Chapter 8 Materiality and Risk

Transcription

1 Chapter 8 Materiality and Risk Review Questions 8-1 Materiality is defined as: A misstatement or the aggregate of all misstatements in financial statements is considered material if, in light of the surrounding circumstances, it is probable that the decision of a person who is relying on the financial statements, and who has reasonable knowledge of business and economic activities would have been changed or influenced by such misstatement or the aggregate of all misstatements. "Present fairly," as used in the auditors report, means that the auditor believes that there are no material misstatements in the client's financial statements. If the auditor concludes that there is a material misstatement, the use of an unqualified opinion, with respect to "present fairly," would not be appropriate. 8-2 Materiality is important because if financial statements are materially misstated, users' decisions may be affected, and they may thereby suffer financial loss. It is difficult to apply because there are often many different users who use the financial statements for different decisions. The auditor must therefore make an assessment of the likely users and the decisions they will make. Materiality is also difficult to apply because it is a relative concept. The professional auditing standards offer little specific guidance regarding the application of materiality. The auditor must, therefore, exercise considerable professional judgment in the application of materiality. 8-3 The preliminary judgment about materiality is the dollar amount the auditor believes the financial statements could be misstated and still not affect user's decisions. Several factors affecting the preliminary judgment about materiality are as follows: 1. Materiality is a relative rather than an absolute concept. 2. Bases are needed for evaluating materiality. 3. Qualitative factors may affect materiality decisions. 4. Expected dissemination of the financial statements will affect the preliminary judgment of materiality. If the financial statements are widely distributed to a large number of users, the preliminary judgment of materiality will probably be set lower than if the financial statements are not expected to be widely disseminated. 5. The level of audit risk which the auditor considers acceptable will also affect the preliminary judgment of materiality. 8-1

2 8-4 The following qualitative factors are likely to be considered in evaluating materiality: a. Amounts involving fraud or other irregularities are usually considered more important than unintentional errors of equal dollar amounts. b. The potential users of the financial statements. 8-5 Identified misstatements are misstatements that are actually discovered by the auditor and not corrected by management. Their existence is not in doubt because the auditor has observed them directly. Likely misstatements include misstatements that, while not conclusively proved, most likely exist, based on the audit evidence examined, and for which no provision has been made by management. The most common example is the projection of sample results to the population by the auditor. Further possible misstatements are misstatements that while not probable are possible. The most common example is the misstatement that results from examining a sample and not the whole population, that is a sampling error. The auditor has discovered identified misstatement in the sample examined. The misstatement in the sample must be extrapolated to the population to determine the likely misstatements in the population. And since the auditor examined only a sample from the population, further possible misstatement exists also. 8-6 If an audit is being done on a medium-sized company that is part of a conglomerate, the auditor must make a materiality judgment based upon the conglomerate. Materiality may be larger for a company that is part of a conglomerate because even though the financial statements of the medium-sized company may be misstated, the large conglomerate statements might still be fairly stated. If, however, the auditor is giving a separate opinion on the medium-sized company, the materiality would be lower for the medium-sized company than for the audit of a conglomerate. 8-7 The audit risk model is as follows: PDR = AR / IR x CR Where PDR = Planned detection risk AR = Acceptable Audit risk IR = Inherent risk CR = Control risk 8-2

3 Planned detection risk - a measure of how willing the auditor is to accept that the audit evidence to be obtained for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. Audit risk - a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. Inherent risk - a measure of the auditor's expectation that a misstatement exceeding a tolerable amount exists in a segment before considering the effectiveness of internal accounting control. Control risk - a measure of the auditor's expectation that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the clients' internal control. 8-8 An increase in planned detection risk may be caused by an increase in audit risk or a decrease in either control risk or inherent risk. 8-9 Inherent risk is set for segments rather than for the overall audit because misstatements occur in segments. By identifying expectations of misstatements in segments, the auditor is thereby able to modify audit evidence by searching for misstatements in those segments. When inherent risk is increased, the auditor should increase the audit evidence accumulated to determine whether the expected misstatement actually occurs. For planned detection risk, evidence is decreased as the desired audit risk is increased; whereas, as inherent risk is increased the amount of evidence is also increased Extensive errors in the prior year's audit would cause inherent risk to be set at a high level (maybe even 100%). An increase in inherent risk would lead to a decrease in planned detection risk, which would require that the auditor increase the level of planned audit evidence When the auditor is in a situation where he or she believes that there is a high exposure to legal liability, the audit risk would be set lower than when there is little exposure to liability. Even when the auditor believes that there is little exposure to legal liability, there is still a minimum audit risk that should be met The first category of circumstances that determine audit risk is the degree to which users rely on the financial statements. Several factors are indicators of this: 8-3

