CHAPTER 7

Chapter 8

Materiality Decisions and Performing Analytical Procedures

Learning Check

8-1. a.Materiality is defined by the FASB as: The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, 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.

b.In applying this definition, the auditor is required to consider both (1) the circumstances pertaining to the entity and (2) the information needs of those who will rely on the audited financial statements.

8-2.In the planning phase of the audit, the auditor should assess materiality at the following two levels:

The financial statement level because the auditor's opinion on fairness extends to the financial statements taken as a whole.

The account balance level because the auditor verifies account balances in reaching an overall conclusion on the fairness of the financial statements.

8-3.Planning materiality is used in audit planning when the auditor makes a preliminary judgment about materiality levels. Planning materiality may differ from the materiality levels used in evaluating the audit findings because (1) surrounding circumstances may change and (2) additional information about the client will have been obtained during the audit.

8-4. a. Several levels of materiality may be defined for each of the financial statements. For example, for the income statement, materiality could be related to total revenues, operating income, income before taxes, or net income. For the balance sheet, materiality could be based on total assets, current assets, working capital, or stockholders' equity.

b.For planning purposes, the auditor should use the smallest aggregate level of misstatements considered to be material to any one of the financial statements. This decision rule is appropriate because (1) the financial statements are interrelated and (2) many auditing procedures pertain to more than one statement.

8-5. a.Currently, neither accounting nor auditing standards contain any official guidelines on quantitative measures of materiality. However, SAB 99 states that the use of a percentage test alone to make materiality determinations is not acceptable. The SEC staff goes on to state that there are numerous instances in which misstatements below 5% of net income could well be material and it recommended qualitative guidance, such as whether the misstatement or omission masks a change in earnings or sales trends, hides a failure to meet analysts consensus expectations for the company, changes a loss into income or vise versa, or whether the misstatement has the effect of increasing management compensation, such as satisfying certain requirements for the award of bonuses or other incentive compensation.b.The following five quantitative guidelines are illustrative of those commonly used in practice:

5% to 10% of net income before taxes.

1/2% to 1% of total assets.

1% of equity.

1/2% to 1% of gross revenue.

A variable percentage based on the greater of total assets or revenue.

8-6. a. Qualitative considerations relate to the causes of misstatements. For example, the magnitude of a misstatement that the auditor considers material when caused by an irregularity or illegal act may be lower than the magnitude of a misstatement caused by an error. AU 312.13 states that although the auditor should be alert for misstatements that could be qualitatively material, it ordinarily is not practical to design procedures to detect them.

b.A quantitatively immaterial misstatement caused by an irregularity or illegal act may be considered qualitatively material because it may lead the auditor to conclude there is a significant risk of additional similar misstatements. There may also be additional consequences such as fines or the loss of an operating license.

8-7. a.Materiality at the account balance level is the maximum misstatement that can exist in an account balance before it is considered materially misstated.

b.Materiality at this level is also known as tolerable misstatement.

c.The term material account balance refers to the size of a recorded account balance, whereas the term materiality pertains to the amount of misstatement that could affect a user's decision.

8-8. a.Two factors that should be considered in allocating financial statement materiality to accounts are (1) the amount of misstatement that would influence a financial statement user and (2) the probable cost of verifying the account.

b.When the amount of error found in an account is less than its materiality allocation, the unused portion of the materiality allocation may be reallocated to other accounts, so long as the tolerable misstatement for an account does not exceed the amount of misstatement that is likely to influence a financial statement user. c.Materiality and audit evidence are inversely related; i.e., the lower the level of materiality, the greater the amount of evidence needed.

8-9. a.First the auditor must project known misstatements found in a sample on the populations being evaluated. The auditor will then compare projected misstatements with tolerable misstatement for the account. As discussed in part b below, the auditor should also consider qualitative issues that may make the misstatement material to financial statement users.

b. Following a multiple examples of misstatement that may be qualitatively material, even if they are quantitatively immaterial: (1) the misstatement masks a change in an earnings or sales trend, (2) the misstatement hides a failure to meet financial analysts consensus expectations for the company, (3) the misstatement changes income to a loss, or (4) the misstatement is due to fraud rather than unintentional error. [Note: more than three examples are provided for the students benefit as many examples might work here.]8-10. a.Analytical procedures are used:

1. In the planning phase of the audit, to assist the auditor in planning the nature, timing, and extent of other auditing procedures.

2. In the testing phase, as a substantive test to obtain evidential matter about particular assertions related to account balances or classes of transactions.

3. At the conclusion of the audit, in a final review of the overall reasonableness of the audited financial statements.

b.The first and third uses (i.e., using analytical procedures in the planning phase and at the conclusion of the audit) are required in all audits.

