In auditing theory and audit practice, there are close relationships between materiality and risk. Understanding the correct relationship between these two concepts will lead to significant improvements in the efficiency of auditing and will also ensure quality auditing and reduce audit risk. Auditors need to provide a true and fair view and maintain an independent position. Otherwise, the Enron’s case (BBC News, 2002) highlights the shortcomings of certified public accountants’ audit independence to the validity of the capital market.
Materiality as one of the most important and popular topics in audit is regarded as the level of an accounting information is material. Information is material if its seriousness of size and nature for misstatements or omission in the financial statements could influence the judgment or decision which its users made. Nevertheless, materiality depends on the amount and nature of an item in specific cases (Iain & Stuart, 2008). From the information ISA320(IFAC, 2009) given, it can be seen that materiality essentially emphasize the level of misstatements and omission, and this level was decided as perspective of financial statements users’ view. If the misstatements or omissions exist in the statements make users change their original decision, then the misstatement or omission is important. Otherwise, it is not important. In fact, the materiality can be interpreted as the maximum tolerable limit of misstatements or omissions, beyond this boundary, omission will not be tolerated, while below this threshold fault, omission is acceptable.At beginning of an audit process, the auditor would planning at what level of misstatements or omissions in the financial statements could influence the judgment or decision which its users made. At that time, the audit risk may occur. The higher the materiality level was, the lower the audit risk would be, and vice versa(SAS220, 05).
Although the definition of materiality is quite simple, there are some points need to be aware of. First of all, within the whole process of audit, the aim of that audit could impact on materiality level of the item and the account, as well as the nature and size of misstatements or emission. Second, in order to give a true and fair view, materiality needs to be related to audit risk. That is to say if a misstatement or omission will affect the economic decision of users, it become a risk. At the same time, that risk is and has been ferreted out and made a loss. This kind of materiality can make sense, if not, materiality is useless to auditors. Furthermore, give a true and fair view is a basic framework to every auditor. The extent of material is based on auditor’s own judgments. It is not only from concept, but also from personal experience.
How to set up a level of materiality for a financial statement is usually based on the profits the clients earned. The greater level we set up the lower the risk will be. As a result of efficiency, usually auditors use samples in stead of go through all the information provided in the financial statements. There are three stages of materiality, Practical materiality level, planning materiality level and estimated auditing materiality level. The internal logic of these three levels is: the user of financial statement always got a decision point which is important for him, but the point as to the auditor is also an objective reality. While in practice, because of the users can accept different materiality, so this objective is only relative. This relatively objective decision point is called the level of practical materiality. Practical materiality level is objectively showed in the statement which would be materially affecting the decision of the economic user. It was objective and uncertain. In the preparation of the audit planning stage, in order to determine the nature, timing and scope of the audit plan and evaluation of audit results, it is necessary to determine the materiality level of planning audit procedures. Therefore, auditors must use their professional judgments in the planning stage under various circumstances, evaluate the planning materiality of level. In other words, planning materiality level is the first judgment for the project during the audit planning period. This information will let auditor conform the nature, timing and the scope of the audit project. Estimated auditing materiality level refers as due to a better understanding of enterprise being audited when evaluate the audit results, the auditor will adjust the level of the original plan to form the estimated auditing materiality level as a basis for the evaluation of the audit result. Thus, practical materiality level is objective exist to the auditors, the auditors can estimate practical materiality level use their own professional judgments at different stages within whole audit process of audit so that produce planning auditing materiality level and estimated auditing materiality level. Generally speaking, it is all rely on auditor’s own professional evaluation.
