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 selecteda 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 clients 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 one) subject to regulations the knowledge of or high risk of fraud. Base Threshold (%) Profit before tax 5.0 Revenues 1.0 Total assets 1.0 Equity 3.0 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. 10 Alpine Bags 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 (A21): Select the basis for planning materiality that you believe is most appropriate. Justify your selection. Calculate the planning materiality (PM) using the December 31, 2023, trial balance and draft Statement of Income in Appendix 2. Based on your determination of PM, calculate and conclude on performance materiality. Assignment 2 11 W/P ref: A21 Prepared by: _____ Date prepared: _____ Alpine Bags Ltd. December 31, 2023 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? APPENDIX 2 TRIAL BALANCE ALPINE BAGS LTD. December 31, 2023 December 31, 2022 DR CR DR CR Cash - operating account 210,024 495,032 Cash - savings account 60,093 1,323,610 Petty cash 500 500 Cash - store locations 1,000 - Trade receivables - stores 231,850 - Trade receivables - wholesale 13,119,041 13,117,217 Allowance for doubtful accounts 546,537 567,390 Miscellaneous receivables 68,849 62,805 HST receivable 40,284 53,292 Inventory 7,612,925 7,333,555 Goods in transit 535,414 692,159 Allowance for inventory obsolescence 526,111 629,824 Amounts receivable from parent 578,767 578,767 Prepaid rent 313,912 245,039 Prepaid insurance 857,183 510,124 Other prepaid expense 61,198 44,102 Furniture and equipment 2,374,158 1,317,948 Accumulated depreciation - furniture and equipment 1,252,869 909,549 Leasehold improvements 1,520,005 866,762 Accumulated depreciation - leasehold improvements 400,097 251,603 Trade payables 2,620,811 1,458,263 Accrued bonuses 282,361 350,000 Sales commissions payable 458,897 499,487 Other accrued expenses 2,103,969 1,444,164 Inter-company payables 663,713 593,233 Accrued vacation payable 175,958 134,324 Loyalty program provision 77,511 - Provision for current tax liabilities 184,953 249,472 Warranty provision 92,906 102,716 Long-term debt 10,379,614 11,472,269 Provision for deferred tax liabilities 234,415 204,340 Share capital 6,279,854 6,265,232 Retained earnings 2,110,452 442,743 Revenue - stores 956,176 - Revenue - wholesale 47,803,535 51,057,288 Interest from bank 68,239 128,107 Foreign exchange gain/loss 27,155 35,481 Alpine Bags Ltd. - An Audit Case Study ACCT442 CC01 Fall 2023 - Student Package 5 Proceeds on disposals - 9,256 Other revenue 304,452 295,827 Cost of goods sold - stores 377,923 - TRIAL BALANCE ALPINE BAGS LTD. December 31, 2023 December 31, 2022 DR CR DR CR Cost of goods sold - wholesale 23,218,870 24,590,091 Salaries and employee benefits 6,943,204 11,265,988 Storage - rent expense, store 167,401 - Storage - rent expense, warehouse 3,425,000 3,403,146 Distribution expenses 2,106,631 2,309,217 Telephone 107,843 - Computer and IT costs 383,558 343,370 Advertising and promotion - print 2,098,658 1,203,668 Trade shows 392,247 442,674 Advertising and promotion - TV 1,989,846 571,545 Advertising and promotion - sponsorships 1,991,272 - Rent expense - office 362,656 355,546 Bad debt expense 160,483 138,000 Depreciation - furniture and equipment 823,138 390,830 Depreciation - leasehold improvements 236,020 110,775 Entertainment 257,090 368,808 Professional fees 336,501 527,738 Insurance expense 3,187,971 1,837,082 Recruitment 227,515 341,769 Interest expense - loan from bank 1,171,555 806,812 Income tax expense - 567,111 77,550,585 77,550,585 76,657,825 76,657,825 DRAFT STATEMENT OF INCOME December 31, 2023 Revenue 48,759,711 Cost of goods sold 23,596,793 Gross profit 25,162,918 Other expenses 26,368,589 Income (loss) from operations (1,205,671) Other income 399,846 Alpine Bags Ltd. - An Audit Case Study ACCT442 CC01 Fall 2023 - Student Package 5 Income (loss) before taxes (805,825) Income tax expense - Net income (loss) (805,825)