How materiality has been operationalized in the financial accounting literature

Hey everybody,

So today I'll elaborate a bit more on a post I made last week and now I'll discuss how materiality has been operationalized in the financial accounting literature. As always, enjoy and feel free to comment!

Auditors use the concept of materiality in their audit planning in order to develop an overall audit strategy and a detailed audit plan (Eilifsen, Messier Jr., Glover, & Prawitt, 2014). Furthermore, the level of materiality is important for giving an appropriate audit opinion over the financial statements of the client. It is a risk management technique that controls uncertainty and reduces audit risk, which is the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated (Edgley, 2014; Eilifsen, Messier Jr., Glover, & Prawitt, 2014). Auditors have to set an overall materiality level for the financial statements and to come up with a level of performance materiality for significant accounts or disclosures. They use materiality in order to provide a cost-efficient audit, because they only assure that they detect misstatements which are greater than the level of materiality. Misstatements under this amount are seen as too unimportant for the users of the financial statements, such as the companies’ shareholders and are thus not being tested. Otherwise, the auditor has to test every transaction, which costs too much time and money (Edgley, 2014). This means that there is a negative relationship between materiality and the level of audit risk, because when the level of materiality is higher, auditors perform a more detailed audit and thus will detect smaller misstatements faster, which decreases the level of audit risk. The auditor uses professional judgement in order to determine the level of materiality. Misstatements in the financial statements are seen as material if they, individually or collectively, influence the economic decisions that users make on the basis of the financial statements (IASB, 2011). These users are considered to have a thoroughly understanding of the business and its activities, want to study the financial statements in detail and make rational decisions based on the information provided by the financial statements. There are three approaches which give a reflection about who has to determine if an account is material (Ro, 1982). Firstly, the information-producer approach, which sees management and auditors as the people who determine the materiality on behalf of the information users (the investor). Secondly, the information-user approach sees the financial information users themselves as the ultimately suitable party who has to determine the materiality. Lastly, there is the producer-user approach, which sees both information producers and users together as the most suitable party to determine the level of materiality. This means that the considerations and classifications of materiality differ between firms, auditors and the users of financial information, which contributes to earnings management and the possible rise of a financial crisis (Juma'h, 2014).

There are a number of steps when an auditor applies the concept of materiality in their audit of a company (Eilifsen, Messier Jr., Glover, & Prawitt, 2014). Firstly, he determines the overall level of materiality for the financial statements as a whole, which is the maximum amount that the financial statements, according to the auditor, could be misstated without affecting the decisions of the users of the financial statements. The setting of this level of materiality is quite subjective, because there are no strict rules which determine how to set the level of materiality. However, often benchmarks like profit before tax, total assets or total revenues are used to set this level, which means that the level of materiality is dependent on the size of the company. A rule of thumb is to use five percent of profit before tax when profits do not fluctuate (otherwise use an average of prior years; Juma'h, 2014; Edgley, 2014). Not only quantitative factors are important to set the level of overall materiality; also qualitative factors like the risk of fraud or the companies business environment might have an impact on this level. Secondly, the auditor has to set the level of performance materiality in order to set a scope for the audit procedures which the auditor has to perform for the individual account balances or disclosures. Mostly, the level of performance materiality is set in between 50 and 75 percent of overall materiality, depending on factors, such as how much risk there is for any misstatements and the number of (historical) accounting issues. A lower performance materiality means that the auditor needs a more extensive audit in order to find all smaller misstatements. Lastly, the auditor has to evaluate the audit findings, which means that he aggregates misstatements from each account or disclosure in order to compare this amount with the level of overall materiality. If the aggregated misstatements are less than the overall materality, the auditor is able to conclude that the financial statements are fairly presented. However, when this amount is higher than the overall materiality, the auditor should ask the firm to adjust its financial statements for the material misstatements. Otherwise, the auditor should issue a qualified or adverse opinion, instead of an unqualified opinion. The auditor should, however, be careful with considering the risk of material misstatements of estimations, because these amounts are not certain.

Auditors mention in their audit report (in the auditor’s responsibility paragraph) that they assessed material misstatements, which means that they acknowledge the risk for possibly not discovering misstatements which are not material (Eilifsen, Messier Jr., Glover, & Prawitt, 2014). However, they do not explain how they exactly determined the level of materiality, which means that not every relevant user of the audit report (from the company and its stakeholders) understands what materiality exactly is (Houghton, Jubb, & Kend, 2011). Therefore, more public disclosure might be useful. This is also shown by the fact that materiality is used as a sort of moral responsibility to protect investors (Edgley, 2014). To fullfill this responsibility, the process of determining and using materiality has to be disclosed by auditors. In that case, financial statement users might better understand the materiality process, which might have a positive influence on the cashflows from investors to the company.