Role of Materiality in Auditing in Advanced Auditing Essay

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Auditing; Topic: Materiality in Auditing

With respect to the field of auditing, materiality is a critically important concept addressing the significance of discrepancies, amounts, and transactions. Specific materiality guidelines are required in accounting practices to avoid judgmental (legal) decisions. Materiality is applied for most, if not all, economic decisions, and the topic of materiality is not a new issue. Disclosures in re financial statements have been emphasized by courts in the United Kingdom since the 1800's, whereas materiality initially rose to importance in the United States following 1933's Security act. The significance of the materiality concept and its implications are pertinent to business decisions, as well as for analysis and preparation of financial statements and in order to apply GAAP, generally accepted accounting principles.

For the accounting field, as well as for all fields of management, the concept of materiality is central to decision making. If something is considered to be immaterial, such as events, transactions, or specific items, it does not have to be separately reported in financial statements; this means that anything deemed immaterial is not accessible in the financial statements to creditors and/or investors. For this reason, stakeholders are often particularly interested in 'non-mandatory' information, as these data are not 'required' to be made available, but may be of considerable significance. Indeed, investors are more likely to focus on non-mandatory information than mandatory in many cases (Juma'h, 2009).

Definition of Materiality

The materiality concept has been addressed by The International Accounting Standards Committee (IASC), as well as by accounting bodies in the United States such as the American Institute of Certified Public Accountants (AICPA), the Securities and Exchange Commission (SEC), the Financial Accounting Standard Board (FASB), and the General Accounting Office (GAO). Materiality was defined by FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information (Para. 132, 1980) as follows: "The magnitude of an omission or mis-statement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or mis-statement"(Juma'h, 2009).

Classification of materiality

What a company releases or discloses on the 'face' of its financial statements is a decision involving limitations as to the amount or extent of information to be disclosed; this also applies for notes. In the first place, a comprehensive inclusion of all economic events affecting a particular business would result in an enormous glut of unnecessary material that is likely to present a false impression of the company to the stakeholders reading the financial statements. Simultaneously, however, the professional accountant is aware that choice of the 'adequate' method for presentation of economic information, or failure to fully disclose certain events of economic significance might mislead financial statement users. An obvious point is that the materiality purview of stakeholders and users of financial statements is potentially distinct from such materiality purview of accountants (Juma'h, 2009)

When materiality guidance is discussed, specific language addresses implied likelihood, in terms of the extent to which this information might influence the judgment of a 'reasonable person': probable, likely to influence, reasonably influence, possible, extremely unlikely, and remote (Price and Wallace, 2001, 2002). In considering the materiality of an event, an accountant's judgment is of critical importance. When an accountant considers these factors, measurements, both qualitative and quantitative, must consider aggregate base, type, and circumstances (Juma'h, 2009).

The Relevance of Materiality to Professional Accounting

Precisely what will be disclosed in a financial statement is determined by materiality, and ergo, the judgments exercised concerning materiality determine the content of financial statements. To evaluate whether financial statements are in concurrence with general accounting principles and are fair, materiality becomes relevant, as well as during the design and planning of auditing protocols. The act of auditing involves assessing the detecting of misstatements at an acceptable level, which is accomplished by testing sample items or transactions. The choice of the materiality level determines the extent of testing for auditory application (Brennan & Gray, 2005). The materiality level to be used in auditing financial statements and presenting such statements is selected at the start of the annual reporting cycle for financial audits. Auditors and company management will select the materiality level independently, generally with upper management making the primary decision. Ideally, the materiality decision by the management is independent of the materiality choice of the auditors; this materiality decision is then used by management to prepare financial statements.

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Some have argued that the precise 'order' of this process is important to avoid 'materiality shopping', in which management attempts to see how far they can 'go' with respect to transparency in materiality. After management has prepared the statements in accordance with their selected level of materiality, the auditors then apply the chosen position of the organization to their audits. The 'bottom line' is that an organization's position on materiality must be decided by management rather than by the auditor(s).

What Measure of Materiality would be Useful to Users?

Common heuristics generally fail to mensurate materiality in a manner that concurs with the requirements of the users of financial Managers may be tempted to act aggressively with respect to materiality in order to achieve either personal or corporate goals. As an example, in 2001 Enron wrote-down $1.2 billion in stockholders' equity. It was reported that Enron viewed this transaction as something that did not need to be publicly disclosed (Turner, 2003).

Consideration of how investors are likely to respond to accounting information is relevant to any discussion of materiality and related professional standards, which are generally presumed to be based upon a 'reasonable' investor of average prudence. It is obviously a daunting task given the complexity of capital markets. Ball and Brown (1968) revealed that stock prices and earnings announcements were significantly correlated. However, it remains the case that research addressing user perceptions about the materiality of financial statements remains limited in terms of appropriate methodology. The impact of auditor communication and precision upon materiality has also not been addressed, given the same methodology limitations.

As reported by Turner (2003), research methodologies that address user perceptions concerning the precision of financial statements include the following: (a) empirical and theoretical examinations of how 'noise' impacts financial information (Holthausen and Verrecchia, 1988; Collins and Salatka 1993); (b) surveys of those who use financial statements (Jennings et al. 1987); (c) examination of how markets react to a given choice of accounting methodology (Chewning et al. 1998); (d) laboratory experiments (Rosen, 1981; Fisher, 1990); and (e) correlations between earnings surprises and market reactions with earnings surprises (Freeman and Tse 1992; Kinney et al. 1999).

Because materiality has an enormous potential impact upon the extent of an audit as well as its scope, investors are particularly interested in this topic. The application and determination of materiality should play a major part in the interactions between auditors and audit committees; the latter are significantly involved in overseeing the audit quality.

In Ireland and the United Kingdom ISA 700 has recently been revised, and auditors must now report the manner in which the materiality concept was applied during an audit, as well as potential effects on the scope of the audit. Thus, audit committees and stakeholders can directly interact with respect to materiality (Financial Reporting Council, 2013)

A genealogical approach to exploring accounting materiality

Using a Foucauldian approach, it is possible to examine materiality in accounting in terms of genealogy. This method considers pertinent discourses and events to address the significance of statements in re materiality. A consideration of 'truth games' in financial discourse is only a portion of the manner in which power may affect the materiality concepts and their development, and an understanding that genealogy is necessarily non-linear in approach is required. Investigation of academic literature as well as guidance from the professional arena, from the International community, the United States, and the United Kingdom, provides statements addressing materiality from the perspectives of environmental, social, accounting, and legal perspectives. This breadth and depth enhances the analysis of materiality, and it becomes obvious that both simile and metaphor are critical components of the discursive placement of materiality, within conflicting contexts. One might envision the approach as being more like that of an impressionist painting rather than a photograph, with each perspective adding another element to the purview of materiality. Indeed, external conditions that may impact on meaning are hinted at through transitions in imagery and inherent contradictions (Edgley, n.d.).

When a simile is used, ideas do not lose their uniqueness but associations are made, whereas two ideas are analogized by metaphors. Dirsmith and Haskins (1991) addressed the manner in which metaphors can be utilized to synthesize and arrange the audit process. Metaphor with respect to materiality may have its roots in the diversity of organizational approaches necessary as well as consideration of the materiality level to be applied (Robson, 1992). While the use of.....

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