4 1. Client size 2. Distribution of ownership 3. Nature and amount of liabilities The second category of circumstances is the likelihood that a client will have financial difficulties after the audit report is issued. Factors affecting this are: 1. Client's liquidity position 2. Profit (or losses) in previous years 3. Method of financing growth 4. Nature of the client's operations 5. Competence of management 8-13 Exact quantification of all components of the audit risk model is not required to use the model in a meaningful way. An understanding of the relationship between model components and the effect which changes in the components have on the amount of evidence needed will allow practitioners to use the audit risk model in a meaningful way. It is possible to think of audit risk in terms of high, moderate or low risk. Even that measurement method is subjective, but there are differences in meanings of those three risk levels. Multiple Choice Questions 8-14 a. (4) b. (4) 8-15 a. (1) b. (1) c. (3) d. (2) e. (2) f. (3) Discussion Questions And Problems 8-16 a. 4. This item is intentional and would therefore be concealed. It would only be discovered if a confirmation were sent and returned as undeliverable or with an exception reported or the auditor requested a bill of lading covering the shipment. In the case of the confirmation, the client may supply a customer whom he or she knows will respond appropriately. The client may also simply state that the bill of lading was lost, if a fictitious one is requested. 3. Would be discovered only if the specific repair and maintenance costs were selected for the vouching of permanent asset additions. 8-4

5 2. Would be detected if the lawyer mentioned the infringement in his or her reply to the request for a lawyer's letter or if the item were shown on an invoice for legal services which the auditor examines. Both of these are likely. 1. Would be detected if the auditor tested the method of valuing inventory, which is a normal procedure. b. For auditors to accept the same responsibility for uncovering errors or fraud regardless of the difficulty of discovering them would require the expansion of audit procedures far beyond the requirements of generally accepted auditing standards and would require an audit fee considerably in excess of that presently required for an audit a. The profession has not established clear-cut guidelines as to the appropriate preliminary estimates of materiality. These are matters of the auditor's professional judgment. To illustrate, the application of the illustrative materiality guidelines shown in Figure 8-2, are used for the problem. Other guidelines may be equally acceptable. Statement Component Percent Guidelines Dollar Range (In Thousands) Earnings from continuing operations before taxes 5-10% $ $ 41.8 Total assets ½ - 1% $ $ 38.6 Shareholders Equity ½ - 5% $ $ 81.3 b. It is necessary for the auditor to be satisfied that the actual estimate of errors is less than the preliminary judgment about materiality for all of the bases. First the auditor would reevaluate the preliminary judgment for earnings. Assuming no change is considered appropriate the auditor would likely require an adjusting entry or an expansion of certain audit tests. c. The auditor is concerned with misstatements in the revenue and expense accounts. Income tax is calculated on the basis of those balances therefore materiality is calculated on the pre income tax net income figure. 8-5

6 8-18 a. A public accounting firm should attempt to have used reasonable uniformity from audit to audit when circumstances are similar. The only reasons for having a different acceptable audit risk in these circumstances are the lack of consistency within the firm, different audit risk preferences for different auditors, and difficulties of measuring audit risk. b. Users who rely heavily upon the financial statements need more reliable information than those who do not place heavy reliance on the financial statements. To protect those users, the auditor needs to be more sure that the financial statements are fairly stated. That is equivalent to stating that audit risk is lower. Consistent with that conclusion, the auditor is also likely to face greatest legal exposure in situations where external users rely heavily upon the statements. Therefore, the auditor should be more certain the financial statements are correctly stated. c. Reasoning for c is essentially the same as for b. d. The audit opinion issued by different auditors conveys the same meaning regardless of who signs the report. Users cannot be expected to evaluate whether different auditors take different risk levels. Therefore, for a given set of circumstances, every public accounting firm should attempt to obtain approximately the same audit risk a. False. The audit risk, inherent risk, or control risk may all be different. A change of any of these factors will cause a change in audit evidence accumulated. b. False. Inherent risk and control risk may be different. Even if acceptable audit risk is the same, those two factors will cause audit evidence accumulation to be different. c. True. These are the primary factors determining the evidence that should be accumulated. Even in those circumstances, however, different auditors may choose to approach the evidence accumulation differently. For example, one firm may choose to emphasize analytical procedures whereas other firms may emphasize tests of control a. 1. The auditor may set inherent risk at 100% because of lack of prior year information, and because of the expectation of misstatement due to internal control. If the auditor believes there is a reasonable chance of a material misstatement, 100% risk is appropriate. Similarly, since the auditor does not plan to test internal controls due to the ineffectiveness of internal control, a 100% risk is appropriate for control risk. 8-6

