In this mini-case you will determine overall materiality as well as tolerable misstatement amounts for balance sheet accounts of EarthWear Clothiers, Inc. Most auditing firms use a simple approach for establishing planning materiality and tolerable misstatement similar to the one illustrated in your textbook. This case illustrates such an approach, with some additional guidance from Willis & Adams relating to the amount of tolerable misstatement to allocate to various balance sheet accounts based on difficulty to audit and expected misstatement, and limiting the total amount of tolerable misstatement to about ten times materiality.

INSTRUCTIONS:

Please download the files below to complete the audit tasks associated with this mini-case. The Excel workbook contains the instructions and workpapers you are to complete.

11e_Ch3_Mini_case_Materiality

Materiality Guidelines

Using your completed Excel file, answer the questions presented below.

The fields below will be populated automatically as you complete the assigned workpapers. You may need to resize the rows to display your complete answer. Input your responses below into Connect.

Measurement Base _______

Factors that you considered to determine the appropriate measurement base

Percentage Applied ________ % (Round your answer to 1 decimal place.)

Factors that you considered to determine the appropriate percentage applied

Planning Materiality $ ____

Total Amount of Tolerable Misstatement Allocated To Balance Sheet Accounts $ _____

Ratio of Total Tolerable Misstatement to Planning Materiality ___________ (Round your answer to 1 decimal place.)

Audit Manual Excerpt: Materiality Guidelines Overall Materiality and Tolerable Misstatement

Overall Materiality This section provides general guidelines for determining overall materiality and tolerable misstatement for audits performed by Willis & Adams. The application of these guidelines requires professional judgment and the facts and circumstances of each individual engagement must be considered.

Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information, defines materiality as follows:

Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

The reasonable person, approach means that the magnitude and nature of financial statement misstatements or omissions will not have the same influence on all financial statement users. For example, a 7 percent misstatement with current assets may be more relevant for a creditor than a stockholder, while a 7 percent misstatement with net income before income taxes may be more relevant for a stockholder than a creditor.

While qualitative factors need to be considered, it is not practical to design audit procedures to detect all misstatement that potentially could be qualitatively material. Therefore, as a starting point, we typically compute a quantitative materiality determined as a percentage of the most relevant base (e.g., Income Before Taxes, Total Revenue, Total Assets). Relevant financial statement bases and presumptions on the effect of combined misstatements or omissions that would be considered immaterial and material are provided below:

Profit Oriented Entity: Income Before Income Taxes - combined misstatements or omissions less than 3 percent of Income Before Income Taxes are presumed to be immaterial and combined misstatements or omissions greater than 7 percent are presumed to be material. For publicly traded companies, materiality is typically set at 5 percent of income before income taxes.

If pretax income is stable, predictable, and representative of the entitys size and complexity, it is typically the preferred base. However, if net income is not stable, predictable, representative, or if the entity is close to breaking even or experiencing a loss, then other bases may need to be considered. If the entity has volatile earnings, including negative or near zero earnings, it might be more appropriate to use the average of 3 to 5 years of pretax net income as the base (referred to as "normalized earnings").

Other possible bases to consider include:

Total Revenue (less returns and discounts) combined misstatements or omissions less than 0.5 percent of Total Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 3 percent are presumed to be material. Total Assets - combined misstatements or omissions less than 0.25 percent of Total Assets are presumed to be immaterial, and combined misstatements or omissions greater than 2 percent are presumed to be material. (Note: Total Assets may not be an appropriate base for service organizations or other organizations that have few operating assets.) Not-for-Profit Entity Total Revenue (less returns and discounts) combined misstatements or omissions less than 0.5 percent of Total Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 3 percent are presumed to be material. Total Assets combined misstatements or omissions less than .25 percent of Total Expenses are presumed to be immaterial, and combined misstatements or omissions greater than 2 percent are presumed to be material.

Mutual Fund Entity Net Asset Value combined misstatements or omissions less than 3 percent of Net Asset Value are presumed to be immaterial and combined misstatements or omissions greater than 5 percent are presumed to be material.

The specific value within the above ranges for a particular base is determined by considering the primary users as well as qualitative factors. For example, if the client is close to violating the minimum current ratio requirement for a loan agreement, a smaller overall materiality amount should be used. Conversely, if the client is substantially above the minimum current ratio requirement for a loan agreement, it would be reasonable to use a higher overall materiality amount.

Tolerable Misstatement In addition to establishing overall materiality for the overall financial statements, materiality for individual financial statement accounts should be established. The materiality amount established for individual accounts is referred to as tolerable misstatement. Tolerable misstatement represents the amount an individual financial statement account can differ from its true amount without affecting the fair presentation of the financial statements taken as a whole.

Establishment of tolerable misstatement for individual accounts enables the auditor to design and execute an audit strategy for each audit cycle. It is an important input in determining the nature, timing and extent of audit procedures.

Tolerable misstatement should be established for all balance sheet accounts (except retained earnings because it is the residual account). Tolerable misstatement need not be allocated to income statement accounts because many misstatements affect both income statement and balance sheet accounts and misstatements affecting only the income statement are normally less relevant to users.

The objective in setting tolerable misstatement for individual balance sheet accounts is to provide reasonable assurance that the financial statements taken as a whole are fairly presented in all material respects at the lowest cost. Factors to consider when setting tolerable misstatement for accounts include:

The tolerable misstatement to be allocated to an account is 50 to 75 percent of overall materiality. Tolerable misstatement should not exceed 25% of the account balance. Tolerable misstatement should not exceed an amount that would influence the decision of reasonable users. Tolerable misstatement normally will be higher for accounts with a higher expectation of misstatement. Willis & Adams limits the total amount of tolerable misstatement allocated to the balance sheet accounts to about ten times materiality in order to limit aggregation risk.