Auditing and the ‘Expectations Gap’ - Part 5
In this series of blogs, I will aim to provide greater clarity around some key areas where differences in the expectations of auditors and businesses commonly arise.
Whilst I am writing these blogs, my mind is constantly drawn back to the start of my accountancy studies, specifically to the concept of the ‘Expectations Gap’ and so much so that it is on this that I have based the name of this series of blogs. I think that it is fair to say that while professional accountants understand the expectations gap, most would agree that more could and should be done to help our clients, Directors of businesses and others who rely on accounts to help them understand exactly what this is as much as feasibly possible.
In this series of blogs, I will aim to provide greater clarity around some key areas where differences in the expectations of auditors and businesses commonly arise, with a hope that this will help address some common issues prior to them arising and hopefully lead to some potentially significant questions which can form a starting point for further conversations.
Part 5: Materiality
The idea of materiality can be a difficult concept for people outside of the audit profession to fully understand, and this is to be expected as it relies almost entirely on the judgement of the Senior Statutory Auditor. Materiality itself is the idea that when an individual is considering a set of financial statements as a whole, there is a numerical value where any error below that value would not impact the individuals overall conclusions based on those statements.
This is a sensible concept as, while it is expected for accounts to be accurate, it is very unlikely that an overstatement of administrative costs of say £100 in a company with over £10m turnover would impact anyone’s overall assessment of the performance and position of that company. Materiality is therefore the idea which makes auditing possible as it allows audit testing to be based on a sample of random or significant balances and transactions, rather than auditors needing to test every individual transaction and balance fully - and to correct for every minor difference found.
What value is material?
This is perhaps the main question people will have in relation to materiality. It is very subjective however, and calculating audit materiality is where the professional scepticism and experience of the auditor comes into play.
It’s important for management to appreciate that what may be material from an audit risk perspective may not always be the same as what they consider to be material from a business risk perspective. There are no set rules for determining what value is and isn’t material, only the indication that it should be based on the key driver of a company and that it should account for the overall inherent and specific audit risks.
In practice, firms will usually adopt a standard policy for calculating the level of materiality across all their clients and these policies can vary significantly from audit firm to audit firm. It is also not uncommon for firms to not inform their clients of the value of materiality or the calculation basis being used, as there is a risk associated with doing so. For example, individuals in the business may then be aware of the value below which is not being specifically tested by the audit work, which could increase the risk of deliberate misstatement. It shouldn’t therefore come as a surprise that firms may not always be willing to provide this information.
As an illustration, an example of a materiality policy could be one of 1% of Turnover, 5% of profit, or 2% of gross assets. It would then be common for that figure to be reduced further to allow for the risk of a figure being marginally less than the original value, which would not have otherwise been tested, and thus being incorrect which could result in the cumulative total errors being in excess of the original calculated figure.
As a further complexity, individual areas of financial statements need to be assessed for their specific risks and this can result in different, lower levels of materiality being used to target areas which are considered to be either a medium or higher risk. There are additionally areas which are considered to be material by their nature, and this can be as a result of specific laws or regulations dictating this or particular transactions that may be smaller in value but of specific interest to an individual reading the account and key to them fully understanding them.
The key point to understand is that materiality exists to make auditing possible, and that even though every transaction and balance is not tested as part of an audit the risk that the accounts are not a true and fair reflection of the business has still been reduced to such a low level that the auditor is happy to sign off this statement. It should however be noted by company Directors (along with the points discussed in a previous blog in this series) that there are limitations to a statutory audit and that a clean audit report does not mean that the accounts are free from all errors.
If you have any questions concerning the above, or anything relating to auditing, please get in touch with your usual Rickard Luckin contact or speak to Shaun Labbett directly at firstname.lastname@example.org
Parts in this series
Part 1: “I thought you were doing that” – A consideration of the responsibilities of both parties and importance of communication.
Part 2: The Limitations of Statutory Audits – Highlighting the limitations of statutory audits and some areas that may not be covered by them.
Part 3: One Size Doesn’t Fit All – A look at alternatives to statutory audit and when they may be of use to both businesses subject and not subject to audit.
Part 4: A Risky Business – A review of the importance of identifying and mitigating business risks and how these can link with audit risks.
Part 5: Materiality – An explanation of the principal of materiality, how this is calculated and why it may differ from management’s expectation.
Still to come:
Part 6: Watchdogs or Bloodhounds – A discussion on the role auditors play in identifying criminal activity, fraud and deliberate errors.
If you have any questions about the above, or would like more information specific to your circumstances, please enter your email address below and we will get in touch: