Importance of Materiality in Auditing - Essay Example

MATERIALITY IN AUDITING Accountability of the business has gained significant importance since the recent past, mainly after the financial crunch of the 2008. Stakeholders of the business make a decision on the basis of the financial information provided in the financial statements. Therefore, information in the financial statement is required to be free from mistakes, mainly material mistakes, to provide stakeholders with a true and fair view of the financial performance of the business. Despite this fact being highly emphasized, there are large notable areas that are left on the judgment and expertise of the auditor. One of the major areas includes materiality where no yardsticks are implied for measuring the level of materiality to be acceptable while producing financial statements. Instead, it is measured by auditors on the basis of professional expertise, intuition and understanding about the economic impact of such decisions on the business. To ascertain, Mock et al., (2009) in the similar vein, has stated that acceptable levels of materiality in the auditing of the financial statements are kept more secret than the levels implied for the formula of Coca Cola. Also, Porter et al. (2014) mentioned that materiality has high importance in reference to auditing. Hence, the underlying essay is produced in the context of exploring various aspects of materiality in auditing. 1. Importance Of Materiality In Auditing Materiality is the concept that is associated with the role and significance of an element in the financial statement. The concept is critical in designing and producing an audit report of quality. The Financial Accounting Standards Board defines materiality as the scale or range of the level that does not affect the decision and judgment of the reasonable person based on the change in information provided in the accounts of an organization. Alongside, the importance of the materiality lies in the fact that the concept is applicable both intentional and unintentional misstatements in accounts. It is important for the auditors to determine the performance materiality and assess the impact that materiality produces on the whole on the financial statement. Materiality carries considerable risk as lenient attention to the misstatements can produce risk that audit reports do not produce with fair information (Johnstone, Gramling, and Rittenberg, 2013). Graphical representation of risks, that in turn will be produced as a result of material misstatements and consequently having an impact on the quality of the audit report, is presented below: (Johnstone, Gramling, and Rittenberg, 2013) Inherent risk refers to the material misstatements produced in the financials of the company. While, internal control risk is the risk for which internal control systems of an organization do not take remedial measures. The product of these two risks in turn adds to the audit risk which is the product of material misstatement risk and the detection risk. Collectively, it requires producing a comprehensive planning to produce quality audit report based on its impact on the on the financial, as well as individual account. 2. Secrecy In The Materiality Levels Used By Auditors An important aspect related to the materiality at affect in the process of audit is the thresholds defined as the acceptable levels. The thresholds defined for the acceptable levels include 5% to 10% of the pre-tax income and the one to 1.5 percent of total assets or revenue, whichever is greater (CFRR. 2013). Though the materiality has profound impact on the quality of an audit report, there often exist considerable differences between the management of an organization and the auditor about the misstatement to be considered material (Johnstone, Gramling, and Rittenberg, 2013). For instance, Brennan, and Gray, (2005) in a review referred to the Enron’s case and stated that auditor’s recommendation related to the earning reduction of a sizeable amount from 1997-2000 was not implanted. Consequently, the results produced were not fair and true, and finally corporation ended with a scandal. Hence, the materiality was noted on the part of the auditor; however, kept secret on being persuaded by the management of the company. Secrecy in the auditing of the financials is also affected by the type of ownership. For example, government prefers auditors with readiness to keep a higher level of secrecy in materiality while auditing the financial reports of the company to sustain the political interest of the government. Hence taking advantage of the judgmental aspect of the materiality, auditors play an effective role in safeguarding the interest of the government (Guedhami, Pittman, and Saffar, 2009). 3. Researches: Both the importance and secrecy in the materiality by auditors is given wide consideration in order to produce standards that ensure the quality level of audit reports. For example, Huang (2005) expanded the role of materiality in investment decision. Huang (2005) in the context of the non-rational attitude towards investment requires that the materiality definition must be altered by taking into account the normal investors’ way of depicting information instead of the rational investors. Additionally, Hope et al. (2008) have noted the importance of the secrecy in the context of the national culture. The results put forward claims that countries with more emphasis on secrecy as a dimension of national culture are less likely to hire an auditor from the quality firm; hence, both factors are negatively related. This puts forward an idea for the audit firms to produce a framework of the audit for different countries based on their cultural factors as well. Zhou, (2012) in specific reference to audit of government affairs have identified five qualitative factors in order to integrate quality while addressing the materiality and controlling secrecy. The five factors include political significance, inefficiency of internal control, public focus, restrictiveness of funds and experience as the prime factors that can contribute feasibility, as well as a generality in the audit. Jennings, Reckers, and Kneer, (1991) in a paper have put forward the core source of the challenge which results in the auditors’ dilemma of having difference between actual auditors’ practice and stated claims in the auditing profession. The core source of challenge lies in the fact that materiality is a judgmental while ideal materiality requires it to be absolute with the certainty. Hence, application and testing of these factors in the assessment of materiality in the country specific context can produce a country or even industry-specific model of the materiality assessment in financial reporting. Hence, with a broader view developed about materiality and secrecy tool in the hands of the auditor it raises the question on the viability of the information provided as financial statement with auditors’ mark of being reasonable. Scharfman, (2012) in a book concluded that as there are no rules hardly defined about the materiality, it would then be crazy to make decisions based on the information provided in the financial statements audited by the auditor. Contrary to this, Kearns (2007) in a paper has suggested that to reduce the unlikely impact of secrecy of materiality in the quality audit, it is more viable to mention the level of materiality maintained by the auditor in assessing transaction. This can be easily done as the auditors are allowed to produce discretionary notes about any transaction in the auditor’s report. 