Stephen Sheen: Living in a material world

Let’s talk materialism and the financial statements.  Is your financial position a construct of “matter” that can only truly be known through the senses?

Are you a child of Democritus who believes that the cause of everything is dependent wholly on physical processes?

Or, alternatively, do you follow the idealists who believe that if everybody were to stop talking about it, your financial challenges would no longer exist?

Oh, hang on.  We’re on the wrong wikipage.

Materialism … materialism … the belief in local government auditing that some things matter more than they actually do.  Supposedly apocryphal, but a number of recent sightings have been reported, particularly by those involved in valuing property.

Bemused accountants

Auditors have a duty to question the reliability of figures in the Statement of Accounts on the basis that they cannot be guaranteed free from material misstatement.

Perhaps valuations have not been updated for a couple of years or estimates have been used where actuals could have been calculated.

Auditor concerns are often justified.  But in my work in local government, I am noting a growing trend for the materiality card to be played to the bemusement of the accountants, who can’t see the significance of the issue.

There is not supposed to be any scope for such differences of view.  Auditing standards do not define materiality for auditors.

Where materiality is discussed in the applicable financial reporting framework, auditing standards require auditors to use this as their reference point.

Both authorities and auditors should therefore be working to the definition of materiality in the Code of Practice on Local Authority Accounting.

The Code defines information as material if  “… omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific … authority”.

It is, therefore, a practical definition, based on the possibility that readers might change their behaviours if the accounts were presented differently.

Voter & readers

Perhaps voters would consider voting for a different administration if a couple of million had to be knocked off revenue balances, or a potential lender would make a more generous proposal if current borrowings had been substantially overstated.

The immediate problem for local government is that this intended practical basis is hypothetical.

In the commercial world, the presumption can be made of a primary readership made up of investors and potential investors, looking to make decisions about shareholdings and funding.

Many authorities will claim that the Statement of Accounts has no readership, let alone a primary readership, because the public focus is elsewhere on the budget reporting cycle.

Those that can identify a readership may find that it is substantially different in nature from their neighbours’.

But any assessment of materiality must be based on a clear understanding of who the primary readers might be and what they might want to know.

If the public is uninterested, then judgements need to be made on the basis of the extent to which they would be disinterested in omissions or misstatements if they were to come across them.

And this is where the problems can arise.  In the absence of a standard readership for local authority financial statements, the temptation for auditors is not to hypothesise a bespoke readership but to retreat to the safety of their firm’s audit manuals.

These will contain ranges of permissible overall materiality levels, based on percentages of the measure deemed most appropriate – gross income, profit, net assets, etc.

The immediate problem is that these ranges are based on the simple presumptions that apply in the commercial world.  They may not reflect the special circumstances that exist for local authorities.

For instance readers of local authority accounts do not have the same interest in the Balance Sheet as potential investors in companies.

For the latter, every pound added to net assets is a pound on the value of the company.

In local government, the net assets position is not a common point of reference (even if it were to turn negative), especially when compared to the prominence of the revenue outturn.

Misstatements in income and expenditure therefore have a greater likelihood of being material than misstatement in measurements in the Balance Sheet.

There is, therefore, no guarantee that a materiality limit set by reference to income and expenditure will be effective for assets and liabilities.

Example

Consider an authority with gross expenditure of £100m and property, plant and equipment (PP+E) valued at £200m.  An auditor sets a materiality level of £2m based on 2% of gross expenditure – enough to have a sizeable effect if it were added or subtracted from your revenue balances.

But would anybody be really interested in the possibility that the PP+E balance could be overstated by £2m?  £5m?  £10m?

Auditing standards do require a single overall materiality level for an audit, but they permit lesser amounts to be set for particular transactions, balances and disclosures.

It is, though, often the case that auditors set the overall level too low and, being unable to rise above it, find themselves making claims about materiality that would not be supported in a practical sense.

If your auditors claim that they have found a material omission or misstatement that needs work to rectify, it is reasonable to be sceptical.

Is it material only because their audit methodology is telling them that it is, or because it would actually have a substantial, practical impact on potential readers?  It could be that the methodology is ineffective, not your accounting approach.

Always be asking.  Get Morrissey to do it for you if you need to – “what difference does it make?”.  And hope that you get the same answer.