auditing

auditing, examination and statement of accounts and of other documents connected with accounts by persons who have had no part in their preparation. Systems of financial inspection have long been used, especially in connection with public accounts. In Italy the elaboration of commerce considerably increased the duties of an auditor in the late Middle Ages, but the auditing of business accounts did not become common until the 19th cent., when there were an increasing number of businesses continually growing in size and complexity. Corporate charters usually came to be granted only on condition that licensed experts conduct annual audits. Such audits are particularly useful to the owners (partners or stockholders); executives (managers, officers, and directors); creditors or prospective creditors (investors, note brokers, and commercial and investment bankers); and receivers, trustees, and creditors' committees of a business. Audits are also useful to the vendors of a firm's merchandise, the owners of patents and other recipients of profit shares or royalties, governmental regulatory bodies, and prospective donors to institutions. An audit settles certain categories of questions. It must determine whether all assets and liabilities shown are actual, and that they are properly incurred, valued, and recorded. A check must be made of the surplus, income, and capital-stock accounts, verified by the examination of the authorizations for stock issues and by comparing the amounts issued with the amounts authorized. Finally, auditing constitutes an independent check on the tendency to overstate assets and understate liabilities. The duties of auditors have even expanded into a comprehensive survey and analysis of the entire conduct of the financial and accounting branches of an enterprise. Thus the auditor needs, in addition to his knowledge of accounting, a broad understanding of business and finance. The accountant records the facts of a business; the auditor must determine whether or not such recording has been done accurately and honestly and then interpret and judge the facts, perhaps adding to his report recommendations for the future conduct of the business. In many countries, auditors are now established as a separate profession, requiring government licensing. In the United States, private audits are usually performed by certified public accountants; auditing of the federal government's accounts is conducted by Congress's Government Accountability Office (GAO). Formerly the General Accounting Office, it was established in 1921. The Internal Revenue Service periodically audits individual and corporate tax returns. The Public Company Accounting Oversight Board (established 2002) registers and regulates accountants and accounting firms that act as auditors.

Examination of the records and reports of an enterprise by accounting specialists other than those responsible for their preparation. Public auditing by independent accountants is common in large firms. The auditor performs tests to determine whether the firm's statements were prepared in accordance with acceptable accounting principles and that they fairly present its financial position and operating results. Personal tax audits are carried out to determine whether people have accurately reported their financial circumstances when filing their taxes. Failing such an audit may result in a fine, or, in cases of extensive and deliberate deception, criminal prosecution. Seealso Internal Revenue Service.

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Materiality is a concept or convention within auditing and accounting relating to the importance of an amount, transaction, or discrepancy. The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in conformity with an identified financial reporting framework such as Generally Accepted Accounting Principles (GAAP). The assessment of what is material is a matter of professional judgment.

Materiality is defined in the International Accounting Standards Board’s "Framework for the Preparation and Presentation of Financial Statements" in the following terms:

"Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful."

The Financial Accounting Standards Board (FASB) has refrained from giving quantitative guidelines for determining materiality. This has resulted in confusion in the use of Auditing Standards No 47, "Audit Risk and Materiality in Conducting the Audit". Several common rules that have appeared in practice and academia to quantify materiality include:

• Percentage of pre-tax income or net income (i.e., 5% of average pre-tax income (using a 3-year average));
• Percentage of gross profit;
• Percentage of total assets; (i.e.,1/2% of total assets);
• Percentage of total revenue; (1/2% of total revenues);
• Percentage of equity; (i.e.,1% of total equity);
• Blended methods involving some or all of these definitions (e.g., use a mix of the above and to find an average);
• "Sliding scale" methods which vary with the size of the entity. (i.e., 5% of gross profit if between $0 and $20,000; 2% if between $20,000 and $1,000,000; 1% if between $1,000,000 and $100,000,000; 1/2% if over $100,000,000)

Using different means to quantify materiality causes inconsistency in materiality thresholds. Since "planning materiality" should affect the scope of both tests of controls and substantive tests, such differences might be of importance. Two different auditors auditing even the same entity might generate differing scopes of audit procedures, solely based on the "planning materiality" definition used.

Materiality as an Empirically Discovered Amount

Alternately, one could argue that rather than being a dollar amount developed by the auditor based on their professional judgement, materiality is a market phenomenon that must be discovered by the auditor through research activities. This interpretation is supported by the phrase "is material if its omission or misstatement could influence the economic decisions of financial statement users". Thus, the auditor must determine what amount does influence the decisions of financial statement users via a variety of methods, and potentially average those methods in an attempt to estimate the real monetary amount of materiality (which can never be known since it is simply the collective sentiment of all investors, creditors, managers, and regulators).

Auditors could conceivably ask the Audit committee or Board of directors to determine materiality since these groups represent investors and creditors. Another approach might involve developing a Sensitivity Analysis model that attempts to measure changes in a company's stock price as a function of changes in financial performance - thus revealing what monetary amounts investors perceive to be actionable. In contrast, materiality may be an amount that is important for regulators in some industries. For example, if a regulatory body has declared it is only interested in violations exceeding a particular monetary amount, this number may form the basis of determining materiality.

For an entity with a relatively small number of creditors, investors, managers and regulators, the auditor can simply determine materiality with direct inquiries made to these constituencies. Averaging the materiality amounts provided by these constituencies may lead to audit efficiency, however using the smallest materiality amount noted during the inquiry process ensures that even the most conservative constituent is satisfied with the relevance of the audit findings.

Materiality in Governmental Auditing

Materiality in governmental auditing is different from materiality in private sector auditing for several reasons.

The typical scope of audits in the private sector encompasses opinions on financial statements and, to a lesser extent, the adequacy of the internal control structure. Governmental audits may have a wider scope including opinions on whether the entity complied with laws and regulations, whether the entity is managing its resources economically and efficiently, and whether the desired results or benefits are being achieved (performance audits). This difference in audit scope requires different means of determining materiality.

The definition of materiality in governmental auditing is different from materiality in other audits, because the definition refers to economic decisions and the financial statements of a public sector entity may be used to make decisions other than economic decisions, such as the discharge of accountability and political and social decisions.

The primary users of government financial statements are different: the citizenry and the parliament in the public sector versus investors in the private sector. It is important to identify the primary users since materiality reflects the auditor’s judgment of the needs of users in relation to the information in the financial statements.

Government auditors typically use different means to quantify materiality such as total cost or net cost (expenses less revenues or expenditure less receipts). In a cash accounting environment total expenditures is often used as a benchmark.

In government auditing, the political sensitivity to adverse media exposure often concerns the nature rather than the size of an amount, such as illegal acts, bribery, corruption and related party transactions. Qualitative materiality is therefore likely to be more important in government auditing than in private sector auditing. Qualitative materiality refers to the nature of a transaction or amount and includes many financial and nonfinancial items that, independent of the amount, may influence the decisions of a user of the financial statements.

The disclosure of the materiality level chosen by the auditor for a specific engagement might be more important for audits of governments, because of the importance of transparency in the public sector.

External links

• Accounting Conventions and Concepts
• Accounting Terminology Guide (New York Society of CPAs)