7 2. Audit risk and planned detection risk will be identical. Using the formula: PDR = AR (CR x IR), if CR and IR equal 1, then PDR = AR. 3. If detection risk is smaller, the auditor must accumulate more audit evidence than if detection risk were large. The reason is that the auditor is willing to take only a small risk that substantive audit tests will fail to uncover existing misstatements in the financial statements. b. 1. The auditor should be conservative in estimates of the likelihood of misstatements in the financial statements, because the costs of being wrong are relatively high. It would be inappropriate for auditors to set low levels of inherent and control risk without doing substantive testing to determine if the financial statements are actually misstated. For example, using the formula of the audit risk model shown in part a, assume inherent and control risk are each set at 20% and desired audit risk is 4%. Using the formula, planned detection risk would be equal to 4%. Therefore, no substantive audit testing would be necessary. That is inconsistent with the responsibilities of the auditor. Therefore, relatively high inherent and control risk are used even under the most ideal circumstances. 2. Using the formula in a, detection risk is equal to 20% [PDR =.05 / (.5 x.5) =.2]. Notice the difference between the answer in a-2. In that case, planned detection risk would have been 5%, because audit risk = detection risk. 3. Less evidence accumulation is necessary in b-2 than if detection risk were smaller. Comparing b-2 to a-2 for an audit risk of 5%, considerably less evidence would need to be acquired in b-2 than for a-2. c. 1. The auditor might set audit risk high because Sackville is in relatively good financial condition and there are few users of financial statements. It is common in municipal audits for the only major users of the financial statements to be provincial agencies who only look at them for reasonableness. Inherent risk might be set low because of good results in prior-year audits and no audit areas where there is a high expectation of misstatement. Control risk would normally be set low because of effective internal control in the past and continued expectation of good controls in the current year. 8-7

8 2. Using the formula in a-2, PDR =.05 / (.2 x.2) = Detection risk is equal to more than 100% in this case. 3. No evidence would be necessary in this case because there is a detection risk of more than 100%. The reason for the need for no evidence is likely to be the immateriality of repairs and maintenance, and the effectiveness of internal control. The auditor would normally still do some analytical procedures, but if those are effective, no additional testing is needed. It is common for auditors to use a 100% planned detection risk for smaller account balances. It would ordinarily be inappropriate to use such a planned detection risk in a material account such as normally found in accounts receivable or fixed assets a. Audit risk: the risk the auditor is willing to accept that a given segment will be materially misstated after the audit is completed. This is the risk that the auditor will give an incorrect audit opinion. Inherent risk: the measure of the auditor's expectation that material misstatements exist in a segment before considering the effectiveness of internal accounting control. This risk relates to the auditor's expectation of misstatements in the financial statements, ignoring internal control. Control risk: the measure of the auditor's expectation that material misstatements in a segment will not be prevented or detected by internal control. This risk is related to the effectiveness of a client's internal control. Detection risk: a measure of the auditor's expectation that material misstatements in a segment will not be detected by audit evidence. In audit planning, this risk is determined by using the other three factors in the risk model using the formula PDR = AR / (CR x IR). b Audit Risk IR x CR AR / (IR x CR) = PDR Planned Detection Risk in percent 5% 15.6% 15.6% 25% 2.5% 5.0% === ===== ===== ==== ==== ==== 8-8

