Chapter 3, Problem 3.31P

a

To determine

Introduction:

Materiality: The theory of materiality is very important to audit practice, it is planning and executing the audit process using the concept of materiality and its application to audit risk, materiality is used to check if misstatements in the financial statements and disclosures are significant, once misstatements are identified auditor requires reliable evidence in support of findings.

Scenario 1

The overall materiality, tolerable misstatement, and effect of two deleted misstatements that aggregated to an overstatement of income of $1.25 million.

Answer to Problem 3.31P

• Determination of Materiality.

Income before taxes, $1,050,000

Total Assets, $27,500,000

Total revenue, $38,750,000

• Determination of tolerable misstatement.

Income before taxes, $525,000

Total Assets, $1,375,000

Total revenue, $19,375,000

1. The overstatement should be adjusted, or auditor would give a qualified opinion

Explanation of Solution

1. Determination of Materiality and tolerable misstatement.
• Determination of Materiality.

when 5 per cent of the benchmark is applied for overall materiality. The materiality of M&J will be:

Total revenue, $38,750,000 = $\$775,000,000\times 0.05$

Total Assets, $27,500,000 = $\$550,000,000\times 0.05$

Income before taxes, $1,050,000 = $\$21,000,000\times 0.05$

• Determination of tolerable misstatement.

The tolerable misstatement is usually kept in between 50 to 75 per cent for each of the accounts of overall materiality. Thus, we assume 50 per cent of tolerable misstatement.

Income before taxes = $525,000 = $\$1,050,000\times 0.5$

Total Assets, $1,375,000 = $\$27,500,000\times 0.5$

Total revenue, $19,375,000 = $\$38,750,000\times 0.5$

2. Evaluation of two misstatements aggregated to an overstatement of income of $1.25 million.

The misstatements and tolerable misstatement are compared with each other. If misstatement is greater than tolerable misstatement or if aggregate misstatements were greater than overall materiality, the business has to correct the financial statements or else auditor will issue qualified or adverse opinion.

In the case of M&J misstatement is both greater than tolerable misstatement and overall materiality.

Income before taxes:

M&J overall materiality $1.05 million and tolerable misstatement $525,000.

Thus, it can be concluded that they have to adjust to $1.25 million in the financial statements or auditor will issue qualified or adverse opinion.

Total Assets

M&J overall materiality $27.5 million and tolerable misstatement $1.375 million.

As aggregated misstatement is an overstatement of income and no information is available about its effect on assets it can be assumed that asset balances are fairly stated in accordance with GAAP.

Total revenue

M&J overall materiality $38.75 million and tolerable misstatement $19.375 million.

Thus, it can be concluded that they have to adjust $1.25 million overstatements if it is related to revenue in the financial statements or auditor will issue qualified or adverse opinion.

b

To determine

Introduction:

Materiality: The theory of materiality is very important to audit practice, it is planning and executing the audit process using the concept of materiality and its application to audit risk, materiality is used to check if misstatements in the financial statements and disclosures are significant, once misstatements are identified auditor requires reliable evidence in support of findings.

Scenario 2

The overall materiality, tolerable misstatement, and effect of two deleted misstatements that aggregated to an overstatement of income of $5.75 million.

Answer to Problem 3.31P

• Determination of Materiality.

Income before taxes, $2,000,000

Total Assets, $215,000,000

Total revenue, $45,000,000

• Determination of tolerable misstatement.

Income before taxes = $1,000,000

Total Assets, $107,500,000

Total revenue, $22,500,000

Explanation of Solution

1. Determination of Materiality and tolerable misstatement.
• Determination of Materiality.
• When 5 per cent of the benchmark is applied for overall materiality. The materiality of M&J will be:

Total revenue, $45,000,000 = $\$900,000,000\times 0.05$

Total Assets, $215,000,000 = $\$4,300,000,000\times 0.05$

Income before taxes, $2,000,000 = $\$40,000,000\times 0.05$

• Determination of tolerable misstatement.