4. Changes In The Audit Regulation (For Audit Reporting) About The Disclosure Of the Materiality With the objective of inculcating quality and comprehensiveness in the information provided in the financial statements, accounting boards consistently update the regulation for developing accountings statement. The International Standard on Auditing (ISA) 320 went effective since December 15, 2009 (International Standard On Auditing 320, n.d.). The ISA produced a comprehensive plan for the application of the materiality and its respective disclosures. Similarly, Public Company of Accounting of Oversight Board (PCAOB) has set Auditing Standard No. 11 for the materiality consideration in planning and performance in the audit of the firms. The regulation has set standards that are to be followed by the auditor in planning and conducting an audit of the financials of the firm. The guideline put forward requires auditor to set a materiality acceptable level for the entries financials as well as the individual accounts. In addition to this, it also requires auditors to produce the tolerable level for the materiality. Finally, it also requires auditors to take into consideration the implication of the materiality standard at different locations in the audit report (PCAOB, 2013). In addition to clearly defining the materiality in the audit planning process, a report from the KPMG about the recently added disclosures requirement from IFRS has put forward the need for respective materiality reconciliation. For instance, the report cited the need of judgment for the materiality reconciliation for the new added disclosures (KPMG, 2013). However, these and other such recommendations leave the materiality reconciliation on the judgment of the auditors. This in turn takes matter back to the starting point where materiality and secrecy remain on the discretion of the auditors experience and judgment. A review report from the UK Financial Reporting Council (FRC) on the auditors conducts of the materiality and concluded higher need of realignment of the auditors with the spirit of the materiality regulation. The review was based on top and reputed organization offering audit services that include Grant Thornton UK LLP, BDO LLP, Deloitte LLP, KPMG LLP Ernst & Young LLP, KPMG Audit plc and PricewaterhouseCoopers LLP. The review produced evidence that instead of producing comprehensive audit that has more errors and misstatements identified, the auditors and firms are moving around. Some of the leverage increased by the firms includes increase in the range of the materiality acceptable level, lack of justification and leaving things on the judgment, and despite of the identification of the errors it was not communicated to the audit committee. The report has also produced the recommendation; however, it is also subject to the acceptance of the auditors and audit firms (FRC, 2013). Hence, it is important to understand that efforts are to be made with an extra edge than a simple change in regulation and ascertaining disclosure requirement. 5. Implications Of Regulatory Change On The Reporting Of Materiality In Auditing Irrespective of the accounting element for which the change is proposed, all are guided by the similar factor of improving the quality of audit of the reports produced. With every passing day, economic shock, as well as the crises of the organizations, the regulatory entities are developing stringent measures for the improvement in the quality of information. In addition to the above examples of change in regulatory affairs, European Parliament has also proposed set of rules to improve the audit quality of the public entities. One of the proposed regulations for improving the quality of the regulation includes mandating the rotation of the audit firms providing service to the public interest entities (PIEs). Similar other proposed recommendations are drawn on the ground of improving accountability and increasing transparency in the audits of the financials (European Commission Statement. 2014). Despite these improvements it is not sure to conclude that quality of the audit reports will be improved. This supposition has a factual support. For instance, EP has proposed that companies will be rotated. However, in the light of the Audit Quality Thematic Review developed by FRC all the reputed firms were found to have produced similar level of problems and lacking in addressing the high standards of quality. In case where none of the renowned companies in the industry of auditing have been found to produce quality standards as required, it cannot be claimed that regulatory changes will produce any effective results. For example, Butler, Leone, and Willenborg, (2004) in paper has discussed that auditor is required to report misstatement to management first and then to auditors committee. Nevertheless in case of mutual understanding between the two parties i.e. management and the auditors for maintaining a high level of secrecy, then such changes in regulation do not carry in role to play. Moreover, Libby and Brown, (2012) in a study have reported the role of consensus building objective among auditors is still able to shadow the audit guideline. Hence, it can be safely stated that changes in the regulation is already given considerable attention. It is high time for the development of standards as well as culture of disclosure of materiality implied in each and every transaction (Kearns, 2007). 6. CONCLUSION The role of audit and the audit firms is increasing in the light of safeguarding interest of the investors as well as stakeholders. However, the case of materiality requires rethink from altering regulation to developing a yardstick that requires some level of quantitative analysis. Hence, striking the right balance between the qualitative and quantitative measures to assess the materiality and the secrecy implied in the study is the need of the hour in the audit industry. To conclude, striking such right balance not only requires contribution from regulatory bodies and auditors but also from the academic researcher in identifying potential areas of the improvement integration (Messier et al. 2005). 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