Chapter 7 Audit judgement, materiality

and evidence

Exercises
7.1 MATERIALITY: Assume the following information about your audit client,
Te Wanui Ltd, a wholesale boat products firm. The industry has prospered this
year, but you are concerned about Te Wanui’s generous credit policy. Ending
account balances are as follows:

Assets ($)

Cash 18 000

Receivables 1 450 000

Stock 10 000 000

Liabilities 7 500 000

Total 4 000 000

revenue

Net income 700 000

Required: What questions might you ask before determining the percentage
and basis for planning materiality? Why did you ask those questions? Assume
your firm decides that planning materiality should be $500 000.
a Allocate this to balance sheet accounts, using the allocation method.
b Allocate this to a test of debtors’ accounts, using the basic allowance
method (advanced).
c Set out your assumptions and rationales in coming to such
disaggregation.

Instructor guide:
Question 1: Relevant questions may relate to overall and inherent risk, controls
over recording and authorising credit and the like.
Question 2: assess risk and its influence on materiality)

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Question 3 (parts (a), part (b) is left to advanced study.

Account Balance Initial Alloc. Adjusted Alloc

Cash 18,000 350 Allocation
Receivables 1,450,000 31,600 adjustment depends
Stock 10,000,000 217,950 on decisions of risk
Liabilities 7,500,000 163,450 and audit cost
Equity (derived) 3,968,000 86,650
Totals 22,936,000 500,000* 500,000
* rounding error 150 closed to equity NB: assumes a balance sheet approach to
allocation, which is why the revenue amounts are omitted from the calculation.

Under the basic allowance method, the $500 000 would be reduced for actual
estimated errors not subjected to testing (for example, individually material
debtors or debtors which are significantly overdue may be singled out for
testing); sampling error (to be calculated under conditions of statistical
sampling) and perhaps a further amount to comply with firm policy or due to a
conservative approach. See 'Basic

‘Allowance Method’. (Advanced study only)

Citing from ISA-320 Audit Materiality: ‘The assessment of what is material is a
matter of professional judgement…In designing the audit plan, the auditor
establishes an acceptable materiality level so as to detect quantitatively material
misstatements.... both the amount (quantity) and nature (quality) of
misstatements need to be considered... The auditor needs to consider the
possibility of misstatements of relatively small amounts that, cumulatively could
have a material effect on the financial statements…Materiality may be
influenced by considerations such as legal and regulatory requirements…’
paras 4-7.

7.3 MATERIALITY AND TOLERABLE ERROR: An auditor finds the following

errors in the books of Jonas Industries:
a $10 000 provisions for doubtful debts not recorded
b $8000 payable to a supplier accrued twice
c $23 000 of recorded sales are in next year’s invoices
d $5000 should be written off as a bad debt (provision method).
Required: Jonas does not wish to adjust for these errors. Prepare a
schedule showing the impact of them on the financial statements and on key
ratios of concern. The following accounts have unadjusted balances:

Accounts receivable (net) $1 043 000

Accounts payable $85 000

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 Chapter 7: Audit judgement, materiality and evidence

Sales $959 000

Expenses $940 000

Net income $19 000

Working capital ratio (2340/1170)

Instructor’s guide:
Error description AcRec AcPay Sales Expen NetInc WC
a (10) 10 (10) (10)
b (8) (8) 8 8
c (23) (23) (23) (23)
d - - - - - -
Unadjusted 1043 85 959 940 19 2340/11
Adjusted balances 1010 77 936 942 (6) 2301/11
Moves from profit to loss; from 2:1 wc ratio to 1.96:1 wc ratio; errors have
9.4% effect on Accounts Payable. Assumes no expected or unknown
errors.

7.5 MATERIALITY: Consider examples (in this chapter) for Basil Ltd. What
would be the effects on overall materiality, the base used for overall materiality,
disaggregation decisions or tolerable misstatement (if any) for each of the
following independent decisions:
a Net sales turns out to be a relatively stable and important account for
Basil’s users.
b The inventory value precision is highly important because it will be relied
on by a new potential owner.
c The inventory value precision is easier to measure than originally
anticipated.
d The cost of sales can be precisely measured along with the inventory
balance.
e Long-term debt values are not being relied on by anyone known to the
auditor.

