Question

Question 3 - Week 4 One of the clients of MMM Chartered Accountants operates a restaurant. From January of the current year, the business has consistently paid its suppliers late, well in excess of the suppliers' normal credit terms. This has resulted in some suppliers requesting cash on delivery from the business. The auditor has reviewed the correspondence between the business and its bank and finds that the business has been experiencing cash flow problems for two years. Required: (a) Explain why determination of materiality is a matter of auditor judgment. Refer to both qualitative and quantitative materiality assessments . (150 - 200 words) (b) Explain whether (and, if so, how) the information provided impacts on the auditor's assessment of preliminary materiality . (250 - 300 words)

Answer 1

Meaning of Materiality:

Materiality is a concept or convention within auditing and accounting relating to the importance/significance of an amount, transaction, or discrepancy. The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in conformity with an identified financial reporting framework such as Generally Accepted Accounting Principles (GAAP).

Example:

An expenditure of ten cents on paper is generally immaterial, and, if it were forgotten or recorded incorrectly, then no practical difference would result, even for a very small business. However, a transaction of many millions of dollars is almost always material, and if it were forgotten or recorded incorrectly, then financial managers, investors, and others would make different decisions as a result of this error than they would have had the error not been made.

The assessment of what is material – where to draw the line between a transaction that is big enough to matter or small enough to be immaterial – depends upon factors such as the size of the organization's revenues and expenses, and is ultimately a matter of professional judgment.

Determination Of Materiality:

In order to design the audit plan the auditors establish an acceptable materiality that is able to detect the significant erroneous presentations from the value (quantitative) and nature (qualitative) point of view.In order to establish the materiality level from the value point of viewthere are following two variants:

1. The direct variantthat consist in determining a certain absolute value

2. The indirect variant that consists in using a percentage of a certain indicator in order to calculate such a value.

For private entities, the auditors establish the materiality by applying a particular percentage on the gross and net assets, on the profit and turnover.

Qualitative Materility Assessment:

There are so many mathod to assess the qualitative materiality, But following mathod is the best mathod:

1. Absolute size of the item;
2. Constant percentage method;
3. Canadian Institute of Chartered Accountants method;
4. Blend method.

Quantitive Materility Assessment Factors:

1. Amount involved in Fraud.

2. Misstatement in Financial statement.

3. Other matters as the case may be.

2. Impacts on Auditors judgement of Information provided to the Auditor:

The material information provided to the Auditor is very important, because it decides the auditors scope and working and it is like a basic material on which basis an auditor draw his/her conclusion. So, while collect information an auditor should take into considration of materiality.

Here I explain Qualitative & Quantitative factors that may affect an auditor's decisions:-

Quantitative Factors: Example of quantitative that determine preliminary judgement about materiality are total assets, total revenues, net income before taxes, net income from continuing operations, gross profit and average of three years net income before taxes. Total assets, total revenues, or some form of net income are frequently used by auditors when establishing materiality. When net income before taxes is relatively stable, predictable and representative of the entity’s size, a rule of thumb to determine overall financial statement materiality that is commonly used in practice is three to five percent of net income before taxes. Examples of qualitative factor that affect an auditor’s materiality judgment include amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts because fraud reflects on the honesty and reliability of the management or other personnel involved. For example, an intentional misstatement of inventory would be more important to users than a clerical error in inventory of the same amount.

Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. For example, if a misstatement causes a required minimum account balance to exceed the minimum, when the correct balance is less than the minimum, this misstatement likely would be important to users.

Qualitative Factors:

1. Amounts involving fraud: Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts because fraud reflects on the honesty and reliability of the management or other personnel involved. For example, an intentional misstatement of inventory would be more important to users than a clerical error in inventory of the same amount.

2. Misstatements: It is affecting contractual obligations. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. For example, if a misstatement causes a required minimum account balance to exceed the minimum, when the correct balance is less than the minimum, this misstatement likely would be important to users.

3. Profit vs. loss. Misstatements that cause a loss to be reported as a profit or misstatements that affect trends in earnings are likely to be important to users.