Workshop Week 5 Solutions

7-8

Assume a company with the following balance sheet accounts:

Account Amount
Cash $ 10 000
Fixed assets 60 000
70 000
Long-term loans 30 000
M. Johnson, Proprietor 40 000
$ 70 000

You are concerned only about overstatements of owner’s equity. Set performance materiality for
the three relevant accounts such that the preliminary judgment about materiality does not exceed
$5 000. Justify your answer.

ANSWER

There are several possible answers to the question. One example is:

Account Performance Risk

materiality
Cash $ 500 Overstatement
Fixed assets 3 000 Overstatement
Long-term loans 1 500 Understatement

Cash and fixed assets are tested for overstatement and the liability for long-term loans for
understatement because the auditor’s objective in this case is to test for overstatements of owner’s
equity.

The least amount of tolerable misstatement was allocated to cash and long-term loans
because they are relatively easy to audit (e.g. confirmations are relatively straightforward yet strong
evidence). The majority of the total allocation was to fixed assets because there is a greater
likelihood of misstatement of fixed assets in a typical audit. Students need to be aware of the
qualitative nature of auditing and the impact of qualitative factors on the setting of materiality. In
most cases, cash, given its nature, will have a low tolerable misstatement.

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Q7.28

Ling, an audit manager, is planning the audit of Modern Technologies, Inc. (MT, Inc.), a manufacturer
of electronic components. This is the first year that Ling’s audit firm has performed the audit for MT,
Inc. Ling set the preliminary judgment about materiality for the financial statements as a whole at
$66 000 and is now in the process of setting performance materiality for asset accounts. Asset
balances for the current year (unaudited) and prior year (audited) are listed in the table below, as
well as Ling’s initial determination of performance materiality for each account.

Based on preliminary discussions with management, a tour of the production facility and background
reading about the electronic components industry, Ling determines that MT, Inc. has strong credit
policies, and most customers pay their full balance on time. Competition in the electronic
components industry is high and inventory can become obsolete quickly due to rapid technology
changes (inventory turnover is a measure that analysts focus on when assessing performance for
electronic component manufacturers). Production equipment is relatively specialised and additional
investment is required when new electronic components are introduced.

Current year Performance Prior year (audited)

(unaudited) materiality
Cash $ 397 565 $ 10 000 $ 356 122
Accounts receivable, 2 583 991 25 000 2 166 787
net of allowance
Inventory 1 953 845 15 000 1 555 782
Total current assets 4 935 401 4 078 691
Property, plant & 1 556 342 20 000 1 458 963
equipment, net
Other assets 153 000 20 000 149 828
Total assets $ 6 644 743 $ 5 687 482

REQUIRED

What factors should Ling consider in setting
performance materiality for the asset
accounts?
Explain why Ling set performance materiality
for cash at the lowest amount.
Explain why Ling set performance materiality
for inventory at a lower amount as compared
to accounts receivable, PP&E and other assets.
Ling should consider the overall audit assurance
desired, expected misstatements in a particular
segment, and the cost of obtaining audit
evidence (efficiency).
Ling set performance materiality for cash at the
lowest amount because cash can be completely
audited, typically there are no misstatements,
and the evidence is mostly objective versus
subjective (e.g. not based on estimates or
complex calculations).
Ling set performance materiality for inventory
at a lower amount because there are concerns
about obsolescence and because inventory
turnover is a ratio of interest to analysts.
Auditing standards suggest auditors should
consider setting a lower materiality for
segments of the audit where there is increased
scrutiny.

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Explain why Ling set performance materiality
for accounts receivable at the highest amount.
Does setting materiality at a lower level result
in collecting more or less audit evidence (as
compared to setting materiality at a higher
level)?
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Performance materiality is the highest for
accounts receivable because the account is
large and requires sampling to test the balance.
In addition, Ling has determined that MT, Inc.
has strong credit policies and customers
generally pay their balance on time.
Setting materiality at a lower level results in
collecting more audit evidence.
Q7.27

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, performance materiality
and estimated overstatements in the accounts are shown below.

Account Balance Performance Estimate of total

materiality 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

a. Assume you tested inventory amount totalling $1 million and found $10 000 in
overstatements. Ignoring sampling risk, what is your estimate of the total misstatement in
inventory?
b. Based on the audit of the asset accounts and ignoring other accounts, are the overall
financial statements acceptable? Explain.
c. What do you believe the auditor should do in the circumstances?

