Mcconnel Auditing Chapter 9 Minitest

Front 1

How does FASB Concept Statement 2 define materiality?

Back 1

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

Front 2

What are auditors required to do upon finding a material misstatement?

Back 2

If they find it they must bring it to a client's attention so a correction can be made.

Front 3

What happens if an auditor finds a material misstatement and the client refuses to correct the misstatement?

Back 3

The auditor must issue a qualified or an adverse opinion depending on the materiality of the misstatement.

Front 4

Since the definition of materiality emphasizes reasonable uses rely on statement to make decisions what must auditors know?

Back 4

THey must have knowledge of the likey users of the client's statements and the decisions that are being made. For example, if an auditor knows the financial statements will be relied upon in a buy/sell agreement for the entire business, the amount that the auditor considers material may be smaler than that for an otherwise similar audit.

Front 5

What 5 steps do auditors follow in regards to materiality?

Back 5

1. Set preliminary judgement about materiality.
2. Allocate preliminary judgement to segments
3. Estimate total misstatement in segment
4. Estimate the combined misstatement
5. Compare combined estimate with preliminary or revised judgement about materiality.

Front 6

What is the first thing an auditor does when he evaluates materiality?

Back 6

Sets preliminary judgement about materiality

Front 7

What is preliminary judgement about materiality?

Back 7

Auditing standards require auditors to decide on the combined amount of misstatements in the financial statements that they would consider material early in the audit as they are developing the overall strategy for the audit.

Front 8

Why is it called preliminary judgement about materiality?

Back 8

It is called a preliminary judgement about materiality because, although a professional opinion, it may change during the engagement

Front 9

Where is the preliminary judgement about materiality documented?

Back 9

In the audit files

Front 10

What is the preliminary judgement about materiality?

Back 10

The maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users.

Front 11

Conceptually what does preliminary judgement deal with?

Back 11

Conceptually this is an amount that is $1 less than materiality as defined by FASB.

Front 12

How important is preliminary judgement?

Back 12

It is one of the most important decisions an auditor makes and requires considerable rofessional wisdom.

Front 13

Why do auditors set preliminary judgement?

Back 13

Auditors set preliminary judgement about materiality to help plan the apropriate evidence to accumulate. The lower the dollar amount of the preliminary judgement, the more evidence required.

Front 14

If there is lower dollar amounts for preliminary judgement what does that mean an auditor must do?

Back 14

They must accumulate more evidence which means audit costs will increase.

Front 15

Revised judgement about materiality

Back 15

During the audit, auditors often change the preliminary judgement about materiality.

Front 16

Why do auditors often change preliminary judgement numbers?

Back 16

Because of changes in one of the factors used to determine the preliminary judgement; that is because the auditor decides that the preliminary judgement was too large or too small. Example, a preliminary judgement about materiality is often determined before year end and is based on prior years financials. Judgement may be revised after current statements are available. Or could be changed because circumstances may have changed due to qualitative events such as issuance of debt that creates new class of statement users.

Front 17

Several factors affect auditor's preliminary judgement the 3 most important factors are:

Back 17

1. Materiality is a relative rather than an absolute concept
2. Bases are needed for evaluating materiality
3. Qualitative factors also affect materiality

Front 18

Materiality is a relative rather than an absolute concept

Back 18

A misstatement of a given magnitude might be material for a small company, whereas the same dollar misstatement could be immaterial for a large one. This makes it impossible to evaluate dollar value guidelines for a preliminary judgement about materiality that are applicable to all audit clients.

Front 19

Bases are needed for evaluating materiality WHY?

Back 19

Because materiality is relative it's necessary to have bases for establishing whether misstatemnets are material.

Front 20

What is often the primary base used for determining materiality?

Back 20

Often net income before the taxes is the primary base for deciding what is material for profit oriented companies because it is regarded as a critical item of information for users.

Front 21

What are some other bases that can be used for evaluating materiality?

Back 21

Net sales, grossprofit, and total asets

Front 22

What should an auditor also determine after establishing a primary base?

Back 22

Once they establish a primary base they should consider whether misstatements could materially affect the reasonableness of other bases such as current assets, total assets, current liabilities, and owners' equity.