8-11. a. Analytical procedures can assist the auditor in planning by (1) enhancing the auditor's understanding of the client's business, and (2) identifying areas of greater risk of misstatement.

b.The effective use of analytical procedures in the planning phase involves the systematic completion of the following steps:

1. Identify the calculations/comparisons to be made.

2. Develop an expectation range.

3. Perform the calculations.

4. Analyze data and identify significant differences.

5. Investigate significant unexpected differences.

6. Determine effects on audit planning.

8-12. a. Calculations and comparisons commonly used in analytical procedures include (1) absolute date comparisons, (2) common-size financial statements, (3) ratio analysis, and (4) trend analysis.

b. The basic premise underlying the use of analytical procedures in auditing is that relationships among data may be expected to continue in the absence of known conditions to the contrary.

c.Several sources of information that may be used by the auditor in developing expectations include:

1. Client financial information for comparable prior period(s) giving consideration to known changes.

2. Anticipated results based on formal budgets or forecasts.

3. Relationships among elements of financial information within the period.

4. Industry data.

5. Relationships of financial information with relevant nonfinancial information.

[Note: more than four examples are provided for the students benefit as additional examples might work here.]

8-13. a.The following table displays one possible determination of overall financial statement materiality. Note: There is no right answer to this problem. Students must exercise their judgment in determining financial statement level materiality.

The proposed solution recognizes that this business is a small business that has very low net profit margins. In essence, this company is a break even company, with net income equal to approximately 1% of sales. The emphasis is put on revenues to arrive at a materiality level that is relevant to the overall volume of transactions for the company. Students should also note that it is appropriate round overall materiality to a round $1,000. Materiality is not more precise than this. b.The following table present one possible determination of tolerable misstatement for balance sheet accounts. Note: There is no right answer to this problem. Students must exercise their judgment in determining financial statement level materiality.

The above table provides a judgmental allocation that recognizes the cost of auditing inventory. A higher proportion is allocated to goodwill because of the estimates inherent in an impairment test. Nevertheless, the auditor must be comfortable that each of the amounts determined for tolerable misstatement would not influence the decisions of a financial statement user. Note that none of these allocations exceed 3.1% of the account balance.

8-14.a.The following discussion first evaluates each potential misstatement individually.

1. Title did not pass on these two shipments until January 20x5. Hence, revenue should not have been recognized. Because the auditor audited every transaction during the cutoff period, sampling is not involved. The following journal entry represents the journal entry needed to correct the potential misstatement.

Revenue

$240,000Inventory

$130,000

Accounts Receivable

$240,000

Cost of Goods Sold

$130,000

2. Inventory has not been recorded at the lower of cost or market. The potential magnitude of the misstatement would be to mark inventory on the books at $395,000 down to $175,000.

Cost of Goods Sold

$220,000

Inventory

$220,000

3. These two transactions represent unrecorded liabilities. Title was received in each transaction prior to year-end. The following journal entry represents the journal entry needed to correct the potential misstatement.

Inventory

$200,000

Fixed Assets

$150,000

Accounts Payable

$350,000

b.The following analysis considers the aggregate impact of these misstatements on the financial statements. It assumes a 35% tax rate.

In aggregate, accounts receivable is overstated by $240,000 (tolerable misstatement is $260,000), inventory is understated by $110,000 (tolerable misstatement is $250,000), accounts payable is understated by $350,000 (tolerable misstatement is $240,000), pretax income is overstated by $330,000 (tolerable misstatement is $675,000). Accounts payable is materially misstated, and misstatements in accounts receivable approaches tolerable misstatement. Accounts payable should be adjusted and since changes are being made to the financial statements the auditor might propose making adjustments for all known misstatements. 8-15. The fact that inventory turn days is speeding up for Construction Industry Resources, Inc. may be an indicator that inventory is understated. This fact, combined with the fact that gross margins are declining may be an indication of inventory shrinkage or the possible theft of inventory. This is a problem in the construction industry. This outcome from analytical procedures should influence the auditors assessment of fraud risk, and the auditor should consider that there is a high risk that inventory might be misstated due to misappropriation of assets.

8-16. a. The following table calculates purchases, gross margin percentage, inventory turn days, accounts receivable turn days, accounts payable turn days, and the gross and net operating cycle.

b.Important trends for 20x5 (the likely year about to be audited) include the significant increase in inventory turn days, the increase in gross margin to the best result in the four year period, and the improved collection period. c.In order to turn tolerable misstatement into inventory turn days the auditor would use the formula for calculating inventory turn days as follows:

Tolerable Misstatement / Cost of Goods Sold * 365 = 45 / 1,859 * 365 = 7.84 daysd.The most significant changes in 20x5 are the combined decrease in purchases and increase in gross margin, increasing to 52.4%, while inventory turn days also increases significantly, increasing to 199 days. The increase from 183 day inventory turn to 199 day inventory turn is significant given the results in part c above. This is potential evidence of an overstatement of inventory that might be due to either an error in counting or calculating inventory or due to fraudulent financial reporting. Comprehensive Cases

8-17.See separate file with answers to the comprehensive case related to the audit of Mt. Hood Furniture that is included with this chapter.

8-18.See separate file with answers to the comprehensive case related to the audit of Mt. Hood Furniture that is included with this chapter.

