Question

Suppose that you are the auditor of a major retail client who has reported the following income before taxes (IBT) for the first two quarters of the year:

1st quarter = $1,200,000

2nd quarter = $1,500,000

You are in the process of establishing overall materiality for the client. Based on prior years, the client has a 10% decline in IBT from the 2nd quarter to the 3rd quarter. You also know IBT in the 4th quarter historically increases by 25% over the 3rd quarter.

Determine the amount of overall materiality for the audit based on these preliminary amounts.

Answer 1

Calculate the amount of pre- tax income as provided below:

Particulars	Calculations	Amount($)
Income before taxes(IBT) for 1st quarter	Given	$1,200,000
Income before taxes(IBT) for 2nd quarter	Given	$1,500,000
Expected IBT for 3rd quarter	$1,500,000-($1,500,000 x 10%)	$1,350,000
Expected IBT for 4th quarter	$1,350,000 x 1.25	$1,687,500
Expected IBT for the year		$5,737,500

The total expected income before tax(that is, the pre-tax income) has been calculated by taking the value as given in the question for the first 2 quarters. For quarter 3, the expected income has been calculated by reducing 10% from the income of quarter 2 as provided in the question and for quater 4, the expected pre-tax income has been calculated by adding 25% to the income of quater 3.

The total pre tax income for the year has been calculated by adding the pre tax income of all the quarter as calculated above

Calculate the amount of materially for audit as provided below:

Particulars	Amount($)
Expected IBT for the year......A	$ 5,737,500
Industrial standard rate for overall materiality.....B	5%
Amount of overall materiality(AxB)	$ 286,875

Thus the amount of overall materiality for the audit based on the preliminary amount is $286,875.

The amount of overall materiality has been calculated on the pre-tax income. As per the industry standards, the amount of overall materiality for the audit is 5% of the pre-tax income. Thus the 5% of 5,737,500 has been calculated to arrive at the overall material amount

The amount of overall materiality for the audit is $286,875.