Introduction
One of the most crucial concepts in auditing is materiality, which is a complex term incorporating both quantitative and qualitative elements. Although the notion of materiality is highly mathematical, the exact definition has not been formulated (TGCCPA, 2018). Still, it is frequently described by auditors as any omissions or misstatements in audit planning and reporting that have an impact on users’ economic decisions (Bunjaku, 2019). Furthermore, reporting material issues is believed to be an obligation of an auditor before users to warn them about mistakes and potential risks (Bunjaku, 2019). The end-users of financial reports that include materiality data are investors, shareholders, creditors, managers, customers, regulating entities, and suppliers (CFI, 2022). This term is critical for auditing since it predicts whether the company makes reasonable or incorrect decisions, which will determine future organizational success.
Discussion
One of the most crucial aspects of materiality is determining its threshold, which is unique for every firm. It primarily depends on a company’s revenue because a $1 misstatement on the financial report may not impact a billion-dollar business (CFI, 2022). However, a $1 million miscalculation can have a negative effect on future decisions (CFI, 2022). Therefore, some small business enterprises may establish a threshold of 2-4%, while big corporations may consider a level of 10-20%.
The quantitative and qualitative aspects of materiality should be evaluated in every stage of audit planning in five consecutive stages. During the first step, it is essential to set the approximate threshold of the materiality (Bunjaku, 2019). The latter is a percentage of a particular item of a financial statement (TGCCPA, 2018). On average, it should be less than 5-10% of net income and 0.5-2% of assets (Bunjaku, 2019). Next, performance materiality, including accounts receivable and inventory, must be considered (Bunjaku, 2019). The third step is determining misstatements in account or cycle (Bunjaku, 2019). During the fourth stage, the actual total misstatements should be estimated (Bunjaku, 2019). Lastly, the true and predicted materials are compared to detect any mistakes in the financial statements (Bunjaku, 2019). The qualitative aspects of materiality include failure to mention a company’s liabilities, transactions, or accounting policies (Bunjaku, 2019). Both quantitative and qualitative elements of materiality are critical in auditing to predict and prevent possible problems in financial statements.
To accurately estimate materiality, various values should be taken into consideration. For example, financial investments, deferred tax assets, liabilities, value-added tax, and undistributed profit must be assessed (Zhukova & Zhukov, 2018). Furthermore, an additional income should be included in calculating quantitative materiality (Zhukova & Zhukov, 2018). The indicators for the income statement are costs, revenue, earnings, and expenses (Zhukova & Zhukov, 2018). All essential numbers and risks should be considered when reporting materiality. Otherwise, there is a risk of errors in financial statements that may negatively influence a firm’s internal control and make the company less compelling for investors.
Unfortunately, no exact formula for calculating materiality exists, but some estimation methods still exist. For example, a study by the Norwegian Research Council developed single-rule and variable-size rule methods (CFI, 2022). In the former, calculations are based on 5% of pre-tax income, 1% of shareholders’ equity, 0.5% of total assets, and 1% of revenue (CFI, 2022). In the latter, materiality is determined based on the gross profit, setting the threshold from 0.5% to 5% for the gross profit in the range of $20,000-$100 million (CFI, 2022). Despite such precision, the concept of materiality is still relative because some statements may be significant for some businesses but irrelevant for others.
Auditing reports and materiality are vital for shareholders and investors because they make decisions about financing specific organizational projects based on this information. It does not suggest that the mere reporting materiality may positively or negatively affect investments. In fact, according to Christensen et al. (2020), this auditing concept had no significant impact on investors’ judgment, but the materiality level did. According to Christensen et al. (2020), investors were more interested in a firm when materiality was set to higher percentages, which may be counterintuitive (Christensen et al., 2020). The preference for increased materiality thresholds can be explained by the difference in the size of companies, meaning that minor misstatements in auditing reports will be less harmful to the overall outcome in larger businesses. Thus, investors may be more interested in higher levels of established materiality. It appears that materiality reporting is more the sign of auditors’ reliability and organizational credentials rather than investors’ increased interest. Still, it should be a company’s priority to estimate materiality to avoid financial issues in the future.
Conclusion
In summary, materiality is a crucial auditing term that helps to estimate possible omissions and misstatements in an organization’s financial statements that may influence the decisions of investors, suppliers, shareholders, and customers. It can be calculated using single and variable size rules, which are based on the income statements and gross profit, respectively. Materiality is a relative concept since its calculations are unique for different organizations with various revenues. Regardless of a business’s size, it should be clearly stated in auditing reports to predict potential risks.
References
Bunjaku, F. (2019). Audit components: Literature review on audit plan, risk and materiality, and internal control. Journal of Economics, 4(1), 36–43.
CFI. (2022). Materiality thresholds in audits. Corporate Finance Institute. Web.
Christensen, B. E., Eilifsen, A., Glover, S. M., & Messier Jr, W. F. (2020). The effect of audit materiality disclosures on investors’ decision making. Accounting, Organizations and Society, 87, 1-13. Web.
TGCCPA. (2018). How materiality is established in an audit for a review. Thompson Greenspon. Web.
Zhukova, A. K., & Zhukov, A. L. (2018). Materiality in audit of financial reporting party conducting accounting of joint activity. European Research Studies Journal, 21(4), 109-118.