Front 23

Where does an auditor document the basis used to determine preliminary judgement about materiality?

Back 23

In the audit files

Front 24

In an auditor decides a misstatement of 100,000$ net income before taxes is material and a misstatement of 250,000$ of current assets is material what should an auditor not do?

Back 24

It is NOT appropriate dfor an auditor to use a preliminary judgement about materiality of $250,000 for net income before taxes and current assets. Instead the auditor must plan to find misstatements affecting income before taxes that exceed the preliminary judgement about materiality of $100,000

Front 25

Qualitative factors can also affect materiality

Back 25

Some types of misstatements are more important to others even if the dollar value is the same.

Front 26

What are some examples of qualitative factors that affect materiality?

Back 26

1. Amounts involving fraud
2. If there are possible consequences arising from contractual obligations.
3. If they affect a trend in earnings.

Front 27

qualitative factors that affect materiality: Amounts involving fraud. WHY?

Back 27

Amounts involving fraud considered more important than unintentional errors because they reflect on honesty and reliability of management and other personnel.

Front 28

qualitative factors that affect materiality: Consequences from contractual obligations. WHY?

Back 28

Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. Say Net working capital included in financial statements is only a few hundred dollars more than the required minimum in a loan agreement. If the correct net working capital were less than the required minimum, putting the loan in default, the current and noncurrent liability classifications would be materially affected.

Front 29

qualitative factors that affect materiality: Misstatements that affect earnings trends

Back 29

Misstatements otherwise immaterial may be amterail if they affect a trend in earnings. For exame, if reported income has increased 3% annually for last 5 years and then declined 1%, that change may be material.

Front 30

Do accounting and auditing standards provide specific materiality guidelines? Why or why not?

Back 30

NO. The concern is that such guidelines might be applied without considering the complexities that should affect auditor's final decision.

Front 31

What is the general rule about combined misstatements regarding materiality

Back 31

The combined total of misstatements 6% or greater is normally material. Combined total of les than 3% persumed to be immaterial. Between 3-6% require most professional judgement.

Front 32

Allocation of the preliminary judgement about materiality

Back 32

This is necessary because auditors accumulate evidence by segments rather than for financial statementas as a whole.

Front 33

How does breaking down preliminary judgement by segment help auditors?

Back 33

If auditors have a preliminary judgement about materiality for each segment, it helps them decide the amount of audit evidence to accumulate.

Front 34

Where do most auditors allocate materiality?

Back 34

To the balance sheet.

Front 35

Why do most auditors allocate materiality to balance sheet rather than income statement accounts?

Back 35

BEcause most income statement misstatements havea n equal effect on the balance sheet because of the nature of double entry accounting. For example, a $20,000 overstatement of A/R is also a $20,000 overstatement of sales.

Front 36

Why is it inappropriateto allocate preliminary judgement to both income statement and balance sheet account?

Back 36

Because doing so will result in double counting which will in turn lead to smaller tolerable misstatements than is desireable.

Front 37

Why should preliminary judgement be allocated to balanc sheet accounts/

Back 37

BEcause there are fewer balance sheet than income statement accounts in most audits, and because most audit procedures focus on balance sheet accounts, materiality should be allocated only to balance sheet accounts.

Front 38

Tolerable misstatement

Back 38

When auditors allocate the preliminary judgement about materiality to account balances, the materiality allocated to any given account balance is referred to as tolerable misstatement. For example if an auditor decides to allocate $100,000 preliminary judgement about materiality of $200,000 A.R, tolerable misstetement for A/R/ is $100,000. This means the auditor is willing to consider a/r fairly stateed if it is misstated by $100,000 or less

Front 39

What 3 major difficulties do auditors face in allocating materiality to balance sheet accounts?

Back 39

1. Auditors expect certain accounts to have more misstatements than others.
2. Both overstatements and understatements must be considered.
3. Relative audit costs affect the allocation.

Front 40

What must the auditor do in regards to over and understatements at the end of the audit?

Back 40

They must combine all actual and estimated misstatements and compare them to preliminary judgement about materiality. In allocating tolerable missteatement. he auditor is attempting to do the audit as efficiently as possible.

