Julia Irvine 13 Dec 2017 10:58am

Top firms must explain materiality judgments better

Differences in the way audit firms assess materiality can lead not only to widely divergent thresholds being set but ultimately to different audit conclusions
Caption: The FRC suggests that in the future auditors should consider qualitative factors that might be material to users

The Financial Reporting Council’s (FRC's) latest thematic review has also found that none of the firms' methodologies provide much guidance on how to calculate materiality for loss-making entities.

To show the impact of the different ranges of overall materiality percentages used by the eight firms involved in the review – the Big Four plus BDO, Grant Thornton, Mazars and Moore Stephens – the reviewers applied their approaches to an illustrative example of a company with profit before tax of £100m and net assets of £500m.

Three of the firms’ methodologies resulted in a far lower materiality figure than four of the other firms.

“In the example, even if the three firms in question set their materiality percentage at the highest end of the range, the materiality calculated would be equivalent to that calculated using the lowest end of the range at four of the remaining five firms,” the review states.

The review says that it is possible that the materiality levels sets by the four firms could be around 100% higher than those set by the more prudent firms.

“As materiality is fundamental to the planning and performance of the audit, these differences could lead to significantly different audits in terms of the selection of balances for testing; scoping of subsidiary audits; the detailed testing undertaken by the firm; and ultimately in the conclusion reached by the auditor,” it concludes.

When the benchmark relates to net assets the differences become even clearer. Two of the firms reached lower materiality levels (£1m) than the others. At the other end of the scale, in two other cases the minimum threshold was £15m.

The FRC suggests that in the future auditors should consider qualitative factors that might be material to users when deciding on the final determination of materiality.

Because of these differences, the regulator would like to see auditors providing more specific information to audit committees and in their public reports about the materiality judgments they make and their impact.

Nevertheless, the thematic review found that the firms had improved their methodologies and guidance since the last thematic review in 2013, especially when it came to certain industry sectors where the judgments involved were likely to be more complex.

The FRC also supported the guidance developed by three of the firms for their auditors involved in first year audits. Given the heightened risk of not identifying misstatements during the first year of an audit, the guidance recommends that the level of performance materiality be reduced.

Commenting on the overall findings of the review, Melanie McLaren, the FRC’s executive director for audit regulation, said, “The assessment of materiality drives the scope, nature and extent of the auditor’s work. Appropriate quantitative and qualitative assessment of materiality affects audit quality.

“We are pleased to see the audit firms take action following our 2013 thematic review. Auditors should be encouraged by investor feedback on the transparency afforded by UK extended auditor reports and redouble their efforts to communicate the reasons for and implications of the materiality threshold applied in specific audits.”

She added that the importance of materiality might well diminish in the future as technological advances enabled companies and their auditors to interrogate and adjust financial information in a more cost-effective and accurate way.

Meanwhile, she encouraged audit committees to discuss with management the level of materiality that is used in preparing the financial statements. They should also discuss it with the audit team, both as part of the planning process and in assessing the appropriateness of the level and benchmarks used, and audit committees should have an understanding of the balances that the team considered immaterial.

In addition, the thematic review recommends that they should assess whether the information provided in their audit committee reports could be improved to give better insight on the judgments made in preparing the financial statements and to provide users with evidence of the degree of challenge seen in the areas of risk which had the most significant impact on the audit strategy.