Use the following case for the next three exercises:

As the auditor conducting the financial statement audit for her client, Interface
Ltd, Leanne discovers indications that a manager is possibly overstating the
value of sales. They do not appear to misstate any other account. Leanne

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 Chapter 7: Audit judgement, materiality and evidence

addresses her concerns to that manager and to his immediate manager, the
CEO. Both say that they believe the account has been stated correctly.
However, rather than ‘delay the audit’, both managers ask Leanne to reduce the
scope of her investigation and conduct an audit of the Statement of Financial
Position only.

Instructor guide:
Overall Base Disaggreg/Tolerable error
Planning decisions
Materiality
a) (a) N/A Net Sales useful base N/A
(b) should Could be a useful base Smaller TE on that account
be small
level
(c) N/A N/A Can be an account on which to
reduce precision (TE) if useful
(d) N/A N/A Can be accounts on which to
reduce TE
(e) N/A Probably not a useful Can increase TE and reduce
base testing costs

7.6 JUDGEMENT: Apply the judgement processes in the left-hand column of

Table 7.1 to the aforementioned situation. Assume no further changes are made
by the client. Where does this lead Leanne? What, as a result of her evaluation,
will she be doing next?

Instructor guide:
The auditor should not comply with this request as it is given after you found
something and has fraud implications.

7.7 JUDGEMENT: What heuristic (of those discussed in this chapter) may be
indicated by each of the following independent situations:
a Leanne received a request only last month to conduct a ‘Balance sheet
only’ audit. She produced the engagement letter with that restriction
on scope and completed the audit. On that basis, she decides to do
the same for Interface Ltd.
b Leanne decides to conduct additional tests for the sales account. While
these tests do not consider accounts receivable or verify sales
documents, the work she performs convinces her that the account
has not been misstated.
c Leanne remembers a similar situation in which someone tried to reduce
the scope of an engagement to avoid problems. On the basis of that
recollection, she declines to follow the managers’ suggestions and
withdraws from the engagement.

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 Chapter 7: Audit judgement, materiality and evidence

d Leanne remembers a similar situation in which a client tried to reduce

the scope of an engagement to avoid problems. On the basis of that
concern, she investigates other activities and adjustments performed
by the managers and makes further inquiries as to their characters.

Instructor guide:
(a) Availability;
(b) may be Giddens (structuration) that tests support pre-conceived notion;
(c) representativeness;
(d) representativeness.

7.8 JUDGEMENT: How might each of the following approaches identify a

concern as to the potential for fraud, or an auditor’s failure to find it, in Interface
Ltd:
a intuitive approach
b analytical approach
c image theory

Instructor guide:
(a) sense from someone hiding things or telling falsehoods are examples;
(b) unusual results from analytical ratios;
(c) sees whole picture as motivating, or enabling, the likelihood of fraud.

7.10 EVIDENCE AND PERSUASIVENESS: On a scale of 1 (low level) to 3

(high level), where would you place the following sources of evidence in regards
to their persuasiveness? Explain why.
a watching the end-of-year stock count
b re-adding a page of the client’s sales journal, which an employee has
downloaded for you
c checking the sales journal data you added up against the original sales
invoices
d contacting the client’s lawyer, with permission, to ask about a case in
progress
e opening a box of stock after it has been counted to see if it has all of the
items claimed
f talking to the manager about the system changes that have occurred
g reviewing whether the current portion of the debt has been revealed in
the current liabilities section of the Statement of Financial Position.

Instructor guide:

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(All dependent on assertion being tested as well)

(a) 3 directly obtained by the auditor;
(b) 2. Direct but internally supplied;
(c) 2.5 less involvement by the employee;
(d) 3 external sources;
(e) 3 directly obtained;
(f) 1, oral and internal;
(g) 3 directly obtained.

7.12 EVIDENCE: What management assertions may be of particular risk in

each of the following circumstances?
a There is a concern with theft in the stock warehouse.
b Items for sale in a tourism shop are all there on consignment.
c The school charity bazaar accepts cash for its sales, and no receipts are
issued.
d Sales in the first few days of the next year are captured in current year
accounts.
e An unintentional program error turns positive amounts into negative
amounts between journal and ledger entries.
f The depreciation policy is unknowable from the financial statements.

Instructor guide:
(a) Completeness, existence
(b) Occurrence
(c) Classification
(d) Accuracy
(e) Valuation, rights and obligations
(f) Original sources, valuation.

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