Question

Uncorrected Misstatements and Performance Materiality. Aaron Rivers, CPA, is auditing the financial statements of Charger Company, a client for the past five years. During past audits of Charger, Rivers identified some immaterial misstatements (most of which relate to isolated matters and do not have common characteristics). A summary of these misstatements follows. (To illustrate, in 2012, the misstatements would have reduced net income by $13,200 if corrected) Year Effect on Net Income Effect on Assets Effect on Liabilities Effect on Equity 2012 ($13,200) ($20,000) ($6,800) ($13,200) 2013 5,000 12,000 7,000 5,000 2014 (9,250) (11,000) (1,750) (9,250) 2015 (2,000) (5,500) (3,500) (2,000) 2016 1,000 1,000 0 1,000 During the most recent audit, Rivers concluded that sales totaling $11,000 were recognized as of December 31, 2017, that did not meet the criteria for recognition until 2018. When Rivers discussed these sales with Chris Turner, Charger Company's chief financial officer, Turner asked Rivers about the performance materiality level used in the audit, which was $25,000. Upon learning of this, Turner remarked, "Then there's no need to worry . . . it's not a material amount. Why should we bother with this item?" Required: a. How does the misstatement identified in 2017 affect net income, assets, liabilities, and equity in 2017? (Assume a 35 percent tax rate for Charger.) b. Comment upon Turner's remark to Rivers. Is Turner's reasoning correct? c. Upon doing some research, Rivers learned of the rollover method and iron curtain method for evaluating the performance materiality of misstatements. Briefly define each of these methods. d. How would Rivers evaluate the performance materiality of the $11,000 sales cutoff error in 2017 under the rollover method and iron curtain method? e. Based on your response to part (d), what adjustments (if any) would Rivers propose to Charger Company's financial statements under the rollover method and iron curtain method? ? Subsequent Events, Subsequently Discovered Facts, and Omitted Procedures. Jay Ralph completed the December 31, 2017, audit of Raider Company on February 3, 2018; Raider's financial statements and Ralph's reports on Raider's financial statements and internal control over financial reporting were released on February 12, 2018. During April 2018, Ralph's firm conducted a quality review over selected audits that had been completed during the most recent year, and the audit of Raider Company was randomly selected for review. The reviewer identified the following matters that Ralph had not addressed during the audit of Raider: 1. On February 9, 2018, Ralph learned of the following events during his post-audit meeting with Raider's chief operating officer. a. A class-action lawsuit was brought against Raider Company by some of its former employees for workplace discrimination. An attorney on behalf of a class of employees filed the lawsuit on January 10, 2018. The letter from Raider's attorneys did not identify this lawsuit. b. One of Raider's major customers is experiencing significant financial difficulties; this customer's account receivable balance on December 31, 2017, was $1.2 million, which represented 2 percent of Raider's total accounts receivable on that date. 2. Because of an important deadline for submitting the financial statements to lenders for evaluation, Raider did not modify its financial statements for the preceding events despite the fact that they were material. Raider's justification was that because the events occurred after the date of the financial statements, they were not required to be disclosed in the financial statements. Ralph acquiesced to Raider's wishes and did not modify the report on Raider's financial statements. 3. On March 16, 2018, Ralph initially learned of the following events affecting Raider Company, neither of which was disclosed in Raider's financial statements: a. Raider Company declared a significant dividend payable to its shareholders. This dividend was declared on March 14, 2018, to be paid to Raider's shareholders of record on May 16, 2018. b. Raider Company activated a portion of its line of credit on February l, 2018, by borrowing $2.5 million. This additional obligation increased Raider Company's long¬-term liabilities by 10 percent. 4. Reviewing Ralph's audit documentation, it does not appear that any tests were con­ ducted to evaluate the need for impairment of the carrying value of Raider Company's property, plant, and equipment. Required: For each of the preceding items, describe what actions Ralph should take after the firm's quality review identified these issues.

Answer 1

Answer to first question:

a.

• While conduction audit for the financial year ending 2017, since the mistatement identified i.e. sale of $11000, recognized as of December 2017 were not actualy belong to the same period, the net effect will be:
• since reduction in sales is $11000, reduction in net income wil be $7150, and tax reduction will be $3850.
• Assets will increase by $11000 and Liabilities will reduce by tax amount of $3850.
• there will be no chan ge in equity.

c.

• The rollover method considers only the current-period income effect(s) of a misstatement when evaluating its materiality;
• The iron curtain method considers the aggregate balance sheet effects of the current misstatement along with previously identified misstatements when evaluating materiality.

d.

• Under the iron curtain method, Rivers would consider both the current misstatement as well as the previous misstatements. Summarizing the misstatements from 2012–2015 reveals an uncorrected misstatement (net balance sheet effect) from prior audits of $18,450; including the current misstatement of $7,150 would result in a cumulative effect of $25,600.
• Under the rollover method, Rivers would only consider the amount of the current period misstatement ($7,150) in evaluating performance materiality.

e.

• Under the iron curtain method, because the cumulative effect noted in (d) of $25,600 exceeds the materiality level of $25,000, Rivers should propose an adjustment to Chargers’ financial statements. Ordinarily, Rivers would recommend an adjustment of the entire $25,600 of uncorrected misstatements (assuming that these misstatements were actual misstatements, not projections of identified misstatements). If a projection of identified misstatements, the minimum adjustment would be $601, which would result in an adjusted cumulative effect of $24,999 ($25,600 – $601 = $24,999), which is less than performance materiality.
• Under the rollover method, because the amount of the misstatement ($7,150) is less than the materiality level ($25,000), Rivers would not require an adjustment to the financial statements