The proposed component materiality method helps the group auditor develop and document a rational plan for achieving the group assurance objective that is rooted in applicable auditing standards and decision theory.

The significant differences in results between the proposed method and the alternatives suggest the need for guidance more definitive than that provided by current auditing standards. Indeed, the authors’ approach could be a useful metric for evaluating the efficacy of methods that do not have as comprehensive a supporting theory.

Field deployment of the proposed method requires software support. A specific implementation is available as an Excel app at http://raw.rutgers.edu/GUAMcalc.

For more information on this study, please contact Trevor Stewart at trsny@verizon.net.

Stewart, Trevor R., and William R. Kinney, Jr. 2013. Group Audits, Group-Level Controls, and Component Materiality: How Much Auditing Is Enough? The Accounting Review 88 (2): 707-737.

Auditing standards mandate that group auditors determine and implement appropriate component materiality amounts, which ultimately affect group audit scope, reliability, and value. However, standards are virtually silent about how these amounts should be determined, indicating merely that they should be less than group materiality but may be greater than proportionate. For example, if group materiality is $1 million and there are five equal size components, then component materiality should be between $200K and $1 million for each component; but how to determine the right amount in that range is not indicated. Various methods used in practice vary widely, lack theoretical support, and may either fail to meet the group audit objective or do so at excessive cost. The authors develop a rigorous method, describe its properties, and compare the component materiality amounts thus derived and the resulting relative audit costs and achieved levels of assurance with those of other methods. 

The authors’ method determines component materiality as a function of group materiality, the group auditor’s assurance objective, and relative component sizes and audit costs. The method formally incorporates group auditor knowledge of group-level structure, controls, and context as well as component-level constraints imposed by statutory audit or other requirements. Application of the method yields component materiality amounts that achieve the group auditor’s overall assurance objective by finding the minimum cost solution on an efficient materiality frontier. To continue the simple five-equal-size-component example, the proposed method indicates that component materiality amounts should be no greater than $330K in order to achieve reasonable assurance at the group level relative to group materiality of $1 million. But these amounts may be increased significantly depending on additional factors that the method accommodates.

The authors’ starting point is the group auditor’s overall objective of achieving reasonable assurance about whether the group financial statements as a whole are free from material misstatement. This overall objective is disaggregated down to the component level and component materiality amounts are determined such that component auditors will do enough work to meet those component objectives. Thus, by design, if the component auditors use component materiality as determined by the group auditor and their audits go as planned, then component objectives will be met and, on aggregation, so will the overall group audit objective.

Audit assurance is a probabilistic concept, where probability is a measure of the auditor’s degree of professional belief—a subjective notion embraced by Bayesian probability theory. The key to the authors’ method is a Bayesian group audit model that generalizes and extends the single-component audit risk model to aggregate and disaggregate assurance across multiple components. 

• A conceptually sound, standards-based planning approach to determining component materiality is developed from the insight that component materiality amounts should be those that result in component assurance that aggregates to the desired overall group assurance. Bayesian probability theory provides the philosophical and mathematical framework.
• The proposed method yields component materiality amounts and achieved group assurance that, depending on circumstances, may differ substantially from other methods. Those methods may be ineffective in meeting professional standards, inefficient in the use of resources, or both ineffective and inefficient.
• The auditor’s prior (pre-audit) assurance based on group-level controls can facilitate substantially increased component materiality amounts, thereby reducing component auditor work and cost. Indeed, numerical results suggest group-level controls and structured subgroups of components are central to efficient group audits.
• Aggregate component audit costs can be reduced by optimizing component materiality to incorporate contextual factors, such as group structure, differing component sizes, component audit costs, and component-level constraints imposed by statutory audit and other requirements.

http://www.auditingresearchsummaries.org

The results of this study are important for auditors to consider when making materiality judgments.  The evidence indicates that auditors are more likely to overlook the qualitative importance of adjustments that affect a client’s ability to meet or beat analysts’ forecasts.  Furthermore, findings suggest that auditors are more lenient with subjective audit differences.  The study suggests that providing auditors with guidance on qualitative materiality may improve materiality judgments, but it does not completely alleviate the differences among the earnings benchmarks. 

Ng, T.B. 2007. Auditors’ Decisions on Audit Differences that Affect Significant Earnings Thresholds. Auditing: A Journal of Practice and Theory 26 (1): 71-89.

Companies have economic incentives to meet or beat certain earnings benchmarks such as the prior year’s earnings, analysts’ forecasts, and positive earnings.  As a result, even small audit differences may be qualitatively material if they allow the client to meet or beat one or more of those benchmarks. However, the SEC and the IAASB both recently recognized that auditors may need further guidance on dealing with small but qualitatively material misstatements, and the SEC issued the Staff Accounting Bulletin 99 in response.  This paper provides evidence on this issue by investigating whether auditors’ propensity to book an adjustment is influenced by: client earnings benchmarks; subjectivity of the audit difference; and the availability of authoritative guidance.

