ASSIGNMENT 2

Calculate materiality

Learning objective

One of the underlying principles in auditing is the concept of materiality. An auditor designs

procedures in order to identify and correct errors or irregularities that would have a material

impact on the financial statements. Such errors or irregularities are considered material if they

would impact the decision-making of the users of the financial statements. Materiality is used

in determining audit procedures, selecting samples, and evaluating differences from client

records to audit results. It is the maximum amount of misstatement, individually or in

aggregate, that can be accepted in the financial statements.

In selecting the base figure to be used to calculate materiality, an auditor should consider

the key driver of the business. They should ask themselves, "What are the end users (such as

shareholders and banks) of the financial statements going to be looking at?" For example, will

shareholders be interested in the net income that can be used to pay dividends and increase

share price?

Planning materiality

W&S Partners' audit methodology dictates that one planning materiality (PM) amount is to be

used for the financial statements as a whole. Further, only one basis should be selected?a

blended approach or average should not be used. The basis selected is the one determined to be

the key driver of the business.

W&S Partners uses the following percentages as starting points for the various bases.

These starting points can be increased or decreased by taking into account qualitative client

factors, which could be:

the nature of the client's business and industry (such as rapid change, either through growth

or downsizing, or unstable environment)

the fact that it is a publicly listed entity (or subsidiary of) subject to regulations

the knowledge of or high risk of fraud.

Base Threshold (%)

Profit before tax 5.0

Revenues 0.5

Gross profit 2.0

Total assets 0.5

Equity 1.0

Typically, profit before tax is used; however, it cannot be used if the entity is reporting a

loss for the year or if profitability is not consistent.

8 Cloud 9 Ltd. - An Audit Case Study

When calculating PM based on interim figures, it may be necessary to annualize the results.

This allows the auditor to properly plan the audit based on an approximate projected year-end

balance. Then, at year end, the figure is adjusted, if necessary, to reflect the actual results.

Note: Adjustments to the starting points are made by an experienced auditor using their

professional judgement. The aim is to set PM at a high enough level that appropriately

balances the amount of testing, while still keeping the audit risk to an acceptable level.

Performance materiality

W&S Partners also dictates that performance materiality be determined for each audit

engagement. Performance materiality is an amount less than planning materiality that reduces

the likelihood that any uncorrected and undetected misstatements within a class of

transactions, account balances, or disclosures in aggregate exceed overall planning materiality.

W&S Partners' policy is to use 70 percent of planning materiality to determine performance

materiality.

Required

Using the working paper provided (A2-1):

Select the basis for planning materiality that you believe is most appropriate. Justify your

selection.

Calculate the PM using the December 31, 2020, trial balance and draft Statement of Income

in Appendix 2.

Based on your determination of PM, calculate and conclude on performance materiality.

W/P ref: A2-1

Prepared by: _____

Date prepared: _____

Cloud 9 Ltd.

December 31, 2020

Setting materiality

Users Financial statement area of most concern to the user

Base selected for planning materiality (PM): ______________________________________

Justification for selection:

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

Calculation of PM

Current Year Prior Year

Trial balance amount: _______________________ _______________________

Normalizing adjustments

(that is, non-recurring items) _______________________ _______________________

Annualized (if required): _______________________ _______________________

Benchmark applied _______________________ _______________________

Calculated materiality: _______________________ _______________________

Conclusion: PM materiality is __________.

Performance materiality: 70% _________.

Conclusion: Performance materiality is __________.

Discussion points

Consider how you will use the planning materiality in your audit. What factors might lead you

to increase or decrease the planning materiality amount? Are there qualitative factors that

could impact your materiality decision?

TRIAL BALANCE CLOUD 9 LTD. DECEMBER 31, 2020 DECEMBER 31, 2019 DR CR DR CR Storage-rent expense, store 191,667 Storage-rent expense, warehouse 3,403,146 3,403,146 Distribution expenses 2,378,493 2,309,217 Telephone 114,468 Computer and IT costs 290,339 343,370 Advertising and promotion-print 2,398,684 1,203,668 Trade shows 376,840 442,674 Advertising and promotion-TV 2,003, 186 571,545 Advertising and promotion-sponsorships 1,969,959 Rent expense-office 355,546 355,546 Bad debt expense 87,069 138,000 Depreciation-furniture and equipment 806,365 390,830 Depreciation-leasehold improvements 231,505 110,775 Entertainment 253,662 368,808 Professional fees 365,936 527,738 Insurance expense 3,166,480 1,837,082 Recruitment 405,301 341,769 Interest expense-loan from bank 1,170,220 806,812 Income tax expense 567,111 83,817,576 83,817,576 76,657,825 76,657,825 Draft Statement of Income December 31, 2020 Revenue 55,633,918 Cost of goods sold 31,713,252 Gross profit 23,920,666 Other expenses 25,815,995 Loss from operations (1,895,329) Other income 431,182 Loss before taxes (1,464,147) Income tax expense Net loss 1,464,147)DECEMBER 31, 2020 DECEMBER 31, 2019 DR CR DR CR Cash-operating account 221,615 495,032 Cash-savings account 72,000 1,323,610 Petty cash 500 500 Cash-store locations 1.000 Trade receivables-stores 261,179 Trade receivables-wholesale 12,725,920 13,117,217 Allowance for doubtful accounts 495,723 567,390 Miscellaneous receivables 53,747 62,805 HST receivable 37,748 53,292 Inventory 6,946,706 7,333,555 Goods in transit 543,602 692,159 Allowance for inventory obsolescence 501,346 629,824 Amounts receivable from parent 578,767 578,767 Prepaid rent 345,518 245,039 Prepaid insurance 863,071 510,124 Other prepaid expense 79,053 44,102 Furniture and equipment 2,034,297 1,317,948 Accumulated depreciation-furniture 1,274,980 909,549 and equipment Leasehold improvements 1,523,606 866,762 Accumulated depreciation-leasehold 414,748 251,603 improvements Trade payables 2,506,543 1,458,263 Accrued bonuses 400,000 350,000 Sales commissions payable 487,354 499,487 Other accrued expenses 2,242,356 1,444,164 Inter-company payables 682,476 593,233 Accrued vacation payable 180,030 134,324 Loyalty program provision 71,824 Provision for current tax liabilities 183,846 249,472 Warranty provision 105,174 102,716 Long-term debt 10,203,354 11,472,269 Provision for deferred tax liabilities 228,444 204,340 Share capital 6,265,232 6,265,232 Retained earni 1,509,046 442,743 Revenue-stores 1,025,251 Revenue-wholesale 54,608,667 51,057,288 Interest from bank 72,691 128,107 Foreign exchange gain/loss 56,747 35,481 Proceeds on disposals 9.256 Other revenue 301,744 295,827 Cost of goods sold-stores 736,898 Cost of goods sold-wholesale 30,976,354 24,590,091 Salaries and employee benefits 5,847,129 11,265,988 Appendix 2 45