9 c. 1. Decrease; Compare the change from situation 4 to Increase; Compare the change from situation 3 to Increase; Compare the change from situation 1 to No effect; Compare the change from situation 2 to 3. d. Situation 5 will require the greatest amount of evidence because the detection risk is smallest. Situation 4 will require the least amount of evidence because the detection risk is highest. In comparing those two extremes, notice that audit risk is lower for situation 5, and both control and inherent risk are considerably higher Control Inherent Acceptable Planned Risk Risk Audit Risk Evidence a N N or I D I b N N D I c D N N D d N I N I e N N I D f D D N D g N I N I h I N D I i I N N I j D I N C 8-23 The third examination standard states that the auditor must gain sufficient appropriate audit evidence to support the content of the report. Because the auditor does not examine all possible evidence doing so would be excessively costly in relation to the benefits received the auditor necessarily assumes some risk that the opinion on the financial statements may be in error. The auditor's assessment of the inherent risk for individual components of the audit will direct the planning of the appropriate evidence-gathering procedures. The greater the risk of misstatement in the accounting process, the more extensive the testing required to provide the desired confidence level. The auditor evaluates the control risk by testing and evaluating the applicable internal controls. If the auditor determines that the controls are working effectively throughout the period to detect material errors, he or she relies on them. The extent of reliance will affect the nature and extent of the substantive auditing procedures used. 8-9

10 In planning and executing the audit, the auditor attempts to reduce the risks to an acceptable level within the constraints set by timeliness and economy. The risks associated with issuing an incorrect audit opinion is influenced by the intended use of the financial statements. The auditor needs to consider the users of the financial statements and the decisions that will be made using them. The audit of a public company is more sensitive than the audit of a private company because of the increased exposure of the statements to a greater number of users. The audit risk is affected by the application of sampling techniques. The sampling risk is the risk that the conclusion derived from a test differs from the conclusion on a 100% evaluation. Sampling risk can be reduced to an acceptably low level by ensuring that the sample size is adequately large. At the present time, what constitutes sufficient appropriate audit evidence is determined by the auditor's judgment. This judgment is tempered by such factors as previous experience, the results of testing and the relative strength of internal controls. Because each engagement is different, it is impossible to establish a set of specific guidelines to determine what is sufficient appropriate audit evidence. The auditor responsible for the engagement is in the best position to judge what evidence is necessary to substantiate an opinion. The auditor bases the decision of the extent of testing required on his or her evaluation of the risk associated with the engagement. It is this evaluation and the subsequent testing that allows the auditor to state his or her opinion on the financial statements. If guidelines were to be established defining what constitutes sufficient appropriate audit evidence, an important component of professional judgment would be removed from the audit function a. There is no information available to users as to how much or how little work the auditors did in arriving at a decision as to the appropriate opinion to report on the financial statements. Many or most users probably assume that all audits are the same. In addition, users have no idea of the imprecision in the amounts on the financial statements. The reporting of materiality would indicate to users the imprecision and also would indicate the degree of audit effort put forth by the auditors. If the users did not like the materiality used (that is if they wanted more or less precision or have the auditors do more or less work), they could request the auditors increase or decrease the materiality used. The students will probably have other reasons as well. b. The auditors opposing disclosure of materiality do so because: 8-10

11 i. They think users would be upset to discover that there is a degree of imprecision in the financial statements. ii. iii. iv. They think that if management and employees knew what materiality was, they would know the degree of imprecision the auditors would tolerate. They could commit fraud with no fear of being caught as long as the amounts involved were less than materiality. They think users would assume that the financial statements were misstated by the amount of materiality instead of believing that materiality represented the maximum likely misstatement and the misstatement was probably some amount less than materiality. They think users would misunderstand what materiality means and would be even more confused than is presently the case. The students will probably suggest other reasons. c. The students should be encouraged to discuss the pros and cons of disclosure; they should be required to support their positions. Some students may also suggest that audit risk should be disclosed to give a more complete picture. They should be encouraged to explore this issue even if it wasn't included in the question. I find it helpful to take a vote once the subject has been fully explored. Cases 8-25 Microcomputer prepared worksheets (using Excel) are contained on the diskette accompanying this manual. Filenames are P825A.XLS and P825B.XLS a. See worksheet 8-25A It is important to recognize that there is no one solution to this requirement. The determination of materiality and allocation to the accounts is always arbitrary. In this illustration, the auditor makes estimated adjustments for problems noted in analytical review. This is an important step as the potential adjustments reduce income before taxes, and thus materiality. The illustrated solution recognizes that with downward adjustments, actual income may be much closer to the contractual amount required for an additional contribution to the employees pension plan. This creates a sensitivity that will need to be watched carefully as the audit progresses. The allocation to the accounts is particularly arbitrary. It is noteworthy that the sum of allocated amounts equals 1.5 times materiality. It is assumed that this is consistent with the audit firm s internal policies. 8-11

