Materiality in government auditing.
The yellow book incorporates American Institute of CPAs audit standards including Statement on Auditing Standards no. 47, Audit Risk and Materiality in Conducting an Audit. These standards do not provide quantitative guidelines (appropriate bases and percentages) for calculating materiality. Our study provides information about materiality levels implicit in current practice and can be valuable to auditors in audit planning and performance evaluation.
In a government context, the probability of client financial failure (and subsequent discovery of material financial statement misstatements) is unknown or very low. This relatively stable environment is characterized by competitive audit pricing practices and, in general, an undue emphasis on price in auditor selection. Consequently, the need for materiality guidelines (as a possible standard for an audit's sufficiency) may be greater in government than in a corporate context.
While guidelines cannot substitute for professional judgment, they can be a starting point. The conclusion of this article provides a sliding-scale materiality guideline CPAs can use to evaluate their professional judgments.
AN ACCOUNTING AND AUDITING CONCEPT
Financial Accounting Standards Board Concepts Statement no. 2, Qualitative Characteristics of Accounting Information, defines materiality as the magnitude of an omission or misstatement that, in the context of surrounding circumstances, would influence the judgment of a reasonable financial statement user. Thus, materiality refers to financial statements' level of precision or accuracy.
SAS no. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities, and SAS no. 54, Illegal Acts By Clients, require an audit to be designed to provide reasonable assurance of detecting material financial statement misstatements (material errors and irregularities) and illegal acts that may have a direct and material effect on financial statement amounts. The phrase "present fairly" in the auditor's opinion incorporates the concept of materiality by suggesting the financial statements are accurate only within reasonable and practicable limits.
Audit service contracts typically are silent on the level of materiality to be applied or achieved. In the absence of quantitative guidelines, it is reasonable to expect nonuniformity in practice. At least 10 different published (but nonauthoritative) quantitative materiality guidelines are found in corporate professional literature, providing materiality amounts that vary widely for the same type of audit. It appears that although the result of the audit process (the audit opinion) is standardized, the key ingredient of materiality (which is invisible to financial statement users) can vary across audits.
The concepts discussed above are incorporated by reference in General Accounting Office (GAO) standards. Although additional compliance reports are required, the auditor need not perform additional tests beyond those performed to issue an opinion on the financial statements.
An organizationwide audit under the Single Audit Act expands the scope of the traditional financial statement audit significantly by requiring auditors to express an opinion on compliance with laws and regulations applicable to major federal financial assistance (FFA) programs. The act defines major FFA programs based on federal assistance expenditures.
According to Office of Management and Budget (OMB) Circular A-128, in testing for compliance auditors are required to consider materiality in relation to the nature and size of each major FFA program. Consequently, the consideration of materiality in a compliance audit of major FFA programs differs from that in a financial statement audit in accordance with GAAS or GAO standards. Also, since major FFA programs vary in size, the materiality threshold varies across audits of different major programs. However, OMB regulations do not provide quantitative guidelines for determining what is material; such determinations are left to the individual auditor's judgment.
Our study relied on a confidential survey to obtain information on the practices of individual auditors. One hundred seventy partners and audit managers of 28 large CPA firms and 227 auditors from state audit agencies in the 50 states responded. Subjects were asked to provide information on their actual materiality practices, notwithstanding any existing CPA firm or state audit agency policies. Respondents had significant experience performing opinion audits of government financial statements (an average of 8 years for outside CPAs and 12 years for state auditors).
Materiality as an auditing concept. Materiality is relevant to planning an audit's scope and influences the nature, extent and timing of audit procedures necessary to provide reasonable assurance the audit will detect material misstatements, if any.
Materiality generally is computed by taking a base (revenues, expenditures, assets, etc.) and multiplying it by a percentage; the percentage can be a fiat rate or one obtained from a sliding scale. A fiat percentage is based on the notion materiality is completely relative, while a sliding scale assumes some amounts are large enough to always be material. The advantage of a sliding scale is that the effect of an increase in auditee size is tempered somewhat by raising the calculated materiality (in dollar terms) at a decreasing rate.
SAS no. 47 requires auditors to form preliminary estimates of amounts that would be considered material to the financial statements taken as a whole, although the estimate need not be quantified. About 95% of respondents said they complied with this requirement in planning an opinion audit of general purpose (or component unit) financial statements. Nearly 79% of respondents said they did so when planning an opinion audit of compliance with requirements governing major programs under the Single Audit Act.
