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How can auditors define material fraud?

[By ICAEW Insights]

Jan 27, 2023

Assessing materiality with regards to fraud is a more nuanced process than it is sometimes represented. So how do auditors interpret it for a given audit and how should it be treated within standards and regulation?

What makes a fraud material? It’s not necessarily as easy a question to answer as you’d expect. If it were, we wouldn’t have conversations about the expectation gap and common misconceptions around audit and fraud from non-auditors.

But even for auditors, the question of materiality is not always straightforward. ISA 240 acknowledges that the assessment of materiality can involve several factors, not just a quantifiable monetary threshold.

It is better understood than it used to be, explains Matthew Howells, Partner and Head of the National Assurance Technical Group at Evelyn Partners. It is referred to in audit reports and engagement letters to explain how the audit works in relation to fraud.

“We do our best to say: this is how an audit is done under the auditing standards as they currently are. This is how it’s designed. It’s done on a sample basis. It’s not a cast iron guarantee. Some errors and frauds, if they are immaterial, may go undetected.”

Politicians are considering defining material fraud in law to make the issue clearer, but this poses some risks due to the nuance in what defines materiality. While a lot of material fraud is defined by a quantitative threshold, it’s not always the case.

“If you’ve got a quantitative threshold, there’s the danger of thinking that therefore anything below that is not material,” says Howells. “That’s true to an extent, but take a specific example. ISA 240 says think about who’s committing the fraud. If it’s a junior employee who has put a £50 false expense claim through, that’s less likely to be material. If it’s the chief executive, or another director who’s committed the fraud, it might not be material in quantum, but it should raise other questions about management integrity.”

In those cases, it means the auditor potentially has to do a lot of extra work, as it calls into question everything else that they have been given up to that point.

Financial statements are also not just about numbers. Judging materiality around narrative disclosures can be really difficult, says Howells, because you’re looking at the way things are phrased within those disclosures.

“Another point ISA 240 makes in this context is people tend to think of fraud as stealing or misappropriation of cash or assets out of a business. But of course, fraud is also fraudulent financial reporting. Are management or those charged with governance deliberately manipulating the accounts to give a better view of the business? That equally is a potential material fraud as far as ISA 240 is concerned.”

Finding a potential or actual fraud that affects the financial statements can lead to some difficult conversations across the audit team. “Talk to the responsible individual (RI), talk to the ethics partner, talk to your technical team, ring the ICAEW advisory helpline. It requires consultation,” says Howells. “You could have been an RI for 20 years and you will still sit there sometimes scratching your head and thinking: where are we on the ‘spectrum’ of materiality?”

ISA 240 requires auditors to consider whether they need to consult a forensics expert when planning and performing risk assessment procedures and responses, and in evaluating findings, so the implications can be significant, says Howells. “It can be one of the most difficult conversations and thought processes that you can have as an auditor. You need to work out where you are on that spectrum of materiality – because it is a spectrum and there aren’t always factors that necessarily point you one way or the other.”

When it comes to regulators’ and lawmakers’ response to improving audit performance around fraud, Howells is grateful that it has given the profession, via bodies such as ICAEW, the opportunity to have its voice heard on the matter. “I’ve been qualified for more than 20 years and in that time, it’s only recently that our voices have been getting louder.”

This lack of auditor representation in the discussions around regulations has been an issue, says Jan Babiak, Audit Committee Chair for the Bank of Montreal and Walgreens Boots Alliance, and Senior Independent Director at private Australian engineering company GHD Group. The expectation gap, for example, is not as big an issue as discussions suggest it is.

“The reality is people who work in business and investors are sophisticated enough to know that the audit has its limitations and is focused around material problems,” she says.

Regulators need to avoid taking a ‘sledgehammer for the peanut’ approach when responding to high profile audit failures, she says. A widening of the scope of materiality will increase the cost of an audit, which while not necessarily a bad thing for audit firms from a revenue perspective, could be met with some resistance from the businesses that have to pay for them.

Babiak also believes the separation of audit and consultancy arms of firms would have a negative effect on audit quality. While the audit should not be used as a route for upskilling, that diverse expertise within a firm can be a useful resource.

“From an Audit Committee Chair standpoint, I’m very worried about the move to separate those arms of the firms because I know the quality that we get when the auditors bring somebody in from their consultancy or forensic teams to aid in the audit. We get such great insight from that. If you take that away, audit quality will be affected,” she says.

ICAEW has been consulting with regulators and the UK’s Department for Business, Energy and Industrial Strategy on any changes around auditing standards and how materiality is treated in law. “Materiality is a complex concept, already defined in a number of ways, depending on the context,” says Nigel Sleigh-Johnson, ICAEW’s Director, Audit and Corporate Reporting. “As a matter of principle, it seems advisable not to enshrine additional definitions in law. It would be difficult to amend as thinking evolves, possibly inconsistent with definitions of materiality elsewhere and potentially adding to complexity for those involved in financial reporting.”

Ultimately, materiality is defined in terms of what users of accounts want to get from them, says Howells. “Auditors may calculate materiality as, say, 1% of turnover or 5% of assets, but that is only a shorthand. We calculate that because we think that anything above that will be of interest to the people who are reading the financial statements, but other things may be of interest, too. You are trying to put yourself in the shoes of those users of accounts. That could be a fairly narrow or a potentially quite broad selection of people, depending on the organisation. So that question of materiality should always be on the auditor’s mind.”

  

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