Discuss the concept of materiality and the relationship it has with risk. Using a set of financial statements discuss how these concepts may have been considered by the auditors during audit.

Materiality concept is a main concept for auditors to take into consideration when planning an audit, before even looking at the financial statements. As materiality has no set rules for every client or management; it is solely dependent on the auditor's judgement and experience they have in the businesses sector, which they believe to be the right level to set materiality at. The auditor must base an opinion on accounts given to them by the management; it is the management's duty to give a true and fair set of financial accounts to the auditor, as the auditor does not look for fraud they only look for misstatement and risk.

However, Materiality is only taken into account if it is large enough. As a £1,000 inventory figure may not be that material when the company turnover is £1,000,000. As it would be a waste of time focusing on such a small figure which would have a small amount of risk for the overall financial statements. But the auditor must take into account ‘creeping materiality' as one small figure may not be material but lots of small misstated figures might be material, so the auditor must decide to use sampling or analytical procedures to reduce the risk of this happening. Thus the auditor must look at individual accounts and the whole financial statements to give a fair opinion of the accounts to the shareholders. The auditor must take into account (ISA 320, paragraph 2, page 323) which states ‘Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.' So the auditor must make sure that figures such as liabilities and expenses are not misstated as they may give more admirable profit figures thus investors and shareholders will be happy. Also losses could be stated as management may be under threat from a takeover, thus making the financial statements look undesirable.

Risk in an audit is hard to manage as some material misstatement will remain undetected, as the auditors are unable to check everything, this is why the choose a level of risk before they start the audit so they can just check certain figures in the financial statements. In (Modern auditing, Graham W Cosserat, page 207) it states ‘Audit risk is the risk of the auditors giving an inappropriate opinion on the financial statements.' This may be caused by the auditor being given misstated financial accounts or they may have not followed procedure correctly. However this is not the only risk auditors may encounter as auditors must take into account business risk, as the clients may be altering accounts to make the auditor and shareholders believe that the business will continue in operations, i.e. going concern. A prime example of this happening in business is Caparo industries plc v Dickman which is stated in (Business Law, Ewan McIntyre, 4th edition, page 382) in which investors relied on auditor's accounts of the company, in which they invested. The company showed a profit but in reality the company was actually making a loss, so the accounts were misstated and did not show a true and fair view of the company's financial position.

Audit risk is comprised of three workings, which are Inherent, control and detection risk. Inherent risk is trying to work out the amounts stated in the accounts, as some accounts and industries sectors are hard to estimate, for example oil companies may estimate they have large amounts of oil in their reserves but may only have a small amount thus reducing future profits. However if good controls are in place and good management ethics and integrity then audit risk can be reduced thus the impact of inherent risk is less severe and the accounts will become more material. Control risk is based on the internal controls of a company of which can never be put at zero, as there is always human error involved, this is why effective controls must be put in place and consistently assessing for risk, such as bank reconciliations. Auditor will want managers to be integral and ethical in the way they run and check their internal controls as if they seem not to be then the auditor may have cause for concern, as management needs to be vigilant with controls to keep down risk thus making the financial account material and reliable otherwise such incidents may happen such as. Detection risk is when the auditors may not acknowledge all of the material misstatements in the financial accounts and the auditor is able to set a level that they wish to stick to. Using all of these workings the auditor is able to discard the financial accounts if one of the risks are too high such as controls are not being monitored and manager's ethics are low, the accounts may be misstated.

The relationship between materiality and risk is an inverse relationship as risk is lowered materiality rises, which is what the auditor and shareholders want, as they will have a reliable set of account but this is not east to achieve. A main problem for auditors is the relationship they have with management, as to carry out a audit, the auditor must give a unbiased view about the accounts, however as the ‘agency theory' tells us that managers are caught in the middle between managers and shareholders. Auditors must not have a special relationship with management, as management may put pressure on the auditor or offer bribes to change their opinions. So forming a relationship keeps risk down, however the auditor must use the accounts given to them by management thus the auditor must believe the management are acting ethically and integral in running the business. It is the auditors own professional judgment to decide if the management are giving true and fair accounts, as some management may be altering the accounts so that they can keep their jobs or too receive rewards for hitting targets, it would be a bad idea for a auditor to take on a client with characteristics such as these as the going concern of the company would be low and effect the auditor. If management are consistently checking controls risk will be lower thus making materiality higher in the accounts. However the auditor cannot change the controls in a business, they can only suggest other ways to carry out the internal controls. So ultimately to keep risk low management are the ones to do this which does not help the auditor in his opinion of the accounts.

One way auditors can keep risk down and materiality high is to gather evidence of the financial accounts, such as going and personally checking assets stated on the financial accounts and revaluing them if need be. This type of sample testing keeps risk down, as lots of individual misstated accounts, i.e. ‘creeping materiality' can change the materiality of the accounts. An auditor is able to look at previous years accounts, so if there are large changes in the financial statements and no clear reason why, then there may be cause for concern or high risk, but an auditor must be experienced in the industry sector as otherwise they will not understand different inherent risks affecting the company and the external environment that may affect the company's profits or losses.

Source: ChinaStones - http://china-stones.info/free-essays/accounting/materiality-concept.php

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