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Understanding the quantitative and qualitative aspects of materiality: Implications for assurance engagements Miami University | The Center for Business.

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Presentation on theme: "Understanding the quantitative and qualitative aspects of materiality: Implications for assurance engagements Miami University | The Center for Business."— Presentation transcript:

1 Understanding the quantitative and qualitative aspects of materiality: Implications for assurance engagements Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger Center for Business Excellence Co-Directors

2 1 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors About the authors Brian Ballou, Ph.D., CPA, has actively taught, researched, and worked with executives in enterprise risk management and reporting in varying capacities since His graduate-level enterprise risk management and reporting course is one of the only courses of its kind in the United States and is taught utilizing a corporate governance perspective. He has conducted executive education courses on enterprise risk management and reporting since He also has taught, researched, and worked with executives in governance-oriented, business risk based auditing approaches since 1998, including extensive seminars conducted for KPMG throughout the United States each summer since 1999, an upcoming textbook utilizing a global enterprise risk management approach to auditing, and membership on the AICPA Risk Assessment Task Force. He also has taught and published articles relating to fraud investigation and forensic accounting. His articles and instructional cases in the area have been published in academic and practitioner journals. Dr. Ballou has received grants related to risk management from the Economic Development Administration. Dan L. Heitger, Ph.D., has actively taught, researched, and worked with executives in enterprise risk management and reporting in varying capacities since His undergraduate and graduate level accounting courses emphasize performance measurement modeling and corporate sustainability reporting as a means for addressing accountability concerns for key decision makers and stakeholders of an organization. He co-founded Indiana Executive Systems, an organization that provides executive education across a variety of business topics for large international organizations. Through his company, Dr. Heitger has taught executives from over 20 different countries on a variety of topics related to governance, risk management and reporting, as well as on fraud investigation and forensic accounting. His articles and instructional cases in the area have been published in academic and practitioner journals. Dr. Heitger has received grants related to risk management and reporting from the Bureau of National Affairs.

3 2 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Understanding the basics of materiality Materiality in financial statement auditing ■Defined as the magnitude of an omission or misstatement of accounting information makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement Why is materiality important? ■Key auditing judgment – Level of effort expended on an audit is inversely related to the level of materiality –Lower materiality means that the auditor will have to expend more effort to find a smaller misstatement –Higher materiality means that the auditor will have to expend less effort to find a larger misstatement

4 3 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Conventional quantitative calculations of materiality ■No required level of materiality – Key auditor judgment ■Standard setters typically suggest selecting a financial base amount and that users focus on when evaluating financial statements –Net Income for companies generating profits (bottom-line) –Revenues (top-line) or net assets for companies generating losses or not-for-profit

5 4 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Conventional quantitative calculations of materiality (continued) ■Standard setters typically suggest selecting a percentage that is reasonable to reflect a high or low level of materiality that is adjusted for the magnitude of the base selected –A range of 5 percent (low) to 10 percent (high) when net income used to establish materiality –A range of 1 percent (low) to 3 percent (high) when sales or net assets used to establish materiality ■One exception – Under SAB 99, all misstatements are material for publicly-traded companies not following GAAP. No calculation of materiality is appropriate in such cases

6 5 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Qualitative considerations for materiality ■Ownership structure of the organization ■Misstatements relative to segment or interim results ■Nature of misstatements – particularly fraud ■Nature of contractual constraints ■Trends ■Meeting or exceeding incentive goals ■External expectations

7 6 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Qualitative considerations for materiality (continued) How is materiality considered during the audit ■Materiality is established at two phases of the audit –Planning phase based on projected financial statements –Conclusion phase based on audited financial statements that reflect adjustments made to the projected financial statements as a result of the audit

8 7 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Qualitative considerations for materiality (continued) Tolerable misstatement ■Defined as the amount of misstatement that an auditor can tolerate in a specific account before it is considered materially misstated. It is the basis by which auditors decompose materiality into smaller pieces applicable to specific audit areas or accounts. Generally accepted guidelines include: –Tolerable misstatements should be less than the overall materiality level –The sum of tolerable error across all accounts may equal materiality

9 8 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Qualitative considerations for materiality (continued) ■Misstatements relative to segment or interim results ■Nature of misstatements – particularly fraud ■Nature of contractual constraints ■Trends ■Meeting or exceeding incentive goals ■Analyst expectations for the industry ■Prior year financial results and upcoming forecasts ■Earnings and trends in other measures

