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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.

8-6.

8-7.

8-8.

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.

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.

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.

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.

8-9.

8-10.

8-11.

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.

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.]

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.

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.
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.

b.

8-12.

8-13.

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.]

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
Inventory
Accounts Receivable
Cost of Goods Sold

$240,000
$130,000
$240,000
$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
Inventory

$220,000
$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
Fixed Assets
Accounts Payable

$200,000
$150,000
$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
days

d.

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
Situation

Audit
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:
.21 In 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.]
.22 Assuming, 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
Situation

Research

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.
Ratio
Accounts Receivable Turn Days
Sales and Accounts Receivable
Growth Rates

Unaudited Ratio
39 days
Sales Growth: 12%

Auditors Expectation Range


28 days 34 days
Sales Growth: 12% - 15%

Accounts Receivable Growth:

Accounts Receivable Growth: 12% -

21%

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.