Auto Parts, Inc. ("the Company") manufactures automobile subassemblies marketed primarily to the "big three" U.S. automakers. The publicly-held Company's unaudited financial statements for the year-ended December 31, 2003, reflect total assets of \(\$ 56\) million, total revenues of approximately \(\$ 73\) million, and pre-tax income of \(\$ 6\) million. The Company's audited financial statements for the year ended December 31, 2002, reflected total assets of \(\$ 47\) million, total revenues of approximately \(\$ 60\) million, and pre-tax income of \(\$ 5\) million. Earnings per share have increased steadily over the past five years, with a cumulative return of \(140 \%\) over that period.

During 2003, the Company significantly expanded its plant and fixed-asset spending to accommodate increased orders received by its brake valve division. The company also accumulated significant levels of tooling inventory, which primarily consists of drill bits and machine parts utilized in the manufacturing process. The nature of the tooling inventory is such that the parts are worn out in a relatively short period of time, requiring continual replacement.

In prior years, the Company expensed tooling supplies as they were purchased. However, at the beginning of fiscal 2003 the controller and chief financial officer (CFO) determined that capitalization of the tooling inventory would be the preferable method of accounting. The Company changed its accounting policy accordingly and began to include the tooling supplies inventory in "other current assets" until the inventory is placed into service at which time they transfer the inventory to expense.

During the prior year, 2002, the Company incurred roughly \(\$ 650,000\) of tooling expense and held approximately \(\$ 175,000\) of the inventory on hand at yearend (the on-hand inventory was not included in assets on Auto Parts' balance sheet at 12/31/02). The unaudited financial statements for the year-ended December 31, 2003 reflect \(\$ 1,000,000\) of tooling expense on the income statement and \(\$ 300,000\) of tooling inventory as current assets on the balance sheet. Given that the \(\$ 175,000\) of inventory on-hand at the end of last year was expensed in fiscal 2002 under the old accounting policy, those costs were not included in the \(\$ 1,000,000\) tooling expense recorded in 2003.

Because your accounting firm serves as external auditor for Auto Parts, the CFO and the controller asked your firm for advice on whether the Company would be required to account for and disclose the accounting policy change as a change in accounting principle. In the client's opinion, the change is not material to the financial statements and, therefore, would not require disclosure in the 2003 financial statements. The client strongly prefers to not make any disclosure related to the policy change.

REQUIREMENTS

1. Describe whether you agree that capitalization of the tooling inventory is the preferable method of accounting for Auto Parts, Inc.

2. Assuming the policy change is considered material, how should it be reported and disclosed in the 2003 financial statements and what effect, if any, would the accounting change have on the auditor's report?

3. In general, how do auditors develop an estimate of planning materiality? For Auto Parts, Inc., what is your preliminary estimate of financial statement materiality? Are there qualitative factors that might impact your decision about the materiality of the accounting treatment and the related disclosure?

4. Do you concur with management's assessment that the accounting change is immaterial and, therefore, requires no disclosure? Why or why not?