ANSWERS

a. The misstatement in the inventory sample is 10 000/1 000 000, or 1%. When projected
to the population, the estimate of the total misstatement is $25 000 ($250 000 x 1%).
b. While the individual balance sheet items do not exceed the tolerable misstatement for
the relevant assets, it can be seen that the total estimated overstatement exceeds the
preliminary judgment about materiality set at $50 000. In principle then, the overall
financial statements are not acceptable.

Account Balance Performance Estimate of total

materiality overstatements
Cash $ 50 000 $ 5 000 $1 000
Accounts receivable 1 200 000 30 000 20 000
Inventory 2 500 000 50 000 25 000
Other assets 250 000 15 000 12 000
Total $ 4 000 000 $ 100 000 $ 58 000

c. There are two main options available to the auditor. First they may decide to reassess
their preliminary estimate of materiality for each of the stated asset categories. If it is
considered that no change to the tolerable misstatement is appropriate, then action
must be taken (as a minimum) to approach the client to correct the misstatements at
least to the point where the actual misstatement is less than $50 000 (the tolerable
misstatement). Failure by the client to correct the misstatements appropriately may
result in a modified audit opinion.

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 MULTIPLE CHOICE QUESTIONS

Question 1

The existence of a management compensation scheme, based on profit, increases:

(a) inherent risk.

(b) control risk.
(c) detection risk.
(d) sampling risk.

Question 2

You are auditing a company's cash payments cycle. You have assessed inherent risk as medium and
internal control risk as low. Consequently, your detection risk will be assessed as:

(a) medium.
(b) high.
(c) low.
(d) very low.

Question 3

A and B are both retail firms. A sells expensive jewellery and B sells concrete pipes. Both have a
June 30 year end. A carries out is stocktake on May 30 and B on June 30. With respect to inventory:

(a) the level of both inherent risk and detection risk is higher for A than B.
(b) the level of both inherent risk and detection risk is lower for A than B.
(c) the level of inherent risk is higher for A but the level of detection risk is higher for B.
(d) the level of inherent risk is higher for B but the level of detection risk is higher for A.

Question 4

The audit risk involved in formulating and issuing an unqualified audit opinion is:

(a) between 5% and 10%.

(b) a combination of tolerable error and inherent risk.
(c) the risk that a material error is included within the audited accounts.
(d) inherent risk multiplied by internal control risk multiplied by transactions risk.

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Exercise 1

Using the audit risk model, state the effect on control risk, inherent risk, desired audit risk, and
planned evidence for each of the following independent events. In each of the events (a) to (j), circle
one letter for each of the three independent variables and planned evidence: I = increase, D =
decrease, N = no effect, and C = cannot determine from the information provided.

(a) The client's management materially increased long-term contractual debt:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

(b) The company changed from a privately held company to a publicly held company:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

(c) The auditor decided to assess control risk at a level below maximum:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

(d) The account balance increased materially from the preceding year without apparent reason:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

(e) You determined through the planning phase that working capital, debt to equity ratio, and
other indicators of financial performance had improved during the past year:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

(f) This is the second year of the engagement and there were few audit errors in the previous
year. The auditor also decided to increase reliance on internal control:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

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(g) About half-way through the audit, you discover that the client is constructing its own
building during idle periods, using factory personnel. This is the first time the client has done this
and it is being done at your recommendation:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

(h) In discussion with management, you conclude that management is planning to sell the
business in the next few months. Because of the planned changes, several key accounting personnel
resigned several months ago for alternative employment. You also observe that the gross margin
per cent has significantly increased compared with that of the preceding year.

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

(i) There has been a change in several key management personnel. You believe that
management is somewhat lacking in personal integrity, compared with the previous management.
You believe it is still appropriate to do the audit:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

(j) In auditing inventory, you obtain an understanding of the internal control structure and
perform tests of controls. You find it significantly improved compared with that of the preceding
year. You also observe that due to technology changes in the industry, the client's inventory may be
somewhat obsolete:

Control risk IDNC

Inherent risk IDNC
Desired audit risk IDNC
Planned evidence IDNC

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Exercise 1 - Suggested Solution

CR IR AR EV

(a) N I D I

(b) N N D I

(c) D N N D

(d) N I N I

(e) N D N D

(f) D D N D

(g) N I N I

(h) I I D I

(i) I I N I

(j) D I N C