The research evidence was collected prior to January 2005.  The author uses a sample of senior and manager auditors from the Singapore offices of the Big 4 firms to complete a simulated task involving the decision to waive or book an audit adjustment.  Participants were each assigned to two scenarios, both involving an audit adjustment that would cause the client to miss one of three earnings benchmarks.  One of the scenarios involved a subjective audit adjustment while the other involved an objective audit adjustment.  In a follow-up experiment, the author used the same methodology, but provided the auditors with materiality guidance from SAB 99.

• The authors find that among the three earnings benchmarks, auditors are most likely to require an adjustment for differences that cause positive unadjusted earnings to become negative (profitability benchmark). 
• Auditors are least likely to require adjustments that prevent clients from meeting analysts’ forecasts. 
• The authors find that when auditors are more likely to require an adjustment when the audit difference is objective versus subjective, regardless of any earnings benchmark effect.
• The authors also find that providing auditors with SAB 99 materiality guidance increases the likelihood that auditors will require small but qualitatively material items to be booked.  However, auditors are still more likely to require adjustments for audit differences that affect the profitability benchmark than the other two benchmarks.

The results of the studies documented in this review suggest that there is a great deal of variability in the approaches taken by firms for establishing materiality. Such differences in materiality methods can affect both the effectiveness and efficiency of audits. For example, if firms differ in how they allocate materiality to financial statement accounts, then the scope of the work could differ across audits with similar characteristics. Auditors also appear to differ in terms of the factors they consider for determining the materiality of internal control weaknesses, suggesting that auditors may need more structured criteria to make materiality judgments about internal control weaknesses. Materiality judgments are influenced by authoritative guidance, suggesting that standard setters and audit firms have the ability to influence auditors’ materiality judgments by providing auditors with specific guidance.

Messier, Jr., W.F., N. Martinov-Bennie, and A. Eilifsen. 2005. A review and integration of empirical research on materiality: Two decades later. Auditing: A Journal of Practice and Theory 24 (2): 153-187.

Materiality has been and continues to be a topic of importance for auditors. There has recently been renewed interest in the concept of materiality, motivated by concerns at the Securities and Exchange Commission, and the Auditing Standards Board and as evidenced by the Sarbanes-Oxley Act and the issuance of proposed standards on materiality by the International Auditing and Assurance Standards Board. Additionally, new guidance has been issued recently in response to some of the materiality concerns, including Staff Accounting Bulletin (SAB) No. 99, Statements on Auditing Standards (SAS) No. 89, and SAS No. 90.  Due to the continued importance of understanding the concept of materiality, this paper reviews and integrates the empirical research on materiality since 1982. Based on the review of the literature, the authors suggest some implications of this research for audit practice and research.

This paper reviews the literature related to materiality that has been published since 1982. The authors divide their discussion of the research into archival studies and experimental studies. Archival studies use audit firm manuals, data from auditor working papers, or published financial statement data and auditor reports to examine materiality decisions. Experimental studies examine materiality judgments and decision-making of financial statement users, auditors and others (e.g., judges/lawyers).

Archival Studies: The primary findings from archival studies are categorized based on whether they were obtained from auditor-related sources (e.g., auditor working papers) or public sources (e.g., financial statements).  

     Auditor Related Sources (i.e., firm manuals and working papers)

• There appear to be differences in the way firms establish planning materiality as well as differences in the extent of guidance provided by firms for setting planning materiality and tolerable misstatement.
• Auditor judgment plays a significant role in setting planning materiality
• Some version of income continues to be the major factor in determining the materiality of a misstatement (e.g., misstatement as a percent of net revenue). 

     Public Sources (i.e., financial statements, disclosures, and auditors’ reports)

• Public sources also indicate that income continues to be the most significant factor in auditors’ materiality and disclosure decisions. This is the case regardless of the type of reporting item or disclosure in question.
• Similarly, the choice to modify the auditor’s report seems consistent with traditional effects of the item on income. 

     Experimental Studies:

• Experimental studies find that net income continues to be the most important factor in determining the materiality of misstatements, consistent with the findings of archival research. A number of studies find that the second most important materiality factor is the effect of the misstatement on a company’s earnings trend.
• A number of qualitative factors were found to affect materiality decisions, including the auditors’ perceptions of management
  and management’s integrity, audit committee effectiveness, audit firm culture and whether a misstatement will be recognized in the financial statements or the footnotes.
• Materiality judgments vary by experience and firm type. Experience appears to lead to greater consensus in materiality judgments and greater scrutiny of materiality judgments relating to discretionary, non-routine transactions.