Governmental and expendable trust funds. GAAS or GAO standards do not specify the appropriate bases or percentages to be used in calculating materiality. The survey asked respondents to indicate the bases and percentages they ordinarily use.
Exhibit 1, above, summarizes the results for materiality bases. The frequently used bases (in declining order of importance) were total revenues, total assets, total expenditures and fund balance. Many respondents said they used the greater of total revenues or total assets. A majority (65%) of respondents used a fiat percentage rather than a sliding scale to compute materiality. The most frequently cited percentage was 5%.
Measuring materiality based on 5% of a gross measure (such as total revenues or total assets) may result in a materiality estimate that is too large. In the private sector, a materiality estimate of 5% of a net measure (such as net income) is likely to approximate materiality in dollar terms of 0.25% to 1% of gross revenues. In contrast to respondents using a fiat percentage, respondents using a sliding scale, as discussed below, tended to use a much tighter materiality estimate.
About 35% of respondents used a sliding scale to compute materiality. We know of only one published scale for governments; it consists of six steps and varies from 4% for amounts below $100,000 to 0.5% for amounts above $10 million. It was the single most popular and was used by about 15% of all respondents. Its popularity was particularly noticeable among smaller CPA firms and state audit agencies.
We received information on more than two dozen other sliding scales used in practice. They varied from a minimum of 3 steps to a maximum of 26 steps and from a maximum of 8% (for amounts below $100,000) to a minimum of 0.015% (for amounts above $300 billion). Exhibit 2, below, provides information about sliding scales with five or more steps.
Proprietary and nonexpendable and pension trust funds. Respondents said the bases and percentages they ordinarily used when measuring materiality for such trust funds (in declining order of importance) were total revenues, total assets, retained earnings-fund balance and net income. Again, there was considerable dispersion in the percentages used; 5% was the most frequently cited.
Written comments suggested the same percentages and sliding scales used in government and expendable trust fund audits also were used in proprietary and nonexpendable and pension trust fund audits.
The comments showed the financiar dynamics of the different fund types varied. For operating-statement-driven fund types--government funds--total revenues or expenditures typically exceed total assets. For such fund types, total revenues were used as the base. For balance-sheetdriven fund types (such as enterprise funds and pension and nonexpendable trust funds), total assets typically exceed total revenues or expenditures. For these fund types, total assets commonly were used as the base. Hence, current practice, as reflected in the survey, was to use the larger of total revenues or total assets as the base. However, practice was not always consistent. For pension and nonexpendable trust funds, some auditors used total assets as the base while others used fund balance or total revenues.
Compliance audits of major FFA programs. Under the Single Audit Act, auditors are required to express opinions on whether each major FFA program was administered in conformity with laws and regulations. The threshold of a major program can vary from $300,000 to $20 million depending on a government's total federal assistance expenditures. Under OMB regulations, auditors must consider materiality in relation to the nature and size of each major FFA program. Hence, materiality relates to the nature and amount of noncompliance according to a program's size and differs from the financial statement materiality concept. Since the size of major programs varies, materiality in dollar terms differs for each major program. The materiality threshold in dollar terms in a compliance audit of major FFA programs almost always differs from materiality in a financial statement audit.
Respondents indicated the bases and percentages they ordinarily used to measure materiality for compliance audits of major FFA programs under the Single Audit Act. Exhibit 3, below, summarizes the results for materiality bases.
Since OMB regulations define major FFA programs based on expenditures and require materiality to be considered in relation to the amount of each major program, the correct base to use in determining materiality is the "amount of FFA expenditure for each major program." However, this base was rated highest (1) by only 43% of respondents. Other preferred bases were "total FFA expenditures" and "amount of FFA revenues for each major program." Moreover, 21% of respondents said their preferred choice was to use the same materiality amount as in financial statement audits. The diversity in the bases used is inconsistent with governing federal regulations that require materiality for compliance audits of major FFA programs to be considered in relation to the nature and size of each major program.
The range of percentages applied against the appropriate bases to compute materiality varied considerably. In general, respondents appeared to use the same percentages and sliding scales used in an opinion audit of financial statements.
Exposure risk factors. Exposure risk is the risk of adverse publicity and injury to an auditor's professional reputation from external events such as potentially embarrassing disclosures or lawsuits. Auditors are likely to respond to a higher level of perceived exposure risk by increasing the extent of audit testing.
