Question: materiality is very important to auditors in all aspects of audit engagement, as stated in ASA 320.9(ISA 320.8): the auditor shall consider materiality when: a)determining the nature, timing, extent of audit procedures; and b)evaluating the Essay Example
Materiality in Auditing
Auditing is a very important aspect in any organization that seeks to ascertain the validity of financial and non financial systems and information of the organization. Non financial aspects of an organization include: information systems; security and safety and environmental issues. An audit is performed to provide reasonable assurance that financial statements contain no material error. Materiality in auditing relates to the significance of any amount, transaction or discrepancy presented in the financial statements.
An auditor should consider materiality when determining the nature, timing, extent of audit procedures and evaluating the effect of misstatements. These procedures are effective if considered during audit planning. Every organization has its own way of considering a statement as material for auditing purposes. This is because what is material in one organization may be immaterial in another organization, hence the need for organizations to provide the auditors with decisions on making materiality judgments. The concept of materiality is addressed in relation to audit risk, another concept considered during audit planning.
Audit risk is the possibility that unknown material misstatements exist in financial statements after an audit has been completed. Information is material if its omission or misstatement is bound to influence the economic decision of users of such information. Users of financial or non financial information rely on the audit conducted by an independent auditor. Financial information is prepared and presented in accordance with accounting policies and practices, such as the Generally Accepted Accounting Principles, the International Accounting Standards and the International Financial Reporting Standards.
According to Gupta (2004, 1145) material misstatement may be presented either as an individual transaction or an aggregate. The purpose of considering the materiality of financial statements is to achieve a true and fair presentation of financial information. Materiality may be influenced by individual considerations, legal requirements and compliance or non compliance with the accounting policies. An auditor should evaluate the quality (nature) and quantity (amount) of a material statement. An example of nature of a misstatement is when the preparer of financial statement intentionally avoids application of a certain accounting policy that is important in providing true and fair financial information.
During audit planning the auditor considers what would make financial information to be materially misstated. The management of the organization may provide the auditor with guidelines in making judgments on misstatements. An auditor can perform an audit on a sample of financials statements. Materiality judgment is based on the opinion of a reasonable person that the omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item would have influenced his decision. In making material judgment, many auditors prefer to assign numerical estimates to specific amounts or transactions.
There are different approaches that auditors use to decide on whether certain financial or non financial information is material. These approaches include: judgmental, ratio and formula which are based on factors such as cost, analytical procedures results, use of account data and consequences of misstatements for other purposes. Material misstatement based on quantitative approaches may be influenced depending on the auditor’s professional judgment on the possible effect of qualitative factors. In addition, an auditor will consider the facts that are material to users based on the information needs of users in a group. This means that the possible effect of a misstatement on information needs of just an individual is not considered since, individuals have varying needs.
In making materiality judgments, auditors often use twelve qualitative factors. These qualitative factors include: possible effects of projected earnings misstatements, likelihood of earnings management, existence of restrictive debt covenants, possible effects of share price misstatements, likelihood of financial statement fraud, potential business combinations (mergers and acquisitions), imminent public stock offering, detection of fraud or fraud symptoms in periods, risk of litigation, inadequate and ineffective audit committee and lack of vigilant board of directors (Rezaee et al 246).
Materiality judgment is made in the light of existing circumstances affected by size or and nature of the misstatements. An auditor issues an audit opinion based on materiality and audit risks concepts. In giving an opinion, an auditor states whether the financial statements present a ‘true and fair view’ in all material respects, the financial position, results of operations and cash flows in conformity with Generally Accepted Accounting Principles (GAAP). To maintain investors and creditors confidence on financial reporting process of an organization, sound materiality judgment is essential. Audit risk is defined in the context of materiality since it is the risk that an auditor will issue an inappropriate or unqualified audit report on materially misstated financial statements.
On the other hand, every assets and liabilities of an organization require different significant judgments. For example, loan securities are subject to fair value estimates and therefore an auditor must consider the possibility that the securities will be returned and the value of the collateral of the securities if not returned. When making materiality judgments an auditor must have assess on disclosures on other clients plans such closing or opening lines of businesses since these changes will have an effect on the amount that is reflected in the financial statements. However auditors have difficulties in making materiality judgments because audit practices and materiality considerations differ from one client to another.
Generally, the auditor’s consideration of materiality is a matter of professional judgment influenced by an auditor’s view on the needs of users of financial information and based on qualitative and quantitative considerations. To support this, the client should allow the auditor to be independent while performing the audit, making material judgments as well as giving an opinion on the financial reports or statements. Rittenberg et al (2009 866) adds that an auditor conducts materiality judgments to make sure that the auditor gathers sufficient evidential matter to obtain reasonable assurance that the financial statements are free of material misstatements. Complex materiality judgments can be disclosed as notes in the financial statements.
To make materiality judgments, auditors make use of certain benchmarks and threshold based on ratios or percentages. A client can provide guidelines to the auditor on what to consider as material or immaterial. For instance, when net income is immaterial if its less than 5%, material if it ranges between 5% and 10 % , while significantly material if it is above 10%. In addition, professional firms provide policies that specify the benchmarks and thresholds that firms and auditors can use in making materiality judgments. Further, an auditor should integrate other judgmental factors of materiality.
There is effectiveness of these decisions aid in improving auditors’ materiality judgments among researchers. Decisions’ aids include: qualitative and quantitative factors in addition to the use of benchmarks or threshold. Further, in using these decision aids, an auditor relies on professional judgments and the users of such information. For the effectiveness of these decisions aids, the auditor should consider materiality and audit risk during audit planning. This is because materiality is used to determine the nature, timing and extent of audit procedures and the effects of misstatements.
Materiality judgments should address both the nature and amount of a statement in considering it as immaterial or material. In making materiality judgment an auditor must perform as an independent auditor since users of financial information rely on audited financial statements in confidence that the auditor was not influenced by the client nor had any other interests in the organization. An organization should be supportive to the auditor in ensuring that the financial statements presented have not been manipulated. This can be achieved through employing a strong internal control system. Materiality judgments are made on both financial and non-financial information.
Gupta, Kamal, Contemporary Accounting, 6th Ed, Tata McGraw-Hill Education, 2004.
Rezaee, Zabihollah & Riley Richard, Financial Statement Fraud: Prevention and Detection,
2nd Ed, John Wiley and Sons, 2009.
Rittenberg, Larry E, Karla J & Gramling Audrey A, Auditing: A Business Risk Approach,
7th Ed, Cengage Learning, 2009.
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