12 b. The level of audit risk is based on an evaluation of three factors; The degree to which external users rely on the statements. The likelihood that the client will have financial difficulties after the audit report is issued. The auditor s evaluation of management s integrity. Stanton Enterprises is a public company and therefore has a high degree of reliance by external users on its financial statements. The company s operating results and financial condition indicate that there is very little likelihood of financial difficulty in the immediate future. With regard to management s integrity, although there has been some concern with Leonard Stanton s past bankruptcy, the carefully monitored relationship has been good for the four years Stanton has been a client. On that basis, it appears management integrity is good. Overall then, an audit risk level of low would seem appropriate. c. See worksheet 8-25B that shows both horizontal and vertical analysis of the 2000 audited and the 2001 unaudited financial statements, as well as computation of applicable ratios. Following are the key observations to be made: Overall Results Stanton Enterprises apparently had an extremely successful year in Sales increased by 36.4 per cent, gross margin increased by 4 absolute percentage points, and income before taxes increased by percent. Return on total assets and return on equity increased and are at admirable levels. These results allowed the company to increase its dividends by 25 percent (recognizing that more shares were outstanding) and total stockholders equity by percent. Furthermore, the company s current, quick, cash, and times interest earned ratios are up, and its debt to equity ratio is down, indicating that the company is extremely sound from a liquidity standpoint. Trade Accounts Receivable In the face of such growth, trade accounts receivable increased by 59.3 percent, and at the same time, accounts receivable turnover and days to collect improved. However, the allowance for uncollectible accounts was only.7 percent of gross receivables at the end of 2001, down from 1.7 percent at the end of That implies that the allowance may be significantly understated for 2001 and must be looked at very carefully during the current audit. This review would include considering whether a liberalization of credit policies was used to help increase sales. Property, Plant and Equipment The company made a significant additional investment in property, plant and equipment, increasing them by 30.5 percent. These new assets will need to be verified during the current audit. It is noteworthy that accumulated amortization increased by only 16.1 percent. This could indicate that amortization on the new assets was understated, but may not, depending on the dates of acquisition and amortization method used. Amortization must be tested considering these facts as determined. 8-12

13 Goodwill Goodwill also increased significantly, by $855,000. This implies that the company made an acquisition during the year. This could explain the increase in operating assets, and any such transaction must be examined in detail as part of the audit. Also, the goodwill from prior transactions must be considered during each audit as to its amortization and recoverability. Accounts Payable Accounts Payable went down from 2000 to This doesn t seem reasonable at all given an increase in business activity. It is very possible there are unrecorded liabilities at the end of 2001, and this must be an area of major emphasis during the audit. Bank Loan Payable It seems somewhat strange for the company to have an outstanding balance on its bank loan payable at the end of 2001 given its admirable results. It s possible this was the result of an acquisition, or they simply haven t paid it off. In any case, verifying this balance is a relatively easy audit procedure. Federal Income Taxes Payable and Income Tax Expense The company s effective tax rate for 2000 was 34 percent. Income tax expense is only 22.5 percent of income before taxes. Federal income taxes payable on the balance sheet is significantly lower at than would be expected based on These both indicate that the company has not made its final tax accrual for 2001, and this area will require careful attention during the audit. Sales Whenever there is a drastic increase in business activity, there is an increased risk of problems. It is possible that controls will lapse or not be carefully observed. It is possible that transactions will not be carefully accounted for. Therefore, in a situation such as Stanton s it is important to understand the nature of the changes that took place and to do a careful review of controls. It will be especially important to thoroughly test cutoffs for both sales and purchase transactions. Cost of Goods Sold and Gross Profit Consistent with the comments under sales, the auditors must determine why the gross profit percent has made such a significant improvement. Tests of costs and inventories will be more extensive than on more stable circumstances. Pension Cost It appears that the company exceeded the contractual amount for additional pension contribution. Yet, pension cost is a lesser percent of sales in 2001 than in This may indicate that an accrual for additional pension cost was not made. As pension cost is a complex and important area, it will be verified in detail during the audit. ACCEPTABLE AUDIT RISK INHERENT RISK ANALYTICAL PROCEDURES Detail tie-in Low Medium see Note 5 Existence Low Medium see Note 5 Completeness Low Medium see Note

