9 3 materiality is important because if financial

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Unformatted text preview: 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. 9-4 The preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users. Several factors affect the preliminary judgment about materiality and are as follows: 1. 2. 3. Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors affect materiality decisions. 9-54 9-4 (continued) 4. 5. Expected distribution of the financial statements will affect the preliminary judgment of materiality. If the financial statements are widely distributed to users, the preliminary judgment of materiality will probably be set lower than if the financial statements are not expected to be widely distributed. The level of acceptable audit risk will also affect the preliminary judgment of materiality. 9-5 Because materiality is relative rather than absolute, it is necessary to have bases for establishing whether misstatements are material. For example, in the audit of a manufacturing company, the auditor might use as bases: net income before taxes, total assets, current assets, and working capital. For a governmental unit, such as a school district, there is no net income before taxes, and therefore that would not be an available base. Instead, the primary bases would likely be fund balances, total assets, and perhaps total revenue. 9-6 The following qualitative factors are likely to be considered in evaluating materiality: a. b. c. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations . Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. 9-7 A preliminary judgment about materiality is set for the financial statements as a whole. Tolerable misstatement is the maximum amount of misstatement that would be considered material for an individual account balance. The amount of tolerable misstatement for any given account is dependent upon the preliminary judgment about materiality. Ordinarily, tolerable misstatement for any given account would have to be lower than the preliminary judgment about materiality. In many cases, it will be considerably lower because of the possibility of misstatements in different accounts that, in total, cannot exceed the preliminary judgment about materiality. 9-8 There are several possible answers to the question. One example is: Cash Fixed assets Long-term loans $500 $3,000 $1,500 Overstatement Overstatement Understatement Note: Cash and fixed assets are tested for overstatement and long-term loans for understatement because the auditor's objective in this case is to test for overstatements of owner's equity. 9-55 9-8 (continued) The least amount of tolerable misstatement was allocated to cash and long-term loans because they are relatively easy to audit. The majority of the total allocation was to fixed assets because there is a greater likelihood of misstatement of fixed assets in a typical audit. 9-9 An estimate of the total misstatement in a segment is the estimate of the total misstatements based upon the sample results. If only a sample of the population is selected and audited, the auditor must project the total sample misstatements to the population to estimate the total misstatement. This is done for each audit area. The misstatements in each audit area must be totaled to make an estimate of the total misstatements in the overall financial statements. It is important to make these estimates so the auditor can evaluate whether the financial statements, taken as a whole, may be materially misstated. The estimate for each segment is compared to tolerable misstatement for that segment and the estimate of the overall misstatement on the financial statements is compared to the preliminary judgment about materiality. 9-10 If an audit is being performed 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 financial statements of the large conglomerate might still be fairly stated. If, however, the auditor is giving a separate opinion on the medium-sized company, the materiality would be lower than for the audit of a conglomerate. 9-11 The audit risk model is as follows: PDR = Where PDR AAR IR CR AAR IR x CR = = = = Planned detection risk Acceptable audit risk Inherent risk Control risk Planned detection risk A measure of the risk that audit evidence for a segment...
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This note was uploaded on 02/04/2014 for the course ACCOUNTING 211 taught by Professor Alikapur during the Fall '13 term at American University of Sharjah.

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