal or rational shareholder, proof as to the manner in which investors react to the financial information is appropriate. The complication of capital markets discourages this form of activity. However, there are numerous studies that established an inter-link amidst the consistency of security prices and the announcement of earnings by a company (Pratt, 2011). A consistency in the outcome of some of these study efforts concerns the financial information users responding to the amounts much less that the level of materiality which consequently lead to normal heuristics. The concept of materiality might not be consistent from one year to another given that some studies have established that about a zero earnings shock there is substantially a positive linear connection of unusual returns to the earnings shock, the gradient of the relation is much more for lesser shock earnings. Therefore, according to statistics, there is no proof of an immateriality gap of earnings shock around zero (Morris, McKay, & Oates, 2009). According to Rittenberg, Johnstone and Gramling (2010) where earnings can be effectively be predictable, small earnings shock can be largely material, and are related with mathematically considerable and significantly higher unusual returns. On the contrary, where earnings are inefficiently predictable, large shock of earnings can be quite immaterial. The authors further attests to the fact that vital to matters of materiality, “statistically significant price responses to earnings surprises of as little as 0.03% of assets and price, amounts far below conventional rules of thumb for materiality in accounting and auditing,” (Rittenberg, Johnstone, & Gramling, 2010). The general compilation of proof apparently reveals a considerable difference amidst the concept of auditor’s materiality and the consistency of the financial information users-and a clear infringement of both the GAAP and the generally accepted auditing standards. Given the latest incidences of financial statement violations and the connected failure of audit, complains have gone high for a consistent materiality and transparency in the financial statement presentation. In spite of the identified significance on precision, consistency and comparability of the financial information, the auditors seem to infringe the same terms in the practice of each audit regarding to the choice of materiality. Given the choice of materiality is not revealed in the report f the auditors or anywhere, transparency on the statements of financial position is greatly hampered. The financial information users lack the information as to the transparency of the balances indicated. The choice of materiality has an impact on the comparability and consistency of the financial information given that for every audit firm auditors reassess materiality on a yearly basis on the modern conditions. Consequently, every period indicated on the financial statements might have a highly conflicting choice of materiality (Epstein & Jermakowicz, 2010). How Do Ethics Play A Role In Materiality and Potential Adjusting Materiality? In regard to the concept of management of earnings there has been a triggered ire of the Securities Exchange Commission in the validation of purposeful misstatement of the financial information on the foundation that they do not override the materiality standards. The notion that such violation of the principle of materiality is a normal occurrence has resulted into the declaration of the SEC Staff Accounting Bulletin 99 (SEC, 1999). This declaration stressed that elite dependence on the measures of quantity of materiality principle is irrelevant and that purposeful misrepresentation of the financial outcome might infringe the laws of federal securities, even though the figures might be lower than the conventional materiality standard. The declaration also raised the perception that it is not appropriate to enter a misrepresentation or fails to rectify an identified misstatement, even though measurably immaterial as a section of the going concern of the firm’s top management to maneuver or control the earnings reported. Haller, Raffournier and Walton (2003) claim that majority of the accounting matters for which the precise explanation is not identified at the time of preparing the financial information such as approximations of the recognizable worth of the stock or receivable collection. The principle of materiality permits the application of approximates in such scenarios as a way of expediency; or else, reporting financial information on time might not be the case. The SEC essentially was in the view that the application of the terminology in use had created a matter of seek and hide game even though the only available proof to accompany this perception was anecdotal in reality (Haller, Raffournier, & Walton, 2003). Majority of the researches on role of ethics in materiality concept have analyzed the issue of manipulation of earnings or the management of earnings, though most of the researches have dependent on data that is stored and concentrated on entirely on the incentives of economy as opposed to the assessing the issue from an ethical prospective of making decisions. The few researches that have assumed an ethical dimension have emphasized fundamentally on the investor’s or manager’s viewpoint of the ethical tolerability of manipulation of earnings and have not offered a hypothetical answer of the reason why the manipulations tend to be dominant in reality. These articles have furthermore not stressed exclusively the impact of materiality on manipulation of earnings (Rittenberg, Johnstone, & Gramling, 2010). Latest studies in the literature of auditing have assessed the impact of comparative materiality on the judgment of financial reporting. Nonetheless, these researches have been constrained to the impact of materiality on the outlook of mistakes and errors that were either found on the objective accounting approximate or real mistakes on the side of management as opposed to the fraud in the financial information. These researches have, on the other hand, limited to the study of autonomy auditors as opposed to the managers and top executives of the company. Executives in finance department normally make opinions and decisions in accounting and in the status of purposeful manipulations of earnings, the allowance of these opinions might never be autonomously assessed except if the mistakes or errors are identified by the auditors of the company (Epstein & Jermakowicz, 2010). Taking into account the latest allegations by the SEC, a clear comprehension of the executives’ of finance tendency to validate the manipulation of earnings on the basis of immateriality is apparently required. The present study is an addition to the expanse of facts of this occurrence in different ways. The theory of ethical power to the study on manipulation of earnings alleges that an explanation on the dominance of management of earnings in reality can be clearly explained. It might also be the first research to investigate the impact of materiality quantitatively in regard to the tendency by the executives in the finance and accounting department to get involved in the purposeful manipulation of earnings. Ultimately, the theory also extrapolates the latest study on the principle of materiality to the background of fraud in the presentation of the financial information and also illustrates that criminal reporting of financial information plots might be validated on the basis of immateriality. On the other hand, they demand that the validity of this type of practice must be questioned intensively (Kwok, 2005). References Epstein, B. J., & Jermakowicz, E. K. (2010). Wiley 2010 interpretation and application of International financial reporting standards: [includes summary of key provisions of U.S. GAAP vs. IFRS]. Hoboken, NJ: Wiley. Fields, E. (2011). The essentials of finance and accounting for nonfinancial managers. New York, NY: American Management Association. Financial Accounting Standards Board. (1975). An analysis of issues related to criteria for Determining materiality. Stamford, Conn: Financial Accounting Standards Board. Haller, A., Raffournier, B., & Walton, P. (2003). International accounting. London: Thomson. Kwok, B. K. B. (2005). Accounting irregularities in financial statements: A definitive guide for litigators, auditors, and fraud investigators. Aldershot, Hants, England: Ashgate. Miller, D. (2005). Materiality. Durham, N.C.: Duke Univ. Press. Morris, G., McKay, S., & Oates, A. (2009). Finance Director's Handbook. Oxford: CIMA. Ryan, B. (2004). Finance and accounting for business. London: Thomson Learning. Pratt, J. (2011). Financial accounting in an economic context. Hoboken, NJ: Wiley. Porter, G. A. & Norton, C. L. (2011). Financial accounting: The impact on decision makers. Mason, OH: South-Western Cengage Learning. Riahi-Belkaoui, A. (2005). Accounting theory. London: Thomson. Rittenberg, L. E., Johnstone, K. M. & Gramling, A. A. (2010). Auditing: A business risk Approach. Mason, OH: South-Western Cengage Learning. Securities and Exchange Commission (SEC). (1999). Staff Accounting Bulletin No. 99. Materiality (17 CFR Parts 211). Read More