Planning 7 Materiality Cases included in this Section 7.1 Anne Aylor, Inc............................. 229 Determination of Planning Materiality and Tolerable Misstatement Other cases that discuss topics related to this section 5.6 Sarbox Scooter, Inc........................... 185 Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting 12.1 EyeMax Corporation.......................... 369 Evaluation of Audit Differences 12.2 Auto Parts, Inc.............................. 379 Considering Materiality When Evaluating Accounting Policies and Footnote Disclosures
C a s e Anne Aylor, Inc. Determination of Planning Materiality and Tolerable Misstatement Mark S. Beasley Frank A. Buckless Steven M. Glover Douglas F. Prawitt 7.1 Instructional Objectives [1] [2] [3] To provide experience with establishing planning materiality. To provide experience with establishing tolerable misstatement for individual financial statement accounts. To illustrate factors considered when establishing planning materiality. [4] [5] [6] To illustrate different materiality bases considered when establishing planning materiality. To illustrate factors considered when determining tolerable misstatement for individual accounts. To illustrate reasons why the sum of tolerable misstatements commonly exceeds planning materiality. KEY FACTS Anne Aylor, Inc. (Anne Aylor) is a publicly traded company (New York Stock Exchange) that had 60,879,663 shares of common stock outstanding with a trading price of $24.42 as of the close of business on March 1, 2008. Anne Aylor is a leading national specialty retailer of betterquality women s apparel, shoes, and accessories At the end of fiscal 2007, Anne Aylor operated approximately 929 retail stores located in 46 states under the name Anne Aylor. Net revenue for fiscal 2007 was $2.4 billion and net income was $97 million. Substantially all of the company s merchandise is developed in-house by its product design and development teams and sourced to 231 independent manufacturers located in 15 countries. Merchandise is distributed to the company s retail stores through a single distribution center, located in Louisville, Kentucky. Anne Aylor is required to have an integrated audit in accordance with the standards of the Public Company Accounting Oversight Board (PCAOB). Donna Fontain, the audit partner, has performed a preliminary analysis of the Company and its performance and believes the likelihood of management fraud is low. Donna s analysis of Anne Aylor s performance is documented in memo G3. Current events have been documented by Donna in memo G4. No material misstatements were discovered during the prior year audit of Ann Aylor s financial statements. The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of an administrative situation. Copyright 2009 by Pearson Education, Inc., Upper Saddle River, NJ 07458 229
Section 7: Planning Materiality USE OF CASE Information from Ann Taylor Stores Corporation s 3/20/2008 form 10-K report was used in developing this case (see www.anntaylor.com for more information on Ann Taylor Stores). The information presented in this case is not identical to the information presented in the Ann Taylor 10-K to simplify some of the reporting issues. Many students will find the determination of planning materiality and tolerable misstatement difficult to understand. This case assignment helps walk students through that process. The case assignment is best used in an undergraduate and graduating auditing course when audit risk and materiality are discussed. Instructors may want to consider simplifying this case assignment by dividing it into two parts. Part one could require students to determine planning materiality while part two could require students to determine tolerable misstatement for individual balance sheet accounts. The approach we recommend for this assignment is to first ask students to review the case assignment materials and conduct a preliminary in-class discussion addressing question 1. Students are then asked to complete question 2 outside of class. Once students have completed this assignment, it is important to discuss the solution with them to maximize their learning experience. Students will commonly provide diverse answers for this assignment. This provides an opportunity to highlight the subjective nature of some of these judgments as well as to point out that many audit approaches would be considered reasonable. Cooperative learning activities can easily be adapted to this assignment. The cooperative learning activity called Roundtable could be used for the preliminary in-class discussion (requirement 1). The basic process for this activity is to have students meet in small groups to state aloud and write down on a single sheet of paper their ideas to a question asked by the instructor. For example, students could be asked to explain why different materiality bases are considered when establishing planning materiality. Once all students have had an opportunity to state their ideas and arrive at a group consensus, the instructor can randomly call on individual students to share their group s answer with the class. The cooperative activity called Homework Review could be used to discuss the students answers to requirement 2. The basic process for this activity is to have the students meet in small groups to compare and discuss their responses on the planning materiality and tolerable misstatement working papers. The tasks of explaining each response on the working papers and checking the accuracy of each explanation should be rotated among group members. After students have had the opportunity to review all their responses the instructor can randomly call on individual students to share their responses with the class. It is important for the instructor to randomly call on individual students to ensure that all students take responsibility for learning the material. PROFESSIONAL STANDARDS Relevant professional standards for this assignment are AU Section 310, Appointment of the Independent Auditor, AU Section 311, Planning and Supervision, AU Section 312, Audit Risk and Materiality in Conducting an Audit, and AU Section 350, Audit Sampling. 230
QUESTIONS AND SUGGESTED SOLUTION [1] Case 7.1: Anne Aylor, Inc. 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] [b] [c] [d] [e] 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. Why are different materiality thresholds relevant for different audit engagements? 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. 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. 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). 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 [2] [f] [g] 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. 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. Based on your review of the Exhibits (1 and 2), audit memos (G 3, and G 4), and audit schedules (G 5, G 6-1, and G 6-2), complete audit schedules G 5, G 6-1, and G 6-2. A solution to the assignment is documented on audit schedules similar to the audit schedules provided to students on the pages that follow. Due to the subjective nature of some of the judgements, alternative solutions could be considered equally acceptable. 232
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