10 9 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors The KPMG professional judgment framework Environment

11 10 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality & KPMG’s professional judgment framework ■Defining Materiality in the Context of Judgment –A judgment is the process of reaching a decision or drawing a conclusion where there are a number of possible alternate solutions –Materiality is one of the most important and challenging judgments made as part of an audit engagement because of the high levels of uncertainty and risk –Determining materiality involves estimating probabilities that misstatements would affect the decisions of a reasonable user

12 11 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality & KPMG’s professional judgment framework (continued) ■Applying Materiality to Components of Judgments –Logical –Flexible –Consistent and reliable –Balance experience with knowledge, intuition, and emotion –Uses right amount of relevant information, including professional literature and evidence

13 12 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality & KPMG’s professional judgment framework (continued) ■Applying Materiality to Five Steps of Judgment Framework 1.Clarify Issues and Objectives – What is the appropriate base and percentage? 2.Consider Alternatives – What combinations of materiality are computed using different bases multiplied by percentages with various ranges? 3.Gather and Evaluation Information – Auditors can research similar firm engagements or authoritative literature to assess proposed alternatives

14 13 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality & KPMG’s professional judgment framework (continued) ■Applying Materiality to Five Steps of Judgment Framework 4.Reach Conclusion – Which materiality combination is best when considering client characteristics and prevailing best practices and guidance? 5.Articulate and Document Rationale – Can the process used to reach a conclusion be clearly document to withstand scrutiny?

15 14 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality in different contexts ■Materiality is relevant in numerous settings: 1.Financial statement audits (as examined earlier) 2.Corporate sustainability reporting (e.g., nonfinancial information disclosures) 3.Executive and management strategic and operating decisions (e.g., interpreting data analytics results, applying competitor intelligence, etc.)

16 15 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality in different contexts (continued) ■Corporate Sustainability Reporting – CSR: –Thousands of organizations issue CSR reports; increasingly they are accompanied by external assurance –Can still apply the concept of multiplying a given percentage by an important account balance (as in financial statement materiality discussions) –But considerable uncertainly exists regarding the selection of the most appropriate percentage and account(s) to apply

17 16 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality in different contexts (continued) ■CSR Materiality Factors to Consider: –CSRs intended not just for investors, but for all stakeholders –Therefore, to define materiality, start with the organization’s strategy and the resulting most critical risks and opportunities –Should consider the organization’s most important stakeholders, because they can significantly affect the degree to which the organization achieves its strategy ■Key stakeholder issues = Key business risks/opportunities! ■As a result, effective stakeholder engagement practices become critically important in determining which issues and percentages would be most impactful to key stakeholder decisions (i.e., relevant)

18 17 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality in different contexts (continued) ■Challenging CSR Materiality Examples: –Manufacturers registered with the SEC must disclose any conflict minerals within their supply chain (to be compliant with Section 1502 of the Dodd-Frank Act) – this issue is estimated to affect more than 50% of SEC registrants; What constitutes a material amount of conflict minerals? –Large international distribution companies disclose their Greenhouse Gas (GhG) Emissions (i.e., level 1, level 2, and level 3); What constitutes a material amount of GhG emissions in order to maintain a company’s license to operate?

19 18 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Materiality in different contexts (continued) ■CSR Reporting and Assurance Guidance on Materiality: –GAAP and GAAS for sustainability reporting still are in their relative infancy as compared to the more traditional financial reporting environment –Examples include: ■Global Reporting Initiative G4 standards – attempt to focus CSR preparers on the economic, environmental, and social impacts that matter most to key stakeholders (its Material Aspects and Boundaries section) ■International Integrated Reporting Committee (IIRC) – defines materiality as items that substantively affect the organization’s ability to create value over the short, medium and long term ■Both the GRI and the IIRC present more of a philosophy, rather than exact guidance, on how to calculate materiality in a nonfinancial reporting setting

20 19 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS Understanding the quantitative and qualitative aspects of materiality Miami University | The Center for Business Excellence Brian Ballou & Dan Heitger, Center for Business Excellence Co-Directors Excerpt from Hess 2012 CSR – Materiality assessment

21 Questions?

22 © 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.


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