Financial reporting bridges the information gap between company owners (the shareholders) and managers to whom shareholders delegate the day-to-day operation of companies. Company management prepares financial reports which are made available to company owners (shareholders) and other stakeholders. Auditors are the "referees" in this process, writes Niamh Brennan
They provide users of accounts with some assurance concerning the accounts. However, the nature of the assurance offered is unclear.
An audit is an independent review of the financial statements. The output of an audit is the auditors' report on the financial statements in which auditors express an opinion on whether the accounts give a "true and fair view". The audit report is not a certificate - auditors do not certify the financial statements.
A "clean" audit report does not guarantee the accuracy of the financial statements - as the auditors do not examine 100 per cent of the transactions of the company.
It is not the function of an audit to detect fraud (although fraud may come to light during an audit). Company law requires auditors to report on whether accounts give a "true and fair view". But what does the term "true and fair view" mean?
It is not defined by legislation, or by the accounting profession. As a result, it is subject to considerable uncertainty and is therefore the most difficult and judgmental aspect of auditors' responsibilities.
The auditing profession acknowledges this uncertainty as follows: ". . . financial statements may be prepared in different ways and yet still present a true and fair view".
However, most investors do not understand that "financial statements may be prepared in different ways and yet still present a true and fair view". The auditing profession's own definition of an audit highlights the imprecision and uncertainty associated with auditing: "An audit . . . is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement." In particular, a number of terms in this definition should be noted:
The audit provides "reasonable assurance" only;
The audit opinion is only on financial statements "taken as a whole";
The audit opinion should not be interpreted as implying that the financial statements are "free from . . . mis-statement";
The audit opinion only indicates that the financial statements are free from "material" mis-statement.
This begs the question: What is "material". The auditing profession defines materiality as: "A matter is material if its omission or mis-statement would reasonably influence the decisions of a user of financial statements." This definition begs a number of questions:
How do auditors know what would reasonably influence decisions of users?
Are auditors' understandings of this phrase the same/consistent from individual to individual?
At the start of every audit, the audit partner and staff on the audit select a level of materiality to apply to the audit. This is almost always expressed as a monetary amount.
Auditors have incentives to choose high levels of materiality - this reduces the amount of work to be done on the audit, and therefore makes the audit less costly/more profitable. Materiality (in effect) builds flexibility into financial reporting. This can lead to abuse. For example, companies may intentionally record "small" errors within a defined percentage ceiling, so that auditors will not scrutinise such errors (as they are not material).
Management excuse errors by arguing that the effect on the bottom line is so small as not to matter - it is immaterial. These small errors can build up and mislead the stock market and other stakeholders e.g. lenders, employees and creditors.
This is illustrated by the following quote in relation to the Enron audit: "The remainder of the earnings reductions of $92 million from 1997 through 2000 came from what Enron called 'prior year proposed audit adjustments and reclassifications' . . . recommended by Arthur Andersen, Enron's auditors, but not made because the auditors were persuaded the amounts were immaterial" (New York Times, November 9th, 2001).
Auditors do not disclose materiality levels applied in audits. Investors (and users of accounts generally) therefore cannot understand the limits/margin of error inherent in the audit opinion being provided.
Materiality levels are often considerably larger than average investors would guess. Staying with the Enron case, in 1997 Enron reported profits of €105 million. The audit adjustment considered immaterial by the auditors in that year was €51 million. Had this adjustment not been deemed immaterial, the reported profits would have been reduced by almost 50 per cent to €54 million.
Prior to the Enron case, few investors would have anticipated that something amounting to 50 per cent of profits could be deemed by auditors to be immaterial.
There is a lesson in this tale for everyone sitting around a boardroom table. Always ask the auditors what level of materiality they applied in carrying out the audit.
You may find yourself quite surprised at the answers you get.
Why don't auditors disclose the materiality level applied during the audit in their audit reports? Then audit reports might have some meaning for shareholders by giving them a guide to the margin of error (crudely speaking) in the accounts.
What effect would there be if materiality levels were disclosed? Would materiality come down, and the level of audit work increase?
In a submission to the public consultation process on the Central Bank and Financial Services Authority of Ireland (No.2) Bill, I have called for such disclosure. As auditors select materiality levels to apply to audits at the beginning of audits, this should not be an onerous requirement. The precise numbers and amounts in profit and loss accounts and balance sheets suggest a precision that does not exist.
Disclosure of materiality levels would significantly enhance users' understanding of the financial statements and would remind them of the underlying imprecision of accounting.
Niamh Brennan is Michael MacCormac Professor of Management at UCD and is academic director of the Institute of Directors Centre for Corporate Governance at UCD