Most users of audited financial statements ignore the audit report. After all, the wording is generally standardized. They invest, contract, lend, and make other business decisions based on the financial statements, but how precise is the information contained therein? As you peruse this article, you will have the opportunity to consider your tolerance for precision (what is “good enough”) as opposed to an auditor’s tolerance for precision. The auditing profession refers to this tolerance for the precision of monetary amounts as “materiality.”
This article will first discuss the historical demand for auditing, followed by a simple explanation of the concept of materiality. The use of materiality during an audit will then be described, followed by the consideration of fraud during an audit. Finally, we will discuss how materiality may contribute to missing the early signs of fraud. The conclusion will review some tips on how you can be first to notice the warning signs of fraud.
The Demand for Auditing
Early artifacts authenticate that auditing dates back to ancient Greece and we know that medieval English monarchs employed an Auditor of the Exchequer. The United Kingdom championed the current age of auditing with the passage of the Joint Stock Companies Act in 1844. British audit law, updated in 1900, requires audits be performed by independent accountants. The New York Stock Exchange has required that securities traded on the exchange be backed by audited financial statements for almost 100 years. The U.S. Securities and Exchange Acts of 1933 and 1934 require that independent accounting firms audit registrants’ financial statements.
An audit by an independent accountant clearly adds a level of assurance to the financial data reviewed, but it does not provide absolute assurance. As you would expect, the quality of the service is directly related to its cost. “Good enough” costs much less than perfection.
A Simple Explanation of Materiality
A vast body of research exists that addresses the concept of materiality: research conducted by accounting academics (which is mostly studied by other accounting academics). However, the independent accountant protects the public good, so this article addresses the concept of materiality to you, the investing public.
A standard unqualified audit opinion reports that the financial statements “present fairly in all material respects, the financial position of the company.” So what is meant by “all material respects”? Auditors use the concept of materiality throughout the audit process. They plan and conduct the audit to detect material misstatements. However, the Financial Reporting Council (FRC) found that even professional investors have difficulty interpreting the meaning and use of the concept of materiality. Materiality is the level of an adjustment, error, or other misstatements that would alter a reasonable investor’s decision-making process. Materiality answers the question, in the cost/benefit trade-off: “Where is the good enough balance?”
To help understand this concept, think about purchasing a house. A home inspection is standard early in the purchasing process and so is a provision that allows the buyer to cancel the purchase (depending on the results of the inspection.) Consider a home purchase of $300,000. You would not expect your home inspector to conduct such a detailed investigation that it would take more than a few hours and you would not be overly concerned if there were burnt-out lightbulbs; this is the cost/benefit trade-off. Table 1 presents a chart showing the estimated cost of replacing certain items in the house.
Table 1: An Asset-Based Materiality Example
Which item or combination of items in Table 1 is “material” enough to cause you to alter your decision about the purchase of the home? The home inspection process and the cost of items, which results in further negotiation, are somewhat standardized. Investors have the impression that audit materiality is similarly standardized. However, auditors use a wide variety of methods to calculate materiality and then use the resulting calculations in surprising ways. We will now discuss how materiality is estimated and used in a financial statement audit.
Although the above example calculates “materiality” based on the purchase price of the home (an asset), only 4.5 percent of auditors measure materiality as a percentage of a firm’s assets. A recent study found that most auditors base materiality on income or revenues: with almost 60 percent using pre-tax income, slightly over 17 percent using revenue, and about 8 percent using net income. They are thus adding an extra layer of complexity, as income measurements are far less stable from year to year than assets. Such variance results in a different level of materiality being used each year, even though the company’s asset size remains stable. As income increases, so does audit materiality, and this can lead to an auditor’s failure to detect “slippery slope” fraud—fraud that begins with a small, questionable transaction or estimate and then balloons over the years. Surprisingly, “Chainsaw Al” Dunlap started his tenure of fraud at Sunbeam Corporation in 1996 with an understatement, not an overstatement, of income.
How Materiality is Used in an Audit
As explained above, auditors determine materiality based on their chosen financial measure taken from either the income statement or the balance sheet. They then apply some percentage (ranging from 0.25 percent to 15 percent) to this financial measure. The result is called planning materiality. The next step is to determine the allowable amount of misstatement for each account, or class of transactions. Each account’s or class of transactions’ allowable misstatement is always less than planning materiality. The benchmark allowable misstatement is between 50 percent and 75 percent of materiality. Several accounts and transactions are audited at once so that if all allowable misstatements, simultaneously in use, were summed they would far exceed planning materiality. Sometimes an audit firm will cap the total allowable misstatements at some multiple of materiality, but most do not.
While applying audit procedures, any likely or known misstatements exceeding the allowable misstatement amount are noted. Towards the end of the audit, these significant misstatements are aggregated and compared to planning materiality. If this aggregated amount is less than planning materiality, the auditor will conclude that the financial statements “present fairly in all material respects, the financial position of the company” or, internationally, are materiality “true and fair.” If the aggregated amounts of significant misstatements exceed materiality, the auditor will request that the company adjusts its books. At this point, it is the company’s choice whether to adjust its books, separate from the auditor or, very rarely, accept a modified or adverse opinion. Often, in the case of management fraud, the auditor is changed. When a publicly-traded corporation changes auditors, it is required to file a Form 8-K with the Securities and Exchange Commission (SEC). Not all changes of auditors are due to managements/auditor disagreements, but enough are that you need to consider the possibility.
