Audit Manual Excerpt: Materiality Guidelines

Willis & Adams, CPAs

AUDIT MANUAL EXCERPT: MATERIALITY GUIDELINES-- Planning Materiality and Tolerable Misstatement

Planning Materiality This section provides general guidelines for determining planning materiality and tolerable misstatement for audits performed by Willis & Adams. The application of these guidelines requires professional judgment and the facts and circumstances of each individual engagement must be considered.

Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics of Accounting Information,” defines materiality as follows:

Materiality is 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.

The “reasonable person,” approach means that the magnitude and nature of financial statement misstatements or omissions will not have the same influence on all financial statement users. For example, a 7 percent misstatement with current assets may be more relevant for a creditor than a stockholder, while a 7 percent misstatement with net income before income taxes may be more relevant for a stockholder than a creditor.

While qualitative factors need to be considered, it is not practical to design audit procedures to detect all misstatement that potentially could be qualitatively material. Therefore, as a starting point, we typically compute a quantitative materiality determined as a percentage of the most relevant base (e.g., Net Income Before Taxes, Total Revenue, Total Assets). Relevant financial statement bases and presumptions on the effect of combined misstatements or omissions that would be considered immaterial and material are provided below:

Profit Oriented Entity: . Net Income Before Income Taxes - combined misstatements or omissions less than 3 percent of Net Income Before Income Taxes are presumed to be immaterial and combined misstatements or omissions greater than 7 percent are presumed to be material. For publicly traded companies, materiality is typically not greater than 5 percent of net income before income taxes.

If pretax net income is stable, predictable, and representative1 of the entity’s size and complexity, it is typically the preferred base. However, if net income is not stable, predictable, representative, or if the entity is close to breaking even or experiencing a loss, then other bases may need to be considered. If the entity has volatile earnings, including negative or near zero earnings, it might be more appropriate to use the average of 3 to 5 years of pretax net income as the base. Other possible bases to consider include:

1 By stable, predictable, and representative we mean that pretax net income does not wildly or dramatically change from profit to loss from year to year. If investors still view pretax net income as a reliable measure of the entity’s performance then pretax net income should be used to determine materiality. The McGraw-Hill Companies, Inc., 2012 EarthWear Hands-on Mini-cases, Chapter 3 3-1 Willis & Adams, CPAs

. Total Revenue (less returns and discounts) – combined misstatements or omissions less than 0.5 percent of Total Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 1 percent are presumed to be material. . Current Assets or Current Liabilities – combined misstatements or omissions less than 2 percent of Current Assets or Current Liabilities are presumed to be immaterial, and combined misstatements or omissions greater than 5 percent are presumed to be material. . Total Assets - combined misstatements or omissions less than 0.5 percent of Total Assets are presumed to be immaterial, and combined misstatements or omissions greater than 1 percent are presumed to be material. (Note: Total Assets may not be an appropriate base for service organizations or other organizations that have few operating assets.)

The McGraw-Hill Companies, Inc., 2012 EarthWear Hands-on Mini-cases, Chapter 3 3-2 Willis & Adams, CPAs

Not-for-Profit Entity . Total Revenue (less returns and discounts) – combined misstatements or omissions less than 0.5 percent of Total Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 2 percent are presumed to be material. . Total Expenses – combined misstatements or omissions less than .5 percent of Total Expenses are presumed to be immaterial, and combined misstatements or omissions greater than 2 percent are presumed to be material.

Mutual Fund Entity . Net Asset Value – combined misstatements or omissions less than .5 percent of Net Asset Value are presumed to be immaterial and combined misstatements or omissions greater than 1 percent are presumed to be material.

“Balance Sheet Materiality” – Even if the planning materiality is based on the income statement, a balance sheet-based calculation is useful for evaluating the materiality of misclassifications between balance sheet accounts. For current assets and current liabilities, the balance-sheet materiality guidelines are 3 to 8 percent. For total assets, the guidelines are 1 to 3 percent.

