Critical Importance of Materiality in Auditing - Coursework Example

 MATERIALITY IN AUDITING Audit scholars have conducted extensive research works concerning the importance of materiality and its secrecy by auditors. The findings of these studies reflect the way auditors treat material elements of bookkeeping in relation to the most recent regulation developments. Two key studies by financial researchers Porter, et al, and Mock et al, came to conclusion that auditors treat materiality with the same outlook and seriousness they do audit regulations. According to Porter, et al, ‘the term ‘material’ is of critical importance in the auditing context.’ Mock et al added, ‘Materiality levels are more secret than the Coca Cola formula.’ The following paper discusses these abstracts by Porter and Mock in the context of academic research and recent developments in audit regulation and practice. Materiality is of critical importance to auditors, which academic research findings have demonstrated and linked to its nondisclosure treatment by auditors. Critical Importance of Materiality in Auditing Information about materiality might be the surplus information most commonly wanted by account users (Messier et al., 2005). Determining materiality and related, acceptable misstatements used in choosing the nature and degree of audit processes have been kept secret to either management or shareholders. Porter said the word ‘material’ is of critical importance to auditors because it often refers to strategic and planned choices essential for conducting an autonomous audit. The word material is important in the sense that it allows auditors to operate under audit regulations more successfully. The word ‘material’ has the ability to change decisions made by executives and major shareholders on financial bases (Porter et al., 2014, p.73). In addition, the performance of an organisation can also be influenced by the levels of materiality included and excluded in financial statements by auditors. An organisation can consider four different situations when determining the importance of materiality in auditing (Porter et al., 2014, p. 73). Materiality is critically important for determining whether to reveal an item, change an error or misstatement in the issued financial statements, make an audit work, and compose an audit opinion (Brennan & and Gray, 2005, p. 10). First, materiality is critically important for choosing whether to reveal an item because only then does an auditor find out how much effort has been made throughout the audit. Secondly, the choice to not change accounts for errors is a managerial and not accounting decision (Brennan & and Gray, 2005, p. 10). According to the IFAC, determining the impact of materiality on current accounts of misstatements that went uncorrected in previous quarters are auditing considerations. Such an error might signify an exclusive material misstatement or a fusion of other auditing errors (International Standard On Auditing 320: Materiality In Planning And Performing An Audit, 2010, p. 323). Thirdly, the level of audit work is a role of the level of materiality used in the accounting review, which is very crucial for an organisation (Brennan & and Gray, 2005, p. 11). This is because a cost-benefit adjustment exists here. An organisation will often pay more for lower levels of materiality since they call for more audit work. However, the organisation might uncover more auditing errors leading to more precise financial statements. It is uncertain that the extra cost of the audit work from lowering degrees of materiality is advantageous to investors. Lastly, audit views are another situation that shows the critical importance of materiality (Brennan & and Gray, 2005, p. 11). The degree of materiality might also affect audit view since this view is a role of whether applicable items are material or immaterial. Materiality is also critically important for auditors when determining the optimal amount of error that is acceptable. Auditors distribute primary materiality to individual financial statements and call them TM (tolerable misstatement) (Gist & Shastri, 2003). The distribution of materiality by auditors enables them to assess the essential sample size or degree of audit considering the mandatory assurance (Brennan & Gray, 2005, p. 13). Auditors normally decide the nature and promptness of tests originally that collectively affect the proficiency or quality of proof (Messier et al., 2005). Afterwards, the auditor decides the degree of proof centred on acceptable financial statement errors. Auditors use distributed materiality to assess the most approximated errors in an issued financial statement or set of accounts. From an investor’s point of view, the materiality in relation to certain very liquid line items is more crucial than those compared with less liquid line items (Porter et al., 2014, p. 76). Examples of very liquid line items are marketable assets and receivable financial statements. Organisations expect auditors to acknowledge the importance of qualitative issues when distributing quantitative materiality. Making professional decision entails practicing due caution in adhering to accounting criteria and regulations, sustaining an attitude of professional scepticism, technical competence in reviewing a client’s fiscal statements, and achieving an unbiased decision successfully and promptly (Gist & Shastri, 2003). In this case, an auditor might not distribute