an empirical study of materiality in uk financial

Journal of Accounting and Finance 7(1) Spring 1993

AN EMPIRICAL STUDY OF MATERIALITY IN UK FINANCIAL STATEMENTS

23


AN EMPIRICAL STUDY FINANCIAL STATEMENTS

OF

MATERIALITY

IN

H. Gin Chong Southampton Institute, Southampton, UK Gerald Vinten University of Luton, Luton, UK

Selected topic area: Auditing Key words: Materiality thresholds, financial statements, auditing

Correspondence should be addressed to: H. Gin Chong Reader, Accountancy Division Southampton Institute East Park Terrace Southampton SO14 OYN UK Tel: (0703) 319609 E-mail:Chong_g@Southampton-institute Fax: (0703) 332627

24

UK


ABSTRACT Materiality is important in all stages of an audit. In the planning stage, auditors apply the materiality concept to decide the size of samples to be tested while in the evaluation stage, it is used as the basis to determine disclosure of an item(s) or otherwise qualifications in auditors' report. There are many descriptions of materiality by academic researchers. This could due to its vagueness in nature and its importance to both the accounting and auditing profession. The extent in which an item(s) is considered material causes both confusion and concern by preparers, users and auditors. There are mathematical

measurements

for

materiality

recommended by accounting bodies in Australia, New 25


Zealand and Scotland, but not the UK Auditing Practices Board. This paper assesses materiality thresholds adopted by Big Six and non Big Six, and large and small companies in the UK on the disclosure of extraordinary and exceptional items in the financial statements. 1000 empirical results revealed that UK companies tend to disclose those items within 5% of net profit before tax. This level of disclosure is lower than recommended by researchers in the USA (5% of net profit) and accounting bodies in Australasia and Scotland (15%). More research needs to be encouraged in the UK and in other countries to assess the current materiality thresholds, and to evaluate the possibility of having a standardised guideline across international boundaries. Standardisation of reporting and evaluation would 26


enhance comparison, and safeguard audit quality, and allows self-regulation of the auditing profession to be continued.

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INTRODUCTION The UK Auditing Practices Board (APB) of the UK issued an exposure draft on Àudit Materiality' (August 1993) which defined materiality as a matter's `...non disclosure, misstatement or omission would be likely to distort the view given by the accounts or other statement under consideration' (para 3). However, it failed to define the extent to which item(s) could be considered material or recommend a mathematical measurement (that is having a structured guideline). A structured guideline is important to preparers of financial statements, auditors and users. Preparers would feel confidence in reporting and disclosing material items (Woolsey, 1968, 1974; Bernstein, 1967; Hensley, 28


1974); auditors could apply the guideline without hesitation or fear of being removed due to clients' resistance for disclosure (Jennings et. al., 1985b; Chong, 1992); and users have additional confidence on reported figures

as

structured

guideline

would

enhance

uniformity in reporting. However, this may bring rigidity to auditors' decision making, and quantitative measurement tends to be the sole criterion for disclosure/qualification rather than also considering the qualitative effects of the item(s) (FASB, 1981; Holstrum & Messier, 1982; Robinson & Fertuck, 1985). This paper attempts to fill the vacuum of whether there is a need of a structured guideline in the UK. It first assesses the literature and then reports on an empirical study of 1000 financial statements on the 29


extent of extraordinary and exceptional items were disclosed.

PREVIOUS RESEARCH There are different levels of feeling and concern on materiality. Materiality has been described as the `cornerstone of accountancy' (Frishkoff, 1970,p.116), `the Achilles' heel of the accounting profession' (O'Glove & Olstein, 1977,p.19), and `the grey area in auditing' (Jennings et al., 1991,p.100). It is a core (Hewitt,

1975,p.892),

1985b,p.338),

elusive

critical (Pattillo, 30

(Jennings

et

1975,p.20;

al., Lee,


1970,p.19), ill-defined (Jennings et al., 1985a,p.640), illusive (Barnes, 1976,p.19), important (Study Group on Audit Technique, 1965,p.1; Jeffries, 1981,p.13), mystery (Rose et al., 1970,p.139), nebulous (Jennings et al., 1985a,p.667), psychological (Moonitz, 1961,p.2) and unknown (Reininga, 1968,p.31) concept. These calls showed the vagueness of the definitions of materiality, its intrinsic nature, and its impacts on preparers, auditors and users.

The literature (mainly from the US) revealed that net profit is the main determinant of materiality but the range of thresholds varies from 5-16%. These thresholds contradict to recommendations by other accountancy bodies of 10% (Table 1) and audit manuals of UK audit 31


firms of 5-25% of net profit (Table 2). Surveys by Woolsey (1954), Messier (1983) and Chewning et. al. (1989) revealed that partners in non Big Six firms generally have lower materiality thresholds than their Big Six counterparts.