Professional Simulation

Research

SituationAudit Findings

1.Answer this question by indicating in the box below the appropriate AU section paragraph(s) that address this issue. AU Section Paragraph(s) AU 312.21-.22

These standards read as follows:

.21In some situations, the auditor considers materiality for planning purposes before the financial statements to be audited are prepared. In other situations, planning takes place after the financial statements under audit have been prepared, but the auditor may be aware that they require significant modification. In both types of situations, the auditor's preliminary judgment about materiality might be based on the entity's annualized interim financial statements or financial statements of one or more prior annual periods, as long as recognition is given to the effects of major changes in the entity's circumstances (for example, a significant merger) and relevant changes in the economy as a whole or the industry in which the entity operates. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 82, February 1997.]

.22Assuming, theoretically, that the auditor's judgment about materiality at the planning stage was based on the same information available at the evaluation stage, materiality for planning and evaluation purposes would be the same. However, it ordinarily is not feasible for the auditor, when planning an audit, to anticipate all of the circumstances that may ultimately influence judgments about materiality in evaluating the audit findings at the completion of the audit. Thus, the auditor's preliminary judgment about materiality ordinarily will differ from the judgment about materiality used in evaluating the audit findings. If significantly lower materiality levels become appropriate in evaluating audit findings, the auditor should re-evaluate the sufficiency of the auditing procedures he or she has performed. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 82, February 1997.]2.AU 312.22 is clear that If significantly lower materiality levels become appropriate in evaluating audit findings, the auditor should re-evaluate the sufficiency of the auditing procedures he or she has performed. As a general rule, as the level of materiality decreases the auditor should obtain more sufficient evidence (a greater amount of evidence) If materiality increases at the end of the audit, the auditor planned a scope for the audit that is sufficient. However, if materiality decreases significantly, the scope of the audit may not be sufficient to obtain reasonable assurance that the financial statements are free of material misstatement at the revised materiality level, and the auditor should obtain more evidence to support the audit opinion. Audit Findings

SituationResearch

To: Audit File

Re: Analysis of results of analytical procedures

From:CPA Candidate

When performing analytical procedures relevant to the sales and collection cycle the auditor the following results were noted.

RatioUnaudited RatioAuditors Expectation Range

Accounts Receivable Turn Days39 days28 days 34 days

Sales and Accounts Receivable Growth Rates Sales Growth: 12%

Accounts Receivable Growth: 21%Sales Growth: 12% - 15%

Accounts Receivable Growth: 12% - 15%

Based on these results accounts receivable is likely to be overstated and these ratios raise questions about the either revenue recognition or about the net realizable value of receivables. Year-end receivables are not in line with annual sales growth. Based on annual sales receivables were expected to grow at 12% - 15% rate. Unaudited receivables actually show a 21% increase. This could be due to revenue recognition problems near year-end, and revenue transactions in the 4th quarter should be carefully reviewed for revenue recognition problems.

It is also possible that the client has grown sales by giving more liberal credit terms. This may result in collection problems and the need to increase the allowance for uncollectible accounts. Careful attention should also be paid to the audit of collectibility of receivables.

_1180107208.xlsSheet1

Tolerable

% of%JudgmentalMisstatement

Total AssetsAllocationAllocation% of Account

Balance Sheet

Cash and Cash Equivalents$2089%$3,300$1,0000.5%

Accounts Receivable$894%$1,412$1,5001.7%

Inventories$1,18354%$18,769$25,5002.2%

Current Assets$1,48067%

Property, Plant and Equipment$63029%$9,995$4,0000.6%

Goodwill$964%$1,523$3,0003.1%

Total Assets$2,206100%$35,000$35,000

_1184007027.xlsSheet1

AssetsLiabilitiesStockholders'Pre-taxIncome Tax

AccountCurrentNoncurrentCurrentNoncurrentEquityEarningsExpense

Revenue$(156,000)$(240,000)$(84,000)

Inventory$130,000

Accounts Receivable$(240,000)

Cost of Goods Sold$84,500$130,000$45,500

Cost of Goods Sold$(143,000)$(220,000)$(77,000)

Inventory$(220,000)

Inventory$200,000

Fixed Assets$150,000

Accounts Payable$350,000

Aggregate Misstatements$(130,000)$150,000$350,0000.0$(214,500)$(330,000)$(115,500)

_1184007210.xlsSheet1

Exhibit 8-16: CTI Selectied Financial Information ($000)

20x120x220x320x420x5

Accounts Receivable, net$837$1,335$1,121$962$822

Inventory$1,025$1,327$1,099$1,003$1,027

Accounts Payable$164$380$225$201$175

Sales$3,780$5,638$4,623$4,022$3,905

Cost of Sales$1,812$2,691$2,399$1,923$1,859

Gross Margin$1,968$2,947$2,224$2,099$2,046

Purchases$2,993$2,171$1,827$1,883

Gross Margin52.3%48.1%52.2%52.4%

Inventory Turn Days160185199199

Accounts Receivable Turn Days70979583

Gross Operating Cycle230282294283

Accounts Payable Turn Days33514336

Net Operating Cycle197231251246

_1180106191.xlsSheet1

Preliminary Calculations

10% of pretax income$8,100

1% of total assts$22,060

1% of equity$9,690

1% of gross revenues$35,130

Variable pecentage of revenues$41,737

Overall Materiality$35,000