Front 41

What are the 2 purposes of the tolerable allocation requirements?

Back 41

1. This requirement keeps the auditor from allocating all of total materialiality to one account
2. Not permit the sum of tolerable misstatements to exceed overall materiality.

Front 42

What are the 2 reasons for the second requirement permitting the sum of the tolerable misstatement to exceed overall materiality?

Back 42

1. It is unlikely that all amounts will be misstated by the full amount of the misstatement. IF, for example, other current assets have a tolerable misstatement of $100,000 but no misstatements are found in auditing those accounts, it means that athe auditor could have allocated zero or a small tolerable misstatement to other current assets.
2. Some accounts are likely to be overstated, whereas others are likely to be understated, resulting in a net amount that is likely to be less than the preliminary judgement.

Front 43

What is the auditor concerned about in the allocation of tolerable misstatement?

Back 43

They are concerned about the combined efect of operating income of the misstaement of each balance sheet account. An overstatemetn of an asset account will have the same effect on the income statement as an understatement of a liability account. In contrast, a misclasification in the balance sheet, such as a classification of a note payable as an account payable, will have no affecton operating income. Therefore, the materiality of itmes not affecting the income statement must be considered separately.

Front 44

In practice what is hard to predict in advance?

Back 44

It's hard to predict which accounts are most likely to be misstated and whether misstatements are likely to be overstatements or understatements. Similarly the relative costs of auditing different account balances cannot be determined.

Front 45

Why is allocation of preliminary judgement about materiality to accounts difficult?

Back 45

Because it's hard to predict which will be misstated, and the costs of auditing different account balances cannot be determined.

Front 46

What is the purpose of allocating preliminary judgement to balance sheet accounts?

Back 46

Help auditor decide appropriate evidence to accumulate for each account on the balance sheet and incomes tatement.

Front 47

What do auditors hope to by allocating tolerable risk?

Back 47

They hope to minimize audit costs without sacrificing audit quality

Front 48

What must the auditor be confident about upon completion of the audit?

Back 48

That the combined misstatements in all accounts is less than or equal to the preliminary (or revised) judgement about materiality.

Front 49

When auditors perform audit procedures for each segment what do they document?

Back 49

Any and all misstatements found.

Front 50

What are the 2 types of misstatements?

Back 50

1. known misstatements
2. Likely misstatements

Front 51

Known misstatements

Back 51

these are those misstatements where auditor can determine the amount of misstatement in the account. Example: When auditing property, plant and Equipment, auditor may identify capitalized leased equipment which should be expensed because it is an operating lease.

Front 52

2 types of likely misstatements

Back 52

1. misstatements that arise from differenece between management and auditors estimates of account balances. For example, difference in the estimate of allowance for uncollectible accounts or warrenty liabilities.
2. Projections of misstatements based on auditor's tests of sample from a population. Example auditor finds 6 misstatements in sample of 200 testing inventory costs. Auditor uses these to estimate a total likely misstatement of inventory.

Front 53

Direct projection estimate of misstatements equation

Back 53

net misstatement in sample / total sampled X total recorded population value - direct projection estimate of misstatement

Front 54

Sampling error is a concern because

Back 54

The auditor has sampled only a portion of the population and there is a risk the sample does not accurately represent the population.

Front 55

If total sampling error is less than the sum of indiidual sampling error why would this happen?

Back 55

because sampling error represents maximum misstatement in account details not audited. It is unlikey that this max misstatement amount exists in all accounts subjected to sampling.

Front 56

If the estimated combined misstatement exceeds the preliminary judgement what happens?

Back 56

Then the financial statements are not acceptable.

Front 57

If the estimated combined misstatement exceeds the preliminary judgement what can the auditor do?

Back 57

They can perform more procedures to see if the estimate was off or they can require the client to make an adjustment for estimated misstatements.

Front 58

If estimated combined misstatements is less than preliminary judgement what can the auditor do?

Back 58

They would not need to expand audit tests because it meets both tolerable misstatement testa nd judgement about materiality.

Front 59

What can the auditor do if they approach the audit in a sequential maner?

Back 59

The findings of the audit of accounts audited earlier can be used to revise the tolerable misstaement established for accounts audited later.