14 Accuracy Low Medium see Note 5 Cutoff Low High High Realizable value Low High High Rights Low Medium see Note 5 Presentation and disclosure Low Medium see Note 5 Tolerable misstatement: Trade accounts receivable $80,000 Allowance for uncollectible accounts 15,000 Rationale Total $95,000 Audit risk is low for engagement, therefore, it is low for accounts receivable and all of its related objectives. Inherent risk for the engagement would be considered medium for the following reasons: a. Stanton s background problems. b. Stanton s autocratic management style c. Some indication of weakness in the control environment, particularly rejection of recommendation to establish an internal audit function. Inherent risk for cutoff is considered high due to the company s rapid growth in 2001 and the general frequency of cutoff errors. Inherent risk for realizable value is considered high because of the company s rapid growth and the amount of judgment involved in establishing the allowance for uncollectible accounts. The analytical procedures performed are preliminary only, and don t provide substantive evidence. However, they can indicate areas where possible problems exist. In other words, they can t lower risk, but can increase it. In this case, they corroborate the high inherent risk level specified for cutoff and realizable value. 8-14

15 Stanton Enterprises Worksheet 8-25A Determination of Materiality and Allocation to the Accounts DETERMINATION OF MATERIALITY Income before taxes $8,004, Possible adjustments estimated. See Worksheet 8-25B: Increase allowance for uncollectible accounts (60,248) Increase to 1.7% of trade accounts receivable. Increase accounts payable (1,069,997) Reflect same increase as cost of goods sold. Pension cost NA Can t estimate. May or may not be required. Adjusted (estimated) income before taxes $6,874, percent $343, Round down to $340, Note: A key consideration is whether the Company will be required to make its additional pension contribution. As more information is obtained, the amount considered material may be reduced to assure any possible misstatements in earnings are considered in light of that contractual obligation. 8-15

16 Stanton Enterprises Worksheet 8-25A, cont. Allocation to the Accounts Preliminary Tolerable Misstatement Cash $243, Easy to audit at low cost. 0 Trade accounts receivable 3,544, Large tolerable misstatement because account is Allowance for uncollectible large and requires extensive sampling to audit. Accounts (120,000) Fairly tight TM because of inherent risk. Inventories 4,520, Large tolerable misstatement because account is large and requires extensive sampling to audit. Prepaid expenses 29, Easy to audit at low cost. Total current assets 8,218,100 Property, plant and equipment: At cost 12,945, Small tolerable misstatement as a percent of acct. bal. because most of balance is unchanged from Less, accumulated prior year & audit of additions is relatively low cost. Amortization (4,382,990) Fairly tight tolerable misstatement due to possible risk 8,562,265 of misstatement. See 8-25B. Goodwill 1,200, Fairly tight tolerable misstatement due to possible $17,980, risk of misstatement. See 8-25B. Accounts payable $2,141, Large tolerable misstatement because account is 8-16

17 Large and requires extensive sampling to audit. Bank loan payable 150,000 0 Easy to audit at low cost. Accrued liabilities 723, Easy to audit at low cost. Federal income taxes payable 1,200, Fairly tight tolerable misstatement due to possible risk Current portion of long-term of misstatement. See 8-36B. debt 240,000 0 Easy to audit at low cost. Total current liabilities 4,455,152 Long-term debt 960,000 0 Easy to audit at low cost. Stockholders' equity: Common stock 1,250,000 0 Easy to audit at low cost. Additional paid-in capital 2,469,921 0 Easy to audit at low cost. Retained earnings 8,845,292 NA 12,565,213 $17,980, $510, x $340,

18 Stanton Enterprises Worksheet 8-25B Analysis of Financial Statements and Audit Planning Worksheet BALANCE SHEET Preliminary Audited % % % Change Cash $243, $133, Trade accounts receivable 3,544, ,224, Allowance for uncollectible accounts (120,000) -0.7 (215,000) Inventories 4,520, ,888, Prepaid expenses 29, , Total current assets 8,218, ,057, Property, plant and equipment: At cost 12,945, ,922, Less, accumulated amortization (4,382,990) (3,775,911) ,562, ,146, Goodwill 1,200, , $17,980, $12,548, Accounts payable $2,141, $2,526, Bank loan payable 150, Accrued liabilities 723, , Federal income taxes 1,200, ,759, payable Current portion of longterm debt 240, , Total current liabilities 4,455, ,123, Long-term debt 960, ,200, Stockholder's equity: Common stock 1,250, ,000, Additional paid-in capital 2,469, ,333,

