Review Exhibits 1 and 2; audit memos G 3, and G 4; and audit schedules G 5,G 6-1, and G 6-2. Based on your review, answer each of the following questions: [a]Why are different materiality bases considered when determining planning materiality? Financial information is prepared for multiple users for different purposes and thus not all elements of the financial statements are equally relevant to all users. For example, stockholders will be more concerned with long-term revenue and profit growth than creditors and thus revenues and earnings will be more important to stockholder decisions than creditor decisions. b] Whyaredifferentmaterialitythresholdsrelevantfordifferentauditengagements? Materiality is a relative rather than an absolute concept. The materiality threshold that will influence users of the financial statements will vary depending on the context in which the entity operates. For example, the magnitude of a misstatement that will influence financial statement users will vary depending on how the entity is performing relative to the industry.
Misstatements of a smaller magnitude will be more influential for an entity just achieving the industry average compared to an entity significantly over- or under-achieving relative to the industry average. [c]Why is the materiality base that results in the smallest threshold generally used for planning purposes? The dual entry nature of accounting results in misstatements affecting at least two accounts. Most misstatements affect both a balance sheet and income statement account. Therefore auditors must design the audit to find the smallest misstatement that would influence users of the financial statements.
Reasonable assurance that the financial statements are free of material misstatements cannot be provided unless the audit is designed to detect the smallest misstatement that would influence users. [d] Why is the risk of management fraud considered when determining tolerable misstatement? A high likelihood of management fraud makes it more likely that individual account misstatements will have the same directional effect on net income (i. e. , asset accounts will be overstated and liability accounts will be understated).
On the other hand, a low likelihood of management fraud makes it more likely that individual account misstatements will have an offsetting effect on net income (i. e. , some asset and liability account misstatements will overstate net income while other account misstatements will understate net income). [e] Why does the auditor not use the same tolerable misstatement amount or percentage of account balance for all financial statement accounts? The objective of an audit is to provide reasonable assurance that the client’s financial statements are fairly presented in all material respects at the lowest possible cost.
The nature and cost of evidence available by account varies. Therefore, to minimize cost, auditors may want to assign a higher tolerable misstatement to accounts lacking competent evidence or costly to audit. The higher the tolerable misstatement for an account the less evidence that will be needed. Conversely, the lower the tolerable misstatement for an account the more evidence that will be needed. The tolerable misstatement assigned to an account is constrained by the dollar size and importance of the account to users.
Auditors cannot assign as much tolerable misstatement to small or very important account balances. 231 Section 7: Planning Materiality [f]Why does the combined total of individual account tolerable misstatements commonly exceed the estimate of planning materiality? For many audits it is not likely to expect that every account will be misstated by an amount equal to its tolerable misstatement. It is more likely to expect that most accounts will be misstated by an amount less than its tolerable misstatement while a few accounts may be misstated by an amount greater than its tolerable misstatement.
Additionally, it is not likely that all account misstatements will have the same directional effect on net income. It is more likely that some account misstatements will overstate net income while other account misstatements will understate net income and thus will offset each other. [g] Why might certain trial balance amounts be projected when considering planning materiality? Planning for an audit is normally conducted well before the financial statement audit year is completed. Early planning helps the auditor expeditiously perform the audit and ensure that sufficient competent evidence is collected.
As part of the planning process the auditor is required to prepare a written audit program (or set of audit programs) that establishes audit procedures to be performed during the audit engagement. When establishing audit procedures the auditor must consider the risk of material misstatement. Materiality is a relative concept that is influenced by the magnitude of reported financial statement amounts. Therefore, to establish materiality thresholds for the current year audit the auditor should have expectations of year-end amounts.