The reason why auditors put materiality before starting audit is they take risk into account. A positive audit opinion on an inappropriate annual financial statement which has misstatement or omission will lead to an audit risk. The audit risk, in other words means auditors might give a qualified opinion when it should be unqualified (Madison, 2007). It is one factor that needs to be considering during the audit process. According to the different types, stages and objectives, there are three elements: inherent risk (IR), detection risk (DR), and control risk (CR). Therefore, audit risk AR=inherent risk IR×detection risk DR×control risk CR. Inherent risk refers to the probability of material misstatement of an assertion, assuming no related internal control differs by account and assertion. Control risk is the likelihood that a material misstatement will not be prevented or detected on a timely basis by internal control. This risk is assessed using the results of tests of control. Detection risk is the likelihood that an auditor’s procedures lead to an improper conclusion that no material misstatement exists in an assertion when in fact such a misstatement does exist. The auditor’s substantive tests are primarily relied upon to restrict detection risk.（http://www.100test.com/html/448/s_448673_44.htm）
The most fundamental purpose is to determine the expected detection risk according to the level of audit risk, inherent risk and control risk. Thus, calculate the detection risk is to determine the size of substantive sample, use it during the audit plan and audit implementation process. According to the definition of audit risk, it is essential to focused on the financial statements which have not been identified have got material misstatements or omissions impact of the audit opinion. As a result of the audit testing and the inherent limitations of internal controls, the auditors can not detect all the misstatements or omissions in the statements. Therefore, there is always a risk on audit. During the audit testing processing, auditors always hope reducing audit risk to an acceptable level through the implementation of reasonable and necessary audit procedures. Hence, in order to improving the efficiency of audit work, auditors need to be fully considered the importance and the relationship between materiality and audit risk. During the audit process, the materiality and audit risk have inverse relationship in between. First of all, the higher the materiality level is, the lower audit risk will be and vice visa (SAS220, 05). Materiality is a key factor in determining the level of audit risk. At the same time, the judgment of the level of materiality will impact determining the level of audit risk directly. If auditors determine materiality at a lower level, then the audit risk will be increased, so they must reduce audit risk through audit implementation procedures. At this point, the materiality level refers to the amount from the perspective of the financial statements users. For example, one million pounds have high level of materiality than half million. In other words, if the materiality level is one million, it means that misstatements and omissions which are less than one million will not affect the financial report user’s judgments and decision-making. The auditor just needs to find out misstatements or omissions more than one million in the audit process. If the materiality level is half million, it means that the amount between half million to one million pounds’ the misstatement or omission will affect the financial statements user’s decision-making and judgments. Thus, the auditor not only needs to identify the amount of one million pounds misstatements or omissions, but also need to identify misstatements or omissions which valued between half to one million pounds. This is clearly shows that audit risk is lower when the materiality level is higher.
Due to the inverse interaction relationship between materiality and audit risk, the level of materiality will directly impact on auditors to implement their audit procedures determination. Therefore, affecting the efficiency of the audit and the audit risks faced. Such as the previous example, if the one million pounds’ misstatements or omissions would affect the users of financial statements of the decision-making, while auditor assess the level as half million. Obviously, that low level of materiality would mislead the auditors believe it had a high audit risk. In order to reduce the high audit risk, auditor will expand the scope of audit procedures or add more audit procedures which in fact is not necessary. This can be only waste of time and recourses, so as to reducing the efficiency of the audit. On the other side, if the original half million pounds misstatements or omissions will affect the users of financial statements to judge or decision-making. However, the auditor determine the level of materiality is one million, this generate the level of materiality is too high and would mislead the auditor believe it is a low-risk audit. The audit procedures performed is less than the original implementation of audit procedures should do. Besides the audit scope is small, collection of audit evidence is insufficient. As a result, it will inevitably lead to erroneous audit results also the auditor will take an increased audit risk. This shows that there is inverse relationship between the level of materiality and audit risk. This relationship has a direct impact on auditors’ procedures by the time, nature, scope. Auditors should maintain a independence and true and fair view. Likewise, comprehensive consider a variety of factors, so that they can determine the materiality at a reasonable level.(Reference)
When auditing an enterprise, the business risk also needs to be taking in account. Business risk results from many things that are in the business’s environment. It is the risk that the business will fail to meet its objectives (reference). To the auditors, it means client is doing something that will affect the business and impact on the auditors themselves. Major changes to working practices, major changes in the working environment, complexity of working practices, failure to recognize the need to change, development of new products by competitors, operating environment, new personnel, major changes to information systems, rapid growth, new technology, corporate restructuring, expanded foreign operations, new accounting pronouncements will all lead to a business risk. Hence, it requests auditors have experience and knowledge of the financial markets, impact of different trading situations, use of comparisons in time or across the sector, statistical analytical tools. Moreover, experience in audit, different sectors and within the company, together with assessment of integrity and competence of management.
Materiality principle requires auditors consider the audit environment, audit resources, audit risk, audit costs,ect. based on various factors when concern for an important audit matters. The principles of materiality are effectively implemented or not will be directly related to the audit efficiency and audit resource conservation so that audit quality will be improved. To determine materiality of an item, auditors should consider the following factors. First of all, the previous audit experience. To determine the materiality level is a professional judgment, auditors can according to the perivious experience amend the materiality level based on change in the operating environment. Furthermore, internal control and risk assessment. the materiality can be set at higher levels if the internal controls are robust and reliable, so as to audit risk is relatively low. If a higher audit risk assessmented, audit materiality level will be low and need to expand audit testing. Moreover, The operation scale and nature of business. The larger operation scale audit, the higher the materility level needs to be established. Besides, different industries have accounting standards which also will influence auditor judge on the materility level. In addition, involved in new business or not. auditors have reasons to focus on significant changes in the basic business, and reduce the level of materiality appropriately. Last but not least, amount abnormal fluctuations. the amount of Financial statements project and its fluctuations may prompt the user to respond. auditor should focus on larger issues, consider the amount and rates of volatility so that determine the materiality level rationally.
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