quantitative materiality to a land fiscal statement that has not been adjusted since the previous audit. Materiality typically determines the entries an auditor will disclose in a fiscal statement (Smith, 2013, p. 1). As a result, the content of a fiscal statement is partially a product of judgments practiced around materiality. This makes materiality critically crucial for planning and developing auditing processes, and assessing whether accounts are fair and adhere to widely tolerated auditing regulations and principles. Auditing entails testing a sample of exchanges or entries from which auditors develop a tolerable level of assurance of detecting misstatements. Deciding the level of materiality to be used in accounting reviews dictates this level of testing (Messier et al., 2005). Many auditors in the banking sector feel like the level of assurance and materiality are essentially similar (Edgley, 2012, p. 5). The matter of materiality produces the most discussion and research questions that it is largely thought of as critically important. For example, when clients place particular collateral for a loan, the respective bank would accept a bigger level of materiality. Sometimes, this margin can be 10% or 20% more or less (Gist & Shastri, 2003). Auditors from creditors like Barclays and Lloyds Bank said they accept such big potential differences even when a client pledges collateral (Edgley, 2012, p. 6). Another example is the order of materiality choices made by banks. Managers must use their selected level of materiality to prepare the accounts. To do this, a materiality choice has to be made without auditing advisory. Clearly, banks consider materiality so important they separate the application of materiality levels between auditors and managers. The Secrecy of Materiality Levels by Auditors Materiality levels used by auditors have always been a secret because there are no requirements for submitting or revealing materiality decisions (Holder et al., 2003). Publishers of fiscal statements are not bound by any requirements or policies to reveal their approaches to the materiality. Accounting regulations just demand disclosure on materiality as it is similar to an auditing regulation decision. There was some truth in Mock et al’s statement that auditors conceal materiality better than Coca-Cola does the formula of its main beverage. Just like Coca-Cola, auditors are not entitled by any regulations or policies to reveal their strong points, which is the level of materiality in this instance (Mock et al., 2009, p. 4). Academic research has shown that the importance and secrecy of materiality influences auditor judgments. For instance, a change in the amount of salary determines auditors’ decision-making processes when trying to approve their judgment (Mock et al., 2009, p. 2). Study findings have also discovered that income is key for auditors trying to come to a decision about material and immaterial items or entries. The same findings showed that auditors need clients to enter changes where the technique used reveals the error to be most material (Gist & Shastri, 2003). Disclosure rises in relation to the scope of contingent loss. A margin scope of disclosure is not always clear, but just the biggest claims cause disclosure. The same research discovered that numerous organisations do not apply the normal 5% of salary materiality standards (Smith, 2013, p. 3). Auditors find above projected disclosures where an entry causes a balance sheet effect and below projected disclosures when it causes a salary effect (Mock et al., 2009, p. 4). Organisations are inclined to reveal fewer entries that surpass 5% of salary or securities standards. These findings demonstrated that auditor decisions on materiality are affected by potentials of legal action, with companies in the legal sector more probable to disclose (Brennan & Gray, 2005, p. 18). Academic research has shown that the importance and secrecy of materiality also affects the judgment of investors (Holder et al., 2003). Even researches can determine materiality objectively. If investors think of an event as material, it should increase the value of the company’s stock. This appreciation offers a technique for deducing investors’ judgments of materiality (Brennan & Gray, 2005, p. 20). Other study findings found out that the judgments of auditors and investors are the same. Apparently, findings showed that small incomes have an unequally huge impact on stock profits. The threshold impact of incomes disclosures on profits is bigger for smaller disclosures (Brennan & Gray, 2005, p. 19). The goal of disclosures is to allow stockholders to understand fiscal statements easily. Instead of revealing the technique behind the calculations, it is much simpler for auditors to reveal the whole amount of materiality degree selected. It is more effective for stakeholders to be aware of the amount of materiality than how auditors came to this amount (Holder et al., 2003). Impact of Audit Regulation on Audit Practice In Relation to the Disclosure of Materiality Accounting regulations have not had any significant impact on audit reporting when it comes to materiality (Financial Reporting Council, 2013, p. 4). This is because accounting panels have not passed benchmarks or policies that require auditors to disclose levels of materiality used during auditing. Currently, audit regulation, for legal and trained accounting, differentiates between material