For each of the following scenarios, perform the three steps in the materiality

Question

For each of the following scenarios, perform the three steps in the materiality process: (1) determine overall materiality, (2) determine tolerable misstatement, and (3) evaluate the audit findings.

Assume further that the auditor’s firm provides guidance that tolerable misstatement will be set 50% of overall materiality.

Swell Computers is a public company that manufactures desktop and laptop computers. The components of the financial statements are: (1) income before taxes = $500,000, (2) total assets = $2.2 billion, and (3) total revenues = $7 billion. Swell Computers' CPA firm might use the lowest percentage for total assets for determining overall materiality, but they also consider qualitative factors.

a. Determine overall materiality and tolerable misstatement. Justify your decisions

b. During the course of the audit, Murphy & Johnson’s CPA firm detected two misstatements that aggregated to an overstatement of income of $1.25 million. Evaluate the audit findings. Justify your decisions.

Explanation / Answer

Materiality is an amount that makes a difference to the users- an audit never provides 100% assurance- only “reasonable assurance."

Steps for determinig materiality:

1.Determine a base and calculate a number.
2.During the audit, track the misstatements on the SUE- Summary of Unadjusted Errors
3.Estimate the likely misstatement and compare the total to the preliminary materiality.

According to the given question,

(1) income before taxes = $500,000
(2) total assets = $2.2 billion= 2.2*1000000000= 2200000000
(3) total revenues = $7 billion= 7*1000000000= 7000000000

tolerable misstatement will be set 50% of overall materiality
overstatement of income of $1.25 million in two misstatements

For Materiality;
Using Single Rule Method:

5% of income before tax: .05*500000= $25000
0.5% of total asset: .005*2200000000=$11 million
0.5% of total revenue: .005*7000000000=$35 million

Using KPMG Formula;
Materiality = 1.84 * (Greater of asset or revenue)^(2/3)

In our case as Revenue is greater,

therefore materiality= 1.84 * (7000000000)^(2/3) = $3659305.71

Determine Tolerable Misstatement

Tolerable Misstatement is the amount of planning materiality that is allocated to an account or class of transactions.
Set tolerable misstatements between 50 and 75 percent of planning materiality.
Establish a scope for the audit process for individual account balances or class of transactions.

Tolerable misstatements

higher of total revenues or total assets= $7 billion
materiality percentage- 1%
so,
Planning materiality at the financial statement level= $ 7 billion
Tolerable misstatement percentage selected assuming risk is moderate =50%
Tolerable misstatement at the financial statement level = 50% of $7 billion = $ 3.5 billion

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