Why are different materiality bases considered when determining planning materiality? Different materiality bases are considered when determining planning materiality because the magnitude and nature of financial statement misstatements or omissions have different influences on different financial statement users. For example, investors are more interested in the accuracy of numbers involving net income because they are mainly concerned with the company’s ability to increase shareholder wealth.
For an audit company, the primary concern when planning materiality is to take into account all expected financial statement users. These different expected users all have different concerns in regards to where financial statements contain misstatements. Debtors such as banks who provide loans to help companies like Anne Aylor raise capital are mainly concerned with company’s maintaining debt covenants involving current assets. Anne Aylor has a debt covenant to maintain a current ratio over 2. 0, which according to the company’s projected 2012 balance sheet, will not be met.
These debtors are more concerned with Anne Aylor overstating assets or understating liabilities in order to meet these debt covenants and avoid potential interest rate changes. B. Why are different materiality thresholds relevant for different audit engagements? Different materiality thresholds are relevant for each audit engagement because various industries contain more risk than others. Also, certain companies have varying amounts of risk due to their history of past misstatements and past year’s financial health of the company.
For example, Smith & Jones uses different tolerable misstatement percentage thresholds that are based solely on the likelihood of management committing fraud. Donna Fontain, through conducting preliminary analysis has determined that risk of management fraud to be low, therefore according to our standards tolerable misstatement should be set to 75% of planning materiality. Also, debt covenants play a large part in determining materiality thresholds. Anne Aylor is in danger of violating its debt covenant by not maintaining the minimum current ratio of 2. . In a situation such as this, a smaller planning materiality should be used in regards to current assets and current liabilities. Smith & Jones would lower the materiality threshold for these accounts to provide reasonable assurance that these accounts have not been artificially adjusted to help the company meet these requirements. Another reason for different materiality thresholds in different audit engagements is a company’s performance in comparison to its competitors.
For example, a large misstatement for a company such as Wal-Mart causes far less concern than a large misstatement in a local retail store. Anne Aylor is a publicly traded company with over a billion dollars in net sales; therefore misstatements must be relatively large to significantly affect financial statement users’ opinions. C. Why is the materiality base that results in the smallest threshold generally used for planning purposes? Audit firms determine the amount of testing they must perform based on the materiality base and the risk of the industry.
For planning purposes, an audit firm wants to assume the maximum amount of testing that could be necessary in an effort to make sure they allocate enough time and resources to perform the audit. Also, planning materiality needs to be based on the smallest amount established from relevant materiality bases to provide reasonable assurance that the financial statements, taken as a whole, are not materially misstated for any user according to Smith & Jones policy statement.
An auditor’s role in setting materiality is to obtain reasonable assurance that the financials are free of material misstatement. This being said reasonable assurance will not be met if the auditor doesn’t come up with the smallest misstatement that would affect financial statement users. D. Why is the risk of management fraud considered when determining tolerable misstatement? The risk of management fraud needs to be considered when determining tolerable misstatement because the risk of fraud directly affects the risk of misstatement.
Smith & Jones has a percentage that tolerable misstatement thresholds should not exceed, which is adjusted tolerable misstatement guidelines, with low risk of management fraud misstatements should balance each other out. However, when high risk of management fraud is likely misstatements will likely skew the company’s numbers to overstate the company’s income (ex. overstating income and understating expenses). If numbers are fraudulently misstated with the goal of increasing income, the chance of highly material misstatements drastically increases. E.
Why does the auditor not use the same tolerable misstatement or percentage of account balance for all financial statement accounts? If an auditor were to have the same tolerable misstatement for each account the cost of the audit would be extremely high due to the large amount of testing that would need to be conducted. Certain accounts will be given a high threshold, therefore requiring less evidence gathering. Accounts that need more evidence require a lower tolerable misstatement. By setting low and high tolerable misstatements the auditor will save money and time.
For example, Smith & Jones when testing the total asset account for tolerable misstatement uses a much lower percentage than net income. This is due to the fact that testing a company’s total assets would take a large amount of evidence gathering which requires many employees and large amounts of time. To keep costs from reaching an impractical level, auditors must adjust the tolerable misstatement percentages based on the risk involved with the account, and the impact that misstatement in certain accounts has on financial statement user’s decision making.
In summary an auditor must balance costs and time while keeping in mind that certain accounts have a greater affect on decisions made by financial statement users. F. Why does the combined total of individual account tolerable misstatements commonly exceed the estimate of planning materiality? The total of individual account tolerable misstatements commonly exceeds the estimate of planning materiality because often account misstatements have a balancing affect on the financial statements. However, as the likelihood of managerial fraud increases this becomes unreliable.
For example, while a company may slightly overstate sales, there may be a misstatement in expenses that helps to balance out net income. Also, many accounts actual misstatement will be less than the tolerable misstatement. While some accounts may contain errors which are higher than tolerable misstatement, the accounts that are below tolerable misstatement help to balance out the total misstatements, keeping total misstatement below the total tolerable misstatement. G. Why might certain trial balance amounts be projected when considering planning materiality?
When planning materiality, certain trial balance amounts must be projected in an effort to estimate the risks involved in each account. By forecasting trial balance amounts, an auditor gains an understanding of how much testing each account could possibly need. Also, the auditor determines what the numbers for the upcoming period should look close to. If the numbers on the actual financial statements are very far off of the projected numbers, an auditor knows that more testing needs to be done to determine what caused these large differences.
These projected amounts help the auditor determine what type and how many different audit procedures must be done to provide reasonable assurance that the financials are free of material misstatement. This gives the auditor an idea of the costs and time commitments needed to perform the upcoming audit. Exhibit G-5 Primary users of financial statements are investors, lenders, shareholders, syndicates of lenders, employees, suppliers, and future auditors. In thousands Base| Lower Limit| Upper Limit| Income Before Taxes| 1908| 6678|
Net Revenues| 3406. 8| 13627. 2| Current Liabilities| 1344| 4704| Current Assets| 3132| 10962| Total Assets| 3202. 5| 12806| Planning materiality: $4,704,000, Upper limit for Current Liabilities Explanation: Anne Aylor is currently in violation of their debt covenant restriction on the company’s current ratio. The projected 2012 numbers make Anne Aylor’s current ratio 1. 95, which is below the 2. 0 requirement by First Bank. If current liabilities were to be understated by the upper limit of $4,704,000 Aylor’s current ratio would jump to 2. 06.
This number would put them in solid standing with the bank artificially. Due to the fact that a misstatement by this amount would change Anne Aylors standings with their lender’s debt covenants, materiality should be set to this amount and the length and amount of testing should be adjusted accordingly. Planning materiality- $4,704,000 Multiplication factor- . 5 Reasonable low likelihood of management fraud Tolerable misstatements $2,352,000 Specific Accounts Requiring Lower Tolerable Misstatement Account and Explanation| Tolerable Misstatement| | | | | | | | | | |