The tolerable misstatement is usually kept in between 50 to 75 per cent for each of the accounts of overall materiality. Thus, we assume 50 per cent of tolerable misstatement.

Total revenue, $22,500,000 = $\$45,000,000\times 0.5$

Total Assets, $107,500,000 = $\$215,000,000\times 0.5$

Income before taxes = $1,000,000 = $\$2,000,000\times 0.5$

2. Evaluation of misstatements of an overstatement of income of $5.75 million.

The misstatements and tolerable misstatement are compared with each other. If misstatement is greater than tolerable misstatement or if aggregate misstatements were greater than overall materiality, the business has to correct the financial statements or else auditor will issue qualified or adverse opinion.

In the case of M&J misstatement is both greater than tolerable misstatement and overall materiality.

Income before taxes:

M&J overall materiality $2 million and tolerable misstatement $1 million.

Thus, it can be concluded that they have to adjust misstatement in the financial statements or auditor will issue qualified or adverse opinion.

Total Assets

M&J overall materiality $215 million and tolerable misstatement $107.5 million.

As aggregated misstatement is below the overall materiality and tolerable misstatement it can be assumed that asset balances are fairly stated in accordance with GAAP.

Total revenue

M&J overall materiality $45 million and tolerable misstatement $22.5 million.

Thus, it can be concluded that they have to adjust $5.75 million overstatements if it is related to revenue in the financial statements or auditor will issue qualified or adverse opinion.

c

To determine

Introduction:

Materiality: The theory of materiality is very important to audit practice, it is planning and executing the audit process using the concept of materiality and its application to audit risk, materiality is used to check if misstatements in the financial statements and disclosures are significant, once misstatements are identified auditor requires reliable evidence in support of findings.

Scenario 3

The overall materiality, tolerable misstatement, and effect of two deleted misstatements that aggregated to an overstatement of income of $5.75 million.

Answer to Problem 3.31P

• Determination of Materiality.

Income before taxes, $25,000

Total Assets, $110,000,000

Total revenue, $350,000,000

• Determination of tolerable misstatement.

Income before taxes, $12,500

Total Assets, $55,000,000

Total revenue, $175,000,000

Explanation of Solution

1. Calculation of Materiality and tolerable misstatement.
• Determination of Materiality.

When 5 per cent of the benchmark is applied for overall materiality. The materiality of M&J will be:

Total revenue, $350,000,000 = $\$7,000,000,000\times 0.05$

Total Assets, $110,000,000 = $\$2,200,000,000\times 0.05$

Income before taxes, $25,000 = $\$500,000\times 0.05$

• Determination of tolerable misstatement.

The tolerable misstatement is usually kept in between 50 to 75 per cent for each of the accounts of overall materiality. Thus, we assume 50 per cent of tolerable misstatement

Total revenue, $175,000,000 = $\$350,000,000\times 0.5$

Total Assets, $55,000,000 = $\$110,000,000\times 0.5$

Income before taxes = $12,500 = $\$25,000\times 0.5$

2. Evaluation of misstatements of an overstatement of income of $1.5 million.
The misstatements and tolerable misstatement are compared with each other. If misstatement is greater than tolerable misstatement or if aggregate misstatements were greater than overall materiality the business has to correct the financial statements or else auditor will issue qualified or adverse opinion.

In the case of M&J misstatement is both greater than tolerable misstatement and overall materiality.

Income before taxes:

M&J overall materiality $25,000 and tolerable misstatement $12,500.

Thus, it can be concluded that they have to adjust misstatement in the financial statements or auditor will issue qualified or adverse opinion.

Total Assets

M&J overall materiality $110 million and tolerable misstatement $55 million.

As aggregated misstatement is below the overall materiality and tolerable misstatement it can be assumed that asset balances are fairly stated in accordance with GAAP.

Total revenue

M&J overall materiality $350 million and tolerable misstatement $175 million.

Thus, it can be concluded that aggregated misstatement is below the overall materiality and tolerable misstatement it can be assumed that asset balances are fairly stated in accordance with GAAP.