The specific value within the above ranges for a particular base is determined by considering the primary users as well as qualitative factors. For example, if the client is close to violating the minimum current ratio requirement for a loan agreement, a smaller planning materiality amount should be used for current assets and liabilities. Conversely, if the client is substantially above the minimum current ratio requirement for a loan agreement, it would be reasonable to use a higher planning materiality amount for current assets and current liabilities.

Planning materiality should 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.

Tolerable Misstatement In addition to establishing planning materiality for the overall financial statements, materiality for individual financial statement accounts should be established. The materiality amount established for individual accounts is referred to as “tolerable misstatement.” Tolerable misstatement represents the amount an individual financial statement account can differ from its true amount without affecting the fair presentation of the financial statements taken as a whole.

Establishment of tolerable misstatement for individual accounts enables the auditor to design and execute an audit strategy for each audit cycle.

Tolerable misstatement should be established for all balance sheet accounts (except “retained earnings” because it is the residual account). Tolerable misstatement need not be allocated to income statement accounts because many misstatements affect both income statement and balance sheet accounts and misstatements affecting only the income statement are normally less relevant to users.

The McGraw-Hill Companies, Inc., 2012 EarthWear Hands-on Mini-cases, Chapter 3 3-3 Willis & Adams, CPAs

The objective in setting tolerable misstatement for individual balance sheet accounts is to provide reasonable assurance that the financial statements taken as a whole are fairly presented in all material respects at the lowest cost. Factors to consider when setting tolerable misstatement for accounts include:

. The maximum tolerable misstatement to be allocated to any account is 75 percent of planning materiality. . The combined tolerable misstatement allocated to all accounts should not exceed four times planning materiality.2 The aggregated sum of tolerable misstatements should be lower as the expectation for management fraud increases. . Tolerable misstatement should not exceed an amount that would influence the decision of reasonable users. . Tolerable misstatement normally will be higher for balance sheet accounts that cost more to audit (e.g., larger accounts that are difficult to audit). . Tolerable misstatement normally will be higher for accounts with a higher expectation of misstatement.3 . Tolerable misstatement normally will be higher if the principle substantive evidence to be obtained for an account will be obtained via substantive analytical procedures.

Tolerable misstatement is an important input in determining the nature, timing and extent of audit procedures. The above guidelines are based on important considerations such as: . The lower the tolerable misstatement, the more extensive the required audit testing. . As a planning tool, tolerable misstatement can be viewed as a “precious resource” that should be carefully allocated. If an account is relatively easy to audit and the expected misstatement is little to none (e.g., Notes Payable or Stockholders’ Equity), then we would allocate a small amount of tolerable misstatement to such an account in order to have a greater amount available to allocate to other accounts that are more difficult and costly to audit. . In no case will we allocate more tolerable misstatement to an account than an amount that would influence the decision of reasonable users.

2 In the textbook, a more general approach to allocate no more than 75% of planning materiality to accounts as tolerable misstatement is followed. However, as noted in the discussion on materiality in Chapter 3 of the text, some firms do use a multiple approach. This mini-case uses the multiple approach so that students get hands-on practice at allocating tolerable misstatement to accounts. 3 This assumes the expected misstatements are not due to fraud. If we have an increased fraud risk, we would utilize fraud-related procedures, see fraud policy guidelines. The reason we will normally utilize a higher tolerable misstatement for accounts with higher expectation of misstatement is related to the costliness of auditing such accounts. For example accounts like “accounts receivable,” “inventory,” or “accounts payable” will often have some degree of misstatement in them and they typically are large balances. Tolerable misstatement is basically a reasonable margin for error. If we set tolerable misstatement too low it can increase sample sizes dramatically. However, as noted in the policy, in no case will we allocate more tolerable misstatement to an account than an amount that would influence the decision of reasonable users. The McGraw-Hill Companies, Inc., 2012 EarthWear Hands-on Mini-cases, Chapter 3 3-4