Determination of Materialist in Auditing & Assurance

Auditing & Assurance

Questions link  -

Response to Question 1:

The case informs that in the year which started on July 01, 2016 and ended on June 30, 2017, DIPL acquired NPL thanks to the value of the copyrights NPL held over a variety of medical textbooks. While the potential demand for these was not very high, each textbook had been in usage in universities around the work for years and entailed a high margin of profits. In the last month of this 12-month period (i.e. in June 2017), an article in a medical journal on some new theory expressed concerns about the said medical textbooks becoming out of date. If this new theory were to hold true, the viability of these medical textbooks as e-books would be in question. This