Respondents identified and rated the exposure risk factors they ordinarily considered (in declining order of importance) as federal oversight and monitoring, auditee financial distress (for example, a low bond rating), the political sensitivity of the area under audit, the media and litigation.
Written comments identified an "adverse budgetary climate" as an additional example of auditee financial distress risk. Litigation sources were government officials who disagreed with audit findings, court actions initiated to pursue findings of fraud, special interest groups, taxpayers and employee unions.
Exposure risk and materiality. Thirty-one percent of respondents' estimates of materiality were influenced by the perceived level of exposure risk associated with an audit engagement. Estimates of the decrease in the number of percentage points used in calculating materiality for audit engagements with higher than normal exposure risk ranged between 0.2% and 5%.
CPA FIRM OR STATE AUDIT AGENCY POLICIES
Both audit firms and state audit agencies are concerned there might be an unjustifiably wide variation in the extent of audit testing performed by auditors in similar audit situations. Sixty percent of respondents said their organizations used materiality guidelines for financial statement audits, while only 47% said their organizations used materiality guidelines for compliance audits of major FFA programs. Written comments frequently referred to the Practitioners Publishing Co. scale. One respondent noted these guidelines were used as a rule of thumb for audits with a moderate level of exposure risk, but the staff was instructed to use smaller percentages if assessed risk was higher.
A number of respondents commented that general quantitative guidelines on materiality would be helpful and were needed; however, these same respondents added that guidelines should be used only as a starting point and not as a substitute for auditor judgment. Others said there was a need for published guidance on materiality and extent of testing in relation to compliance audits of major FFA programs to satisfy Single Audit Act requirements.
IMPLICATIONS FOR PRACTICE
Our survey results suggested materiality for audits of government (and proprietary) funds was based generally on the larger of total revenues or total assets. Based on our results we developed the sliding scale in exhibit 4, above, which can be viewed as a possible quantitative guideline. It is intended to provide a useful starting point for estimating materiality.
Many auditors, especially those in smaller CPA firms and state audit agencies that do not have the resources to develop inhouse guidelines or policies, apparently would welcome a quantitative guideline provided it was not perceived as a substitute for auditor judgment. For materiality judgments, as for most audit judgments, there is no objective external criterion and it is not possible to specify the correct decision.
The diversity in the bases used for estimating materiality for compliance audits of major FFA programs under the Single Audit Act suggested this was a significant problem. While OMB regulations require materiality to be considered in relation to the amount of FFA expenditure for each major program, only 43% of respondents rated this base highest for calculating materiality.
TABULAR DATA OMITTED
K. K. RAMAN, CPA, DBA, is professor of accounting at the College of Business at the University of North Texas. He served as an academic fellow at the Governmental Accounting Standards Board. RELMOND P. VAN DANIKER, CPA, DBA, is professor of accounting at the University of Kentucky and executive director of the National Association of State Auditors, Comptrollers and Treasurers. He is a member of the American Institute of CPAs.
The authors gratefully acknowledge helpful comments and suggestions from Neil Tierney, Philip Calder and James Williams of Ernst & Young.
* GOVERNMENT AUDITORS do not agree on an appropriate base for calculating materiality in conducting audits. Current practice varies widely. The need for materiality guidelines--as a standard for an audit's sufficiency--may be greater in government than in a corporate context.
* IN THE ABSENCE OF quantitative materiality guidelines, it is reasonable to expect nonuniformity in praCtice. At least 10 different quantitative guidelines appear in corporate professional literature.
* ABOUT 95% OF RESPONDENTS to a survey said they complied with the requirements of Statement on Auditing Standards no. 47, Audit Risk and Materiality in Conducting an Audit, in planning audits. Nearly 79% said they followed the same rules in planning opinion audits of compliance with the Single Audit Act of 1984.
* SURVEY RESPONDENTS CITED more than a dozen sliding materiality scales used in practice.
* BOTH AUDIT FIRMS and state audit agencies are concerned there might be an unjustifiable wide variation in the extent of audit testing performed by auditors in similar audit situations. Written survey comments emphasized the need for general materiality guidelines, but not as a substitute for auditor judgment.
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|Author:||Van Daniker, Relmond P.|
|Publication:||Journal of Accountancy|
|Date:||Feb 1, 1994|
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