Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    Group Audits, Group-Level Controls, and Component...
    research summary posted December 1, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
    507 Views
    Title:
    Group Audits, Group-Level Controls, and Component Materiality: How Much Auditing Is Enough?
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    Aggregation, audit assurance, Bayes’ rule, component materiality, group audits, group-level controls, ISA 600, auditor judgment, materiality and scope decisions
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    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. 

    Findings:
    • 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.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Materiality & Scope Decisions