Role of Materiality in Auditing in Advanced Auditing Essay

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Accounting (Auditing)

The information that an auditor gathers as he runs analytical procedures in an entity he is auditing and as he gets better acquainted with the organization must be enough in determining materiality and assessing risks. Materiality is very important especially in helping the auditor determine what kind of audit report to be given. The auditor has to make reference to two key issues as regards what areas the financial audit covered. This helps in highlighting risk and materiality. These issues are: the limitation of the liability of the auditor to the significant information given to him and established by him by way of the materiality parameters he has established given his professional capacity and reasoning and his supplying an assurance that is not absolute but reasonable as pertaining to the financial statements' accuracy. The materiality is relative. A given figure or value may be viewed as material in one organization and immaterial in another organization. The auditor is to determine what is material based on his judgment and professional capacity. Some materiality levels cannot be pre-established or defined regardless of it being a guide or template for auditing various concerns. Audit risk calculation is very critical and thus it is not pre-determined but left for the auditor to establish by using his experience and reasoning as a professional. Materiality inversely relates to audit risk. A high audit risk affects materiality and therefore materiality should be slowly determined (Joldos, et al., 2010).

Materiality - Important Indicator for Auditing and For Issuing Audit Opinions within the Audit Report

International Standards on Auditing (ISA) 320 defines materiality as 'the amount or amounts set by the auditor as an error, an inaccuracy or an omission that may lead to annual misstatements, as well as the fairness of the results, of the financial statements and the enterprise's patrimony. The IASC declares that for information to be material, its omission or misstatement can have an influence on economic or financial decisions based on the financial statements. It depends heavily on item size and/or error as determined in certain circumstances of their misstatement or omission. Materiality thus gives the threshold instead of being the primary characteristic that useful information has to posses. Financial Accounting Standards Board (FASB) puts it that materiality represents the magnitude of a misstatement or omission of information in a financial statement which a reasonable individual making a decision based on the financial statements would be influenced by. Various reference points can be used in determining materiality e.g. turnover, net result and equity capital (Joldos, et. al. 2010).

The elements are referred to as benchmarks. They are the pivots where materiality is determined against either in relative or absolute values. The elements might have two effects:

On the exercise outcome: the benchmark used is the financial result or in a case where its size is not as important, a different benchmark like self-financing capacity, operating result, etc. could be used. Importance has to be given to those elements that can regroup in order for them to make reference to the current cycle only. The auditor also needs to document previous results so as to avoid using abnormal benchmarks (Joldos, et al., 2010)

On the balance sheet presentation: based on the inconsistencies in double entry. Where a credit bank account and debit bank account are compensated, the importance of the compensation will be established by comparing the compensation with the total value of the posts (Joldos, et al., 2010).

When an auditor prepares an audit plan, he requires a certain materiality level to aid in the detection of the significant errors and distortions quantitatively. None the less, the value (the quantity) as well as the nature (the quality) of such distortions has to be considered. Qualitative distortions include improperly or inadequately describing an accounting policy, when there is a chance such an error could mislead a user of the financial statements; or failing to present regulations' breach where it is probable that the restrictions the regulations give can significantly have a deteriorating effect on the organizations operating capacity. An auditor must especially pay attention to the small distortions that when added up could have far reaching effect on the financial statements. For instance, a recurring monthly error could be very detrimental to the accuracy of the statements prepared using those figures. Materiality must be evaluated both universally and on the specific affected accounts and transactions. Also, legal requirements could have a huge effect on materiality. Other things that can affect materiality include balances in accounts, classes of transactions and how information is presented and interconnected.

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These do have varying amounts of materiality basing on the statements being considered (Joldos, et., 2010).

Audit risk can be revised during the actual execution of auditing as the one set during the planning phase may not reflect the arising issues during auditing. When errors reach levels of materiality, the auditor will consider reducing the risk by applying more procedures or having management correct the financial statements associated with the errors in question (Morariu A., & Turlea e., 2001). All the same, the audit risk is still determined at planning stage and is further revised when the auditor comes along new significant information. The materiality foreseen is that highest level that the auditor thinks can have an influence on the decisions of any rational individuals using the financial information (Oprean, et al., 2007). Where the auditor realizes a reduction in materiality levels, then levels of trust do increase but the auditor must continue collecting new information (Joldos, et al., 2010).

Preliminary Estimate of Materiality

As per Auditing Standards no.22. Planning and Supervision (1978), an auditor should consider, among others, materiality levels estimates during his planning to audit the financial statements. The standard, however, doesn't seek of the auditor a quantified specific amount of materiality estimate. None the less, this is probably the only way to get an accurate picture of materiality during planning. Since financial statements are used to gauge the performance of the entity both in the past and the future, especially its cash flows, changes in timing, amount or apparent uncertainty in the cash flows of the entity would be considered a factor that would influence decision making of a rational individual. Since the predictions are quantified, the materiality levels of the auditor should also be quantified. Further, the auditor should allow some allowance for errors and should communicate this to the audit staff and let them know the procedures and design to be followed and executed (Zuber, et al., 1983).

Despite the existence of several levels of materiality, it is reasonable to have audit procedures designed on the basis of one materiality level for all the financial statements of the organization. How an auditor arrives at the estimate is due to the auditor's inability to plan the timing, nature and the extent of the audit procedures simultaneously with varying error sensitivities. There are several considerations that would influence the evaluation of the auditor's procedures when finding out if there are any material errors in the financial statements. When the auditor estimates materiality, he has to anticipate these factors. For instance, in understanding the operations of the client, the auditor gets to comprehend the scope of operations of the client's entity (e.g. assets, sales revenue and equity) and the specifics concerning those operations and associated transactions (Zuber, et al., 1983). These factors aid the auditor in estimating materiality. This means that such realizations would not make any difference in the levels of materiality as the auditor carries out the audit. They were already factored in during the estimation and may include circumstances like mergers or disposal of a business segment as well as those factors whose anticipation couldn't be made when designing audit procedures (Zuber, et al., 1983).

Motorola and KPMG negotiated one audit fee for their worldwide operations by agreeing on a base year and adding an agreed upon inflation factor and also a growth factor when Motorola's sales grow by more than 12 percentage points. To calculate the growth factor, they consider the total audit fee vis-a-vis total sales over the base figure of 12%. This means that the audit fee charged to Motorola for all their worldwide operations is a figure arrived at by adding an inflation and growth factor to the previous year's audit fee. The control of profit margins for the auditor is therefore left for them by having their offices worldwide streamline operations and reduce costs during auditing. This is advantageous to Motorola as KPMG performs extra services for them. Motorola, in the past, had perceived auditing just as a statutory requirement and not as something that can contribute massive value to the company. Motorola had spent long hours in negotiating fees and mulling over results of their operations with several auditors the world over. Every unit in every country had previously independently negotiated terms with individual country KPMG offices. The results were then handed in to the headquarters. Senior vice president, Kenneth Johnson, recalls the process being very confrontational….....

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