and immaterial entries and use diverse rules, strategies, and requirements for both types. This differentiation is particularly crucial in deciding what will be revealed and what will remain a secret in the accounts. For instance, audit standards by AICPA require organisations to reveal auditing rules for material entries only. Another example is audit regulations that require the disclosure of only material, contingent liabilities. Revealing unrevised errors would enable shareholders to make autonomous assessments of the materiality of the overlooked items (International Standard On Auditing 320: Materiality In Planning And Performing An Audit, 2010, p. 324). The effect of failing to revise financial statement balances relates to audit regulation in the sense that it allows different auditors and investors to make different decisions about the organisation’s financial progress. For instance, some shareholders may assess the effect of unrevised errors on net salary and dividends per share. Other shareholders may be more interested in the effect of unrevised errors on balance sheet books like portfolio or receivable financial statements. At the same time, audit regulations do demonstrate a highly varied understanding of the idea of materiality (Smith, 2013, p. 2). However, auditing regulators appear to understand that auditors do not review financial statements and dealings to a penny. This is also likely why the word ‘material’ often appears in audit regulations. It is possible to conclude whether changes made by audit regulation are for the better. For instance, if auditors revealed materiality levels in accounting reports, then stakeholders may gain insight about the reports’ margins of error. This direction helps stakeholders find some significance in these reports. A prudent shareholder always knows he or she has the right to know the level of materiality used by his organisation’s accountants (Porter et al., 2014, p. 359). If it were not for audit regulations, shareholders would know of these rights. Accountants contend that when they raise the levels of materiality, accounting costs rise consequently and correspondingly. The cost of the financial review, and its connection with the selected level of materiality, is a matter that stockholders ought to know (International Standard On Auditing 320: Materiality In Planning And Performing An Audit, 2010, p. 326). It is not very burdensome to oblige auditors to reveal the planning materiality in their reports. As a result, stockholders can evaluate the margin of error in the performance of the report. In conclusion, Porter et al. was correct when they said the word ‘material’ is very important in auditing. However, managers and investors have no basis for assessing the effect of the primary accuracy of reviewed accounts. This is understandable because auditors have a lot of adaptability in making materiality choices based on trained judgment. In addition, these choices are not revealed to managers or shareholders. Academic researches on materiality have proven Mock et al.’s assertion that an organisation’s levels of ‘materiality are more secret than the Coca-Cola formula” (Mock et al., 2009, p. 4). If auditors have made levels of materiality a secret for years, they clearly have the best insight of the importance of materiality. References Brennan, N & Gray, SJ 2005, ‘The Impact of Materiality: Accounting's Best Kept Secret,’ Asian Academy Of Management Journal Of Accounting And Finance, vol. 1, pp. 1–31. Edgley, C 2012. A Genealogy of Accounting Materiality, Cardiff Business School, viewed 13 December 2014, http://elsevier.conference- services.net/resources/247/2182/pdf/CPAC2011_0091_paper.pdf Financial Reporting Council 2013, ‘Audit Quality Thematic Review Materiality,’ Thematic Review, Financial Reporting Council, Aldwych, London, viewed 13 December 2014, https://frc.org.uk/Our-Work/Publications/Audit-Quality-Review/Audit-Quality-Thematic- Review-Materiality.pdf Gist, WE & Shastri, T 2003, ‘Revisiting Materiality,’ The CPA Journal, viewed 13 December 2014, http://www.nysscpa.org/cpajournal/2003/1103/dept/d116003.htm Holder, WW, Schermann, KR, & Whittington, R 2003, ‘Materiality Considerations,’ Journal of Accountancy, viewed 13 December 2014, http://www.journalofaccountancy.com/Issues/2003/Nov/MaterialityConsiderations.htm International Standard On Auditing 320: Materiality In Planning And Performing An Audit. 2010. New York: International Federation of Accountants: IFAC. Messier, WF, Martinov-Bennie, N, & Eilifsen, A 2005, ‘A Review and Integration of Empirical Research on Materiality: Two Decades Later,’ Auditing: A Journal of Practice & Theory, viewed 13 December 2014, http://ssrn.com/abstract=786688 Mock, TJ, Turner, JL, Gray, GL, & Coram, PJ 2009, The Unqualified Auditor’s Report: A Study of User Perceptions, Effects on User Decisions and Decision Processes, and Directions for Further Research. Auditing Standards Board, New York, NY. Porter, P, Hatherly, D, & Simon, J 2014, Principles of External Auditing, 4th edn, John Wiley & Sons, New York, NY. Smith, J 2013, ‘Illustrative Example of a UK auditor’s report reflecting the requirements of ISA (UK and Ireland) 700 (Revised June 2013),’ Financial Reporting Council, Aldwych, London, viewed 13 December 2014, https://www.frc.org.uk/Our- Work/Publications/Audit-and-Assurance-Team/ISA-700-%28UK-and-Ireland%29-700- %28Revised%29/Illustrative-example-of-a-UK-auditor-s-report.aspx Read More