In view of this, three hypotheses were established: H1: there exists no consensus on disclosing materiality items in the annual reports in the UK;

H2: there exists differences between Big Six and non Big Six firms in the UK on the treatment of material items in annual reports; and

H3: in the context of financial reporting, materiality 32


thresholds for large companies are higher than those smaller companies due to the size and nature of businesses and the spectrum of users of financial statements.

METHODOLOGY AND RESULTS

100 UK registered companies (excluding foreign undertakings) were randomly selected from Times 1000. This selection avoids samples from a particular sector of business are being chosen for testing. Extraordinary and exceptional items disclosed in the financial statements of these 100 companies were extracted and examined for the past 10 years (i.e. 1,000 observations were obtained). 33


H1: Rejected UK

financial

statements

tend

to

disclose

extraordinary (22%) and exceptional (51%) items, even though they are less than 5% of net profit before tax. This 5% range is well below that stated in the literature of 10%. This implies more items were separately disclosed in the UK financial statement than their overseas counterparts. Additional disclosure, as long as relevant for decision making, is good, but this may confuse

users

and

distract

decision

making.

Inconsistency in disclosure could be due to a lack of a structured guideline.

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H2: Rejected Big Six and non Big Six in the UK tend to have similar behaviour in disclosing extraordinary and exceptional items. This result contradicts those derived by Woolsey, 1954, Messier, 1983 and Chewning et. al., 1989. Consistency in practice provides an excuse to avoid introducing a structured guideline for the auditing profession. However, this argues for whether there is a real need of having a guideline in the first place. The level

of

disclosure

remains

lower

than

those

recommended by their audit manuals. This either shows that firms do not practise what they preach, or could be due to lack of a materiality guideline.

H3: Rejected 35


We divided the selected samples into two categories depending on whether they lie above or below the median of the total amount of share capital plus reserves (£314 million). Companies having share capital plus reserves of £314 million or more are classified as `large'. The empirical results show that more extraordinary items are being disclosed by `large' (31.8%) than `small' (21.8%) companies. This is due to large companies having larger numbers of stakeholders, and having wider ranges of demand on financial reporting. For exceptional items, there is no obvious distinction between size of companies and level of disclosure, but a large majority (63.6% and 70.5%) of the items were disclosed even though they are within 5% range of profit.

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CONCLUSIONS AND DISCUSSIONS Preparers and auditors in the UK tend to disclose more material items in the financial statements than their overseas counterparts. This could be due to lack of a proper guideline, and fear of being sued for negligence, or serving a wider range of users. Whatever it is, inconsistency in disclosure could bring inconsistency in reporting and thus decision making. A guideline is needed before the auditing profession is exposed to more unwanted litigation, and to improve consistency and harmonisation in reporting, both within the UK and across the international boundaries.

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TABLE 1: GUIDELINES RECOMMENDED ACCOUNTING BODIES

BY

ACCOUNTING ITEM(S) IS CONSIDERED BODY MATERIAL IF IT IS The Australian (1974) and The New Zealand (1985)

>10% of the appropriate base~. ~Appropriate base means: (a) for errors in profit and loss accounts: compared with: (i) operating profit for the current year; or (ii) average operating profits for the last 5 years: whichever is relevant; (b) for errors in balance sheet: lower of (i) total share capital plus reserves; and (ii) appropriate balance sheet class total.

The Canadian (1987)

>10% of income before income taxes and extraordinary items.

The South African (1984)

>1% of gross revenue or >2% of total assets or >2% of gross profit or >5% of shareholders' equity or >10% of net profit. 38


The Scottish (1973)*

(a) >10% of the standard net profits~~; (b) >5% of total expenses for an * the research was expense item or >5% of total carried out by income for an income item: for Anderson (1973) statutorily-required disclosure a for The Scottish profit and loss items, and Institute (c) >5% of total assets or >10% of the balance sheet caption for a balance sheet item. ~~A standard profit is the average profits before tax for the preceding five years; but during a loss-making year or if the company is having an abnormally low profits for a number of years, then the standard profits should be based on the profit trend of the industry as a whole.

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TABLE 2: MATERIALITY GUIDELINES RECOMMENDED BY AUDIT MANUALS IN THE UK*

Turnover Net Profits Net Assets

Overall materiality 0.4% - 2% 5% - 25% 0.7%- 3.3%

Testing materiality 0.2% - 2.9% 3.3% - 36% 0.1% - 4.8%

*based on surveys carried out by Chandler (1984, 1985) and Turley & Cooper (1991).

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