Module Name Auditing II

Module Code ACC309

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Lecturer Name Dr. Yasmine Magdi
 Chapter 1

Materiality and Audit Risk

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 Materiality
Example (1): For the following scenario, perform the five steps in the materiality process: (1) Set preliminary
judgment about materiality, (2) Allocate preliminary judgment about materiality to segments, (3) Estimate total
misstatement in segment, (4) Estimate the combined misstatement, and (5) Compare combined estimate with
preliminary judgment about materiality.
EarthWear Clothiers net income before taxes is $3,600,000. The auditors, Willis & Adams, have decided that 5 percent of
this benchmark is appropriate for planning materiality and allocate 50 percent of planning materiality to each account as
tolerable misstatement.
Determine preliminary judgment about materiality, and determine tolerable misstatement.
During the course of the audit, Willis & Adams CPA firm detected three misstatements. The first misstatement indicates an
error in the cash related to unrecorded bank service charges. The total misstatement of cash is $2,000. The second entry is
based on the results of a statistical sampling application for inventory. In the auditing inventory, the auditor found $3,500 of
net overstatement amounts in a sample of $50,000 of the total population of $450,000. The third misstatement indicates an
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error in accounts receivable. The total misstatements of accounts receivable is $18,000.
Evaluate the audit findings. Justify your decisions.
 Materiality
Solution:
a. Step 1: Determine the preliminary judgment about materiality.
Preliminary judgment about materiality= $3,600,000× 0.05= $180,000.
Step 2: Evaluate Audit Findings.
Tolerable misstatement= $180,000× 0.50= $90,000.
a. Evaluate Audit Findings.
Direct Projection Estimate of Misstatement= (Net Misstatement in the Sample/ Total Sampled) × Total
Recorded Population Value
Direct Projection Estimate of Misstatement in inventory accounts= ($3,500/ $50,000) × $450,000
Direct Projection Estimate of Misstatement in inventory accounts= $31,500
Combined misstatement= $2,000+$18,000+$31,500= $51,500
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As combined misstatement is less than the preliminary judgment about materiality amount of $180,000,
the auditor can conclude that the financial statements are fairly presented.
 Materiality
Example (1): For the following scenario, perform the five steps in the materiality process: (1) Set preliminary
judgment about materiality, (2) Allocate preliminary judgment about materiality to segments, (3) Estimate total
misstatement in segment, (4) Estimate the combined misstatement, and (5) Compare combined estimate with
preliminary judgment about materiality.
EarthWear Clothiers net income before taxes is $3,600,000. The auditors, Willis & Adams, have decided that 5 percent of
this benchmark is appropriate for planning materiality and allocate 50 percent of planning materiality to each account as
tolerable misstatement.
Determine preliminary judgment about materiality, and determine tolerable misstatement.
During the course of the audit, Willis & Adams CPA firm detected three misstatements. The first misstatement indicates an
error in the cash related to unrecorded bank service charges. The total misstatement of cash is $2,000. The second entry is
based on the results of a statistical sampling application for inventory. In the auditing inventory, the auditor found $3,500 of
net overstatement amounts in a sample of $50,000 of the total population of $450,000. The third misstatement indicates an
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error in accounts receivable. The total misstatements of accounts receivable is $18,000.
Evaluate the audit findings. Justify your decisions.
 Materiality
Solution:
a. Step 1: Determine the preliminary judgment about materiality.
Preliminary judgment about materiality= $3,600,000× 0.05= $180,000.
Step 2: Evaluate Audit Findings.
Tolerable misstatement= $180,000× 0.50= $90,000.
a. Evaluate Audit Findings.
Direct Projection Estimate of Misstatement= (Net Misstatement in the Sample/ Total Sampled) × Total
Recorded Population Value
Direct Projection Estimate of Misstatement in inventory accounts= ($3,500/ $50,000) × $450,000
Direct Projection Estimate of Misstatement in inventory accounts= $31,500
Combined misstatement= $2,000+$18,000+$31,500= $51,500
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As combined misstatement is less than the preliminary judgment about materiality amount of $180,000,
the auditor can conclude that the financial statements are fairly presented.
 Materiality
Example (2):
You are evaluating audit results for assets in the audit of Roberts Manufacturing. You set the preliminary judgment about
materiality at $50,000. The account balances, tolerable misstatement, and estimated overstatements in the accounts are shown next.
Account Account Balance Tolerable Misstatement Estimate of Total Overstatements
Cash $50,000 $5,000 $1,000
Accounts receivable 1,200,000 30,000 20,000
Inventory 2,500,000 50,000 ?
Other assets 250,000 15,000 12,000
Total $4,000,000 $100,000 ?

Required:
•Assume you tested inventory amounts totaling $1,000,000 and found $10,000 in overstatements. What is your estimate
of the total misstatement in inventory?
•Based on the audit of the assets accounts and ignoring other accounts, are the overall financial statements acceptable? 7
Explain.
•What do you believe the auditor should do in the circumstances?
 Materiality
Solution:
a. Direct Projection Estimate of Misstatement= (Net Misstatement in the Sample/ Total Sampled) × Total
Recorded Population Value
= (10,000/1,000,000) × 2,500,000
= $25,000
a. Total misstatements= $1,000 Cash+ $20,000 accounts receivable+ $25,000 inventory+ $12,000 other assets=
$58,000
As Preliminary judgment about materiality $50,000< Estimated total misstatement $58,000, the overall
financial statements must be rejected.
a. The auditor should request that the client adjust the financial statements. If the client refuses to adjust the
financial statements for the likely misstatements, the auditor should issue a qualified or adverse opinion
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because the financial statements do not present fairly in conformity with GAAP.
 Materiality
Tolerable Estimate of Total
Account Account Balance
Misstatement Overstatements
Cash $50,000 $5,000 $1,000
Accounts receivable 1,200,000 30,000 20,000
Inventory 2,500,000 50,000 25000
Other assets 250,000 15,000 12,000
Total $4,000,000 $100,000 58000

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