19 Retained earnings 8,845, ,891, ,565, ,224, $17,980, $12,548, Stanton Enterprises Worksheet 8-25B, cont. Combined Statement of Income and Retained Earnings Sales $43,994, $32,258, Cost of goods sold 24,197, ,032, Gross profit 19,797, ,225, Selling, general and administrative expenses 10,592, ,900, Pension cost 1,117, , Interest cost 83, , ,793, ,869, Income before taxes 8,004, ,356, Income tax expense 1,800, ,141, Net income 6,204, ,215, Beginning retained 3,891,015 2,675,911 earnings 10,095,292 4,891,015 Dividends declared (1,250,000) (1,000,000) Ending retained earnings $8,845, $3,891, SIGNIFICANT RATIOS Current ratio Quick ratio Cash ratio Accounts receivable turnover Days to collect Inventory turnover Days to sell Days to convert to cash Debt to equity ratio Tangible net assets to equity

20 Times interest earned Efficiency ratio Profit margin ratio Profitability ratio Return on total assets Return on equity Note: Some ratios are based on year-end balances, as balances are not provided a. Factors to be considered in determining materiality The CICA Handbook (section ) states: A misstatement or the aggregate of all misstatements in financial statements is considered to be material if, in the light of surrounding circumstances, it is probable that the decision of a person who is relying on the financial statements, and who has a reasonable knowledge of business and economic activities (the user), would be changed or influenced by such misstatements or the aggregate of all misstatements. The materiality level should be determined on the basis of the needs of all users. The CICA Handbook states that materiality is essentially a matter of the auditor s professional judgement. In setting the level of materiality in this situation, the auditor should have included the creditor as a user of the financial statements and assessed whether the creditor would have changed his/her decision if there was a misstatement of $250,000. The auditor should have weighed such a misstatement against the fact that the company had total assets of $50 million at year end. It is possible, that given this level of total assets, a misstatement of $250,000 would not have changed this creditor s decision about the loan. However, the creditor s loan of $100,000 was secured by inventory, and not total assets. The auditor should have considered this fact in auditing and setting the materiality level for inventory. For example, if inventory was valued at $2 million, then the auditor likely would not have decreased the materiality level for inventory. Other factors influencing the level of materiality chosen are: Nature of the business some enterprises are in risky sectors of the economy. The auditor should consider whether the client is in such an industry and decrease the level of materiality if necessary. 8-20

21 Prior year audit experience whether or not the auditor has experienced accounting or auditing problems in the past with this client will affect the materiality level selected. Prior years materiality level if the auditor is proposing a significant increase in the materiality level in the current year but expects the level to drop to past levels in future years, then increasing the level is not recommended. Such a step might make it impossible to decrease the level of materiality later, due to possible misstatements included in the company s carry-forward balances. Normalization of assets and/or income auditor should base the preliminary calculation of materiality on the company s assets and/or income, deducting all unusual items that do not represent the normal course of the business. Impact of materiality on the extent of audit testing Materiality has a direct impact on the extent of audit testing. The higher the dollar value of materiality, the lower the extent of audit testing. Audit testing is performed to minimize the risk of material misstatements remaining undetected. Other relevant matters The Assurance and Related Services Guideline, Applying Materiality and Audit Risk Concepts in Conducting and Audit, provides quantitative guidelines for the calculation of materiality. It is emphasized that in no circumstance should these guidelines be substituted for the auditor s professional judgement. Professional judgement must take into account all relevant factors. For example, the loan secured by inventory might have been a factor in lowering the materiality level. b. The relationship between materiality and audit risk Audit risk is defined as the risk of a material misstatement occurring in the financial statements. The CICA Handbook (section ) states that there is a direct relationship between materiality and audit risk If, in the circumstances, a reduction in materiality or audit risk level is appropriate, the auditor will be required to obtain further audit evidence by increasing the extent of his/her procedures or by modifying their nature or timing. Consideration of concepts In this situation, the quantitative guidelines the auditor has used are generally accepted guidelines. The auditor chose the more conservative figure as the materiality level this choice seems to be in the right direction. Whether the audit work was appropriate depends largely on the level of testing performed on inventory and its value. 8-21