8-4 The preliminary asessment of materiality is the dollar amount the auditor

believes the financial statements could be misstated and still not affect the
decision to issue an unqualified audit report. The assessment is made to
determine an appropriate quantitative level of materiality for audit planning and
strategies. Several factors affect the preliminary judgment about materiality and
are as follows:
1 . Materiality is a relative rather than an absolute concept.
2. ases are needed for evaluating materiality.
!. "ualitative factors will affect materiality decisions.
#. $%pected dissemination of the financial statements will affect the
preliminary assessment of materiality. &f the financial statements are
widely distributed to a large number of users 'e.g. for a publicly listed
company() the preliminary assessment of materiality will probably be
set lower than if the financial statements are not e%pected to be
widely disseminated 'e.g. for a small proprietary company(.
* . The level of audit ris+ which the auditor considers acceptable will
also affect
the preliminary assessment of materiality.
8-7 , preliminary assessment of materiality is set for the financial statements as
a whole. Tolerable error 'misstatement( is the ma%imum amount of error that
would be considered immaterial for an individual account balance. The amount of
tolerable error for any given account is dependent upon the preliminary estimate
of materiality. -rdinarily) tolerable error for any given account would have to be
lower than the preliminary estimate of materiality. &n many cases) it will be
considerably lower because of the possibility of errors in different accounts
which) in total) cannot e%ceed the preliminary assessment about materiality.
8.9.igger /ineries is the client with the greater inherent ris+ for the following
reasons:
Comments on Big Deal Trailers:
The company manufactures to order and has only a small
amount of inventory.
They produce a standard line of trailers with only two major
models. &nventory counting would be relatively
uncomplicated.
-ne off trailers are made to specification 0 and these could
be easily traced to customer orders.
,cordingly there do not appear to be many ris+s apparent from the information
provided.
Comments on Digger Wineries:
The company is involved in the e%port mar+et) adding a
number of ris+s including &nternational competition) foreign
e%change issues) more comple%ity in recording etc.
&nventory is specialised and wine is stored in vats. $%perts
would need to be involved to ensure that wine is properly
identified) described and measured.
ottled wine 0 the accumulation of costs to determine
inventory values for bottled wine and cas+ wine is li+ely to be
comple%.
1aluation of grapes on the vine requires specialist e%pertise.
There are numerous categories of inventory adding
comple%ity to the inventory recording process 0 wine in vats)
a broad range of bottled wines) cas+s) wor+ in progress)
pac+aging) and grapes on the vine.
&nventory spoilage would be an issue.
&t seems that the li+elihood of misstatement in inventory in .igger /ines without
considering internal controls 'i.e. inherent ris+( would be much higher than that of
ig .eal Trailers.
8-11 The audit ris+ model is as follows 'refer ,S, 222 and ,S, !1* for
3technical4 definitions(:
PDR 5 AAR
IR % CR
/here PDR 5 6lanned detection ris+
AAR 5 ,cceptable audit ris+
IR 5 &nherent ris+
CR 5 7ontrol ris+
Planned detection risk: , measure of the ris+ that audit evidence for a
segment will fail to detect misstatements that could be material) should
such misstatements e%ist.
Acceptable audit risk: , measure of how willing the auditor is to accept that
the financial statements may be materially misstated after the audit is
completed and an unqualified opinion has been issued.
Inherent risk: , measure of the auditor8s assessment of the li+elihood that
there are material misstatements in a segment before considering the
effectiveness of internal control.
Control risk: , measure of the auditor8s assessment of the li+elihood that
misstatements e%ceeding a tolerable amount in a segment will not be
prevented or detected by the client8s internal controls.
8-12 6lanned detection ris+ ',S, 222( is the ris+ the auditor is willing to ta+e
that the audit evidence accumulated by the auditor will not detect material errors
in the financial statements. /hen planned detection ris+ is increased from
medium to high) the amount of evidence the auditor accumulates is reduced.
This movement in 6.9 may result from assessments of low &9 and 79) or a
change in ,,9. 7onversely) an increase in planned detection ris+ may be caused
by an increase in desired audit ris+ or a decrease in either control ris+ or inherent
ris+.
8-13 &nherent ris+ ',S, 222( is the susceptibility of an account or class of
transactions to material misstatement) before considering the effectiveness of
relevant internal controls. &nstructors may refer to ,S, !1* ,ppendi% ! 'and
perhaps ,ppendi% 1 also( for e%amples of inherent ris+s that may arise in an
audit.
:actors affecting assessment of inherent ris+ include:
;ature of the client8s business
9esults of previous audits
&nitial vs. repeat engagement
9elated parties
;on<routine transactions
=udgment required to correctly record transactions and
Ma+eup of the population
8-16 ,cceptable audit ris+ is a measure of how willing the auditor is to accept
that the financial statements are may be materially misstated after the audit is
completed and an unqualified opinion has been issued. ,cceptable audit ris+ has
an inverse relationship to evidence. &f aceptable audit ris+ is reduced) planned
evidence should increase.
8-34
a.
MAJOR CONCERNS
a.
REASONS FOR CONCERN
b.
INVESTIGATION
APPROACH
1. right 7hemicals >td
is a publicly traded
company.
>ow acceptable audit ris+ is
associated with public
shareholders and governmental
regulating agencies.
;?,
2. :irst<year audit. @nfamiliarity with the company)
its operations) and its previous
history.
