Question

Ana Dinh used 0.5 to 5 percent of gross profit in determining materiality of $70,000 in her audit of XYZ Inc., a company that builds replacement engines for tractors and combines. She used the $70,000 amount as her planning materiality, identifying account balances and transactions to be tested. She also used materiality as a guide when deciding on the appropriate audit opinion in her report.

Required

a.  Provide three other examples of a base (other than 0.5 to 5 percent of gross profit) that an auditor could use in determining materiality in a financial statement audit.

b.  Suppose Ana initially reviewed parts inventory account #102641-1 and found that none of the account transactions exceeded $45,000. Does this mean that none of these transactions should be selected for examination, based on her materiality decision of $70,000? Explain your answer.

Answer 1

Ans a

The materiality threshold in audits refers to the benchmark used to obtain reasonable assurance that an audit does not detect any material misstatement that can significantly impact the usability of financial statements.

"Materiality is an entity-specific aspect of relevance, based on the size, or magnitude, or both," of the items to which financial information relates

How do auditors determine materiality?

To establish a level of materiality, auditors rely on rules of thumb and professional judgment. They also consider the amount and type of misstatement. The materiality threshold is typically stated as a general percentage of a specific financial statement line item

Examples of base other than the one used by Ana :

Single rule methods:

• 5% of pre-tax income;
• 0.5% of total assets;
• 1% of equity;
• 1% of total revenue.

Ans b

The materiality determined when planning the audit does not necessarily establish an amount below which uncorrected misstatements, individually or in the aggregate, will always be evaluated as immaterial. The circumstances related to some misstatements may cause the auditor to evaluate them as material even if they are below materiality. It is not practicable to design audit procedures to detect all misstatements that could be material solely because of their nature (that is, qualitative considerations). However, consideration of the nature of potential misstatements in disclosures is relevant to the design of audit procedures to address risks of material misstatement

Importance of Auditing Inventory

Observation of inventory is a generally accepted auditing procedure, where an independent auditor issues an opinion on whether the financial records of inventory accurately represent the actual inventory being carried.

Auditing inventory is an important aspect of gathering evidence, especially for manufacturing or retail-based businesses. It can represent a large balance of assets or capital.

Auditing inventory must verify not only the amount of inventory but also its quality and condition to see whether the value of the inventory is fairly represented in financial records and statements

The auditor should evaluate whether, in light of the particular circumstances, there are certain accounts or disclosures for which there is a substantial likelihood that misstatements of lesser amounts than the materiality level established for the financial statements as a whole would influence the judgment of a reasonable investor. If so, the auditor should establish separate materiality levels for those accounts or disclosures to plan the nature, timing, and extent of audit procedures for those accounts or disclosure

Ana should select some transactions in Inventory account even though they fall below materiality as Inventory accout is one of the important line item of the financial statements and a high risk area where there are possibilities of mistatements or frauds.