1. Not all adjustments in the financial statements are corrected. Some of them are deemed immaterial. A basic principle is that a misstatement is deemed material if it can impact the decision of a reasonable user of the financial statements. In my firm when we plan the nature, timing, and extent of audit procedures, we establish a materiality level for the financial statements as a whole that is appropriate in light of the particular circumstances. This includes consideration of the entity’s earnings and other relevant factors. To determine the nature, timing, and extent of audit procedures, the materiality level for the financial statements as a whole needs to be expressed as a specified amount.
Materiality is determined while establishing the overall strategy for the audit based on the results of risk assessment analytical procedures, our understanding of the business and industry and professional judgment. Judgments about materiality are subjective and may change during the course of the engagement. These judgments are often implicit, and will be reflected in our assessments of risk and our decisions about which components, account balances and other items are of greater or lesser significance.
Although determination of materiality is a matter of professional judgment, it is helpful to apply a percentage to a chosen benchmark as a step in determining overall materiality. A benchmark is an element of the financial statements to which a threshold will be applied for purposes of calculating materiality. Such threshold or percentage is frequently based on our experience.
Generally Expected Benchmarks
• Pre-tax income (loss) from continuing operations or after-tax income (loss) from continuing operations are, in most circumstances, the measure of greatest significance to the financial statement users of entities whose debt or equity securities are publicly traded and for other “profit-oriented” entities. (e.g. 5% of PBT)
• For “not-for-profit” organizations, total expenses, total revenues or total assets.
• For asset-based entities (e.g., mutual funds and benefit plans that accumulate assets), net assets.
Needless to say – higher the threshold is – less substantive work needs to be done in order to gain comfort over the account balances. In case where aggregated misstatements which the client does not accept to adjust higher than this threshold a qualified adverse opinion may be issued.
2. The primary responsibility is to verify the financial statements. If the statements did not meet standards, an adverse opinion at first seemed all that is needed. However, Auditors do have the responsibility to report any illegal acts discovered during the course of an audit. Recently, the PCAOB required auditors to examine related parties with more skepticism for fraud. The new rule will be effective December 15, 2014.
Reporting of an illegal act must first be reported to an audit committee or similar authority (Arens, Elder, & Beasley, 2012). If the company is publicly traded the company must report the findings to the SEC.
Barriers to discovering fraud in one instance is management’s involvement in the process. If management is committing the fraud, the question and answer session could be nothing but misleading responses. Management could also provide false and incomplete information. Another barrier is management’s lack knowledge of a the fraud, which suggest lack of internal controls. To overcome the barriers, auditors need to independently verify the results through additional testing, reviewing company minutes, public filings, or interviews. Auditors could always withdrawal from the engagement or complete the engagement and issue an adverse opinion or disclaimer.
Reference:
Arens, A., Elder, R., Beasley, M. (2012). Auditing and Assurance Services (14th ed.) Upper Saddle River, NJ: Prentice Hall. Retrieved October 22, 2014 from University of Phoenix Week 2 Learning Activity
Katz, D. (2014). PCAOB Cracks Down on Fraud. Retrieved October 22, 2014 from https://ww2.cfo.com/auditing/2014/06/pcaob-cracks-fraud/
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