Thorough research into the
previous history of the company)
review of the audit schedules
prepared on previous
engagements by the predecessor
auditors) discussion with the
members of the previous audit
team) and thorough
documentation and analysis of the
company8s internal controls.
!. 9elationship with
previous auditors
was severed over
accounting disputes.
,ttempt by management to
improperly value inventory and
record cut<off transactions
improperly 'i.e.) as they had
done in the previous year(.
Thorough discussion with
previous auditors and client
personnel as to the nature of
these disputes) the handling of
these items) and the effect on the
current year.
#. The company has
prospered even
though its industry
as a whole has
suffered dramatic
setbac+s in recent
years.
;ormally companies follow the
trends of their industry. The
company8s prosperity could
indicate misrepresented
financial statements or a
downturn several years after the
industry8s e%perience.
Aou should be more s+eptical than
usual and you should be
especially alert to signs of a
downturn in business or possible
fraudulent financial reporting.
*. $%ecutives receive
relatively low
salaries with a high
proportion of income
resulting from an
unusually generous
profit< sharing plan.
,ggressive e%ecutives reliant on
profit sharing for higher incomes
have an unusually high
motivation to create large profits
for the companyB in fact) their
e%istence depends on it.
Aou should be especially alert for
the possibility of income
generating transactions that are
improper. Aou should develop
audit procedures to test revenue
transactions in detail.
C. The accounting
records for the
company are not
highly sophisticated.
The audit trail and the support
for transactions may be
none%istent or difficult to
achieve.
Aou should be deliberate in your
e%amination of detailed
transactions. >ac+ of support for
transactions should not be
tolerated.
8-34 (c!"#!$%&'
a.
MAJOR CONCERNS
a.
REASONS FOR CONCERN
b.
INVESTIGATION
APPROACH
D. The personnel in the
accounting
department are
being overwor+ed
and underpaid
relative to other
employees.
These employees may not be
motivated to achieve accurate
recording of transactions or to
assure that the proper internal
controls are enforced.
Aou should be deliberate in your
e%amination of detailed
transactions. >ac+ of support for
transactions should not be
tolerated.
E. The company
recently installed a
sophisticated
computer system.
6art of the audit trail may have
disappeared with the use of the
computer) and control over the
entry of transactions may no
longer rest with the accounting
department.
Aou must perform a review of the
computer and properly audit the
transactions through or around
the computer.
F. The new computer
system was not run
in parallel before
implementing the
new system and
discarding the old
one.
Systems that are not properly
tested may result in system
errors or unforeseen
programming problems.
@nreliable accounting systems
is an inherent ris+.
, detailed review of the system
conversion) and a computer audit
review of controls in the new
system should be underta+en.
12. The first si% months8
profit decreased by
only 12G from the
previous year even
though the volume
was reduced
significantly and a
segment of the
business was
disposed of.
The reduction in volume and
disposal of the segment
normally would have produced a
more dramatic drop in profits.
Aou should investigate the
statistics) obtain a reasonable
e%planation of this situation) and
perform proper audit procedures
to verify the e%planation you
receive. ,S, *22
11. Mercury Supplies)
which was
purchased from ert
9andolph8s brother
as an attractive
acquisition several
years ago) has been
an unprofitable
segment. Most of
the sales of Mercury
Supplies were to
another company
which ert
9andolph8s brother
also owns. ,fter the
purchase of Mercury
Supplies) Saturn
Holdings
discontinued its
purchases from
Mercury Supplies
&f transactions were definitely
non<arm8s<length) there appears
to have been potential for a
fraud against right 7hemicals.
The profits of Mercury Supplies
prior to the purchase may have
been inflated because most of
its sales were to a related
company. The sale of Mercury
Supplies during the year could
have been another non<arm8s<
length transaction with the
potential for fraud.
Aou should investigate the original
purchase of Mercury Supplies and
attempt to establish the
reasonableness of the financial
statements of Mercury Supplies at
the time of the original purchase.
&f possible) you should verify the
reasonableness of the
transactions between Mercury
Supplies and Saturn Holdings
prior to the purchase of the
company by right 7hemicals. &n
addition) you should investigate
the sale of Mercury Supplies
during the current year to
determine if the sales agreement
is reasonable under the
circumstances.
8-34 (c!"#!$%&'
a.
MAJOR CONCERNS
a.
REASONS FOR CONCERN
b.
INVESTIGATION
APPROACH
12. Saturn Holdings
buys a large volume
of its products from
right 7hemicals
Transactions between Saturn
Holdings and right 7hemicals
are non<arm8s<length and could
be tainted with fraud.
Aou should investigate the terms
of the sales between right and
Saturn Holdings to determine that
they are consistent with terms
available in the mar+et.
1!. There is a pending
legal case arising
from employee
health problems at
one of the chemical
plants.
The case will need to be
properly disclosed in the
financial statements if not settled
before balance date.
, solicitor4s lertter shoul d be sent
at year end to determine the
nature of the litigation and its
possible outcome and impact on
te cmpany.6roper disclosure must
be made.
1#. :inancial analysts
believe that right is
severely under<
financed.
Such underfinancing could lead
to financial difficulties and
possible ban+ruptcy for the
company.
The auditor should consider
sources of financing available to
the company and determine
whether or not disclosure should
be made of the difficulties
associated with the company8s
financing problems.