Fraud and the Consideration of Audit Materiality
Fraud causes an average organizational revenue loss of 5 percent annually, which translates to an estimated annual worldwide loss of $3.5 trillion. In a Committee of Sponsoring Organizations (COSO) study of over 300 cases of fraud, where the average loss was $25 million, improper revenue recognition was the most common vehicle (60 percent of the cases) for committing the fraud with the CFO and/or CEO the most likely perpetrators (89 percent of the cases). Financial statement fraud caused the demise, through bankruptcy or other liquidation, of 28 percent of the companies affected. Nothing more than press coverage of the fraud caused an average16.7 percent drop in the stock price with a 7.3 percent drop following the announcement of a governmental investigation. These financial fates are rather “material.”
Worldwide, the most costly fraud, with a median loss of $800,000, is financial statement fraud; and while external audits are the most common method employed to control fraud, they only detect 4 percent of fraud cases. Thus, auditors do not generally detect fraud, including the largest four audit firms (the Big Four). In the COSO study, 79 percent of the companies committing fraud were being audited by one of the Big Four. Although the employment of a Big Four auditor does not provide a high level of fraud detection, they may be a good deterrent. Also, a change in auditor does sometimes precede the detection of fraud, with more than twice as many fraudulent companies changing auditors than non-fraudulent ones.
Audit firms will be quick to emphasize that a financial statement audit is not designed to detect fraud, but the Public Company Accounting Oversight Board (PCAOB) requires that auditors obtain “reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud.” Essentially, this requires auditors to detect fraud that is material to the financial statements. So why do so many massive scams, such as the $2.2 billion of fraudulent revenue reported by HealthSouth Corporation, go undetected by the auditor year after year? In the beginning months or years of fraud, the annual fraudulent revenue may be below audit Planning Materiality. Even though a manager may set forth to make only a one-time questionable entry, once the fraud line is crossed, it is much easier to ride the “slippery slope” of ballooning fraudulent revenues than to reverse the misstatement.
Consider that the auditor sets materiality at 5 percent of pre-tax income and further consider that financial statement fraud often begins as a small misstatement. HealthSouth began fraudulently boosting their revenues in 1986 by under-adjusting for insurance providers’ contractually required reductions to their standard fees. They reported some revenues at their standard charge, not at what they agreed to accept from insurance companies. As a result, they reported higher net income, and the auditors used a higher measure of audit materiality. The amount of fraud increased each year, but so did audit materiality. This may be why the auditors missed the fraud in the early years. However, the deception continued for years, to a total of $2.2 billion. By 2001 HealthSouth overstated revenue by 4,722 percent! No wonder the fraud was finally detected in 2002.
If a company is operating in a flourishing economy, such a revenue fraud can be hidden for many years, particularly if the CFO/CEO begins with relatively small amounts (less than 5 percent of pre-tax income) and increases the fraudulent revenues slowly. If the fraudster is exceptionally clever, he will spread the fraud across several accounts and transactions to avoid detection even longer. It is often the lack of cash flow and not the auditor, which reveals the overstated revenues, as a shortage of cash will cause the company to become unable to sustain the fraud. In the Sunbeam case, the corporation reported earnings of $189 million in 1997 but also reported negative cash flows from operations of $60.8 million. Positive cash flows from operations should always back operating income. There may be some lag in the timing, but the cash should flow into the company eventually.
The standard benchmark for materiality is 5 percent of pre-tax income. A loose (large) range of materiality affect an audit in several ways because audit work and materiality are inversely related (the higher the materiality, the fewer audit hours required.) First, when an auditor uses higher materiality amounts the range of allowable misstatements will be greater, resulting in the need to gather less audit evidence. So, fewer hours are spent on the audit by the independent accounting firm, causing the auditors to miss more irregularities and as a result, propose fewer adjustments to the financial statements. Larger measures of materiality are associated with the need to restate and reissue financial reports. How can you tell if the auditors are setting materiality unusually high? The public is provided with certain disclosures regarding an audit, and one of those is the level of audit fees. Lower audit fees are an indication of a higher level of materiality and, thus, more risk to you.
External audits of financial statements are required throughout the world and appear to deter fraud rather than to detect fraud. Smaller frauds are below materiality, and more extensive frauds are generally committed by those in positions that provide them the capability of hiding their malfeasance, sometimes for years or even decades. The cost/benefit trade-off between audit effort and audit detection is reflected in the level of materiality used by the auditor. Because each audit firm has its own methods of deriving both materiality and allowable misstatement, even professional investors generally do not possess a working knowledge of materiality. A larger materiality estimate leads to fewer audit hours worked and, as a result, lower audit fees. Audit fees are a required disclosure and a company reporting lower than expected audit fees is most likely employing an audit firm who uses a loose calculation of materiality. When an auditor finds a misstatement or combination of misstatements that exceeds materiality, the company can refuse to make the adjustments, which often leads to a change of auditor. Any change of auditor is required to be reported to the SEC on a Form 8-K. Form 8-K’s are available to you on sec.gov. An improved understanding of materiality will help you make more informed decisions.
The author would like to thank the reviewers of this article for their excellent suggestions that help to improve the article.