The goal of conducting an audit and preparing an associating audit report is to allow the auditors to express an opinion regarding whether or not a company’s financial statements were prepared in accordance with a specific, identified financial reporting framework. The financial reporting framework is often with respect to generally accepted accounting principles set forth by the Financial Accounting Standards Boards. The auditors are responsible for opining in the context of the guiding principle of materiality, which is a type of judgment regarding the usefulness of the underlying information.
Materiality
According to the book, “Modern Accounting,” information is material if its omission or misstatement could affect the economic decision-making of the users of the financial statements. This definition is based on the FASB definition of materiality, from which it is concluded that materiality and audit risk are related. When preparing an audit, the auditors assess materiality on two levels. First is the overall financial statement level, in regard to overall materiality. Second is at the account balance level, which is more about the actual testing of materiality.
Quantitative Guidelines
Quantitative measures determine if an omission or misstatement is material based on a comparison to a base amount. Within the actual financial statements, this means comparing changes in balance sheet accounts to total assets or equity. Typically, a change in excess of 0.5 percent of total assets or 1 percent of total equity is deemed material. On the income statement, profitability is the appropriate reference point. Generally, a decline greater than 5 percent of pre-tax income or 0.5 percent of total revenues is material, but it can depend on the size of the company. Single rules do not allow for allowances based on company size, whereas variable, or size, rules do.
Qualitative Guidelines
Qualitative guidelines are by nature more subjective than quantified guidelines. Their discovery increases the risk that more qualitative material missteps may exist within the financial statements. Examples of qualitative misstatements include a failure to disclose the breach of regulatory requirements, an inadequate or improper description of an accounting policy or failure to disclose a related party transaction or other event requiring disclosure. For example, Wal-Mart and News Corporation are two companies that in recent years, as of 2013, failed to disclose certain payments made to public officials in foreign countries that constituted illegal bribes.
Communicating Material Issues
Upon finding material issues, the auditor must inform management and any other entities responsible for related governance issues. The auditor must document the level of materiality, a summary of uncorrected misstatements and the auditor’s conclusion regarding if the omissions or misstatements have a material impact on the financial statements. Based on management’s response and any corrective actions taken or not taken, the auditor can communicate material issues in the audit report by issuing a modified opinion. This allows the auditor to express either a qualified opinion, an adverse opinion or disclaimer of opinion. These are generally disclosed in the cover letter accompanying final audit financial statements, which is signed by the audit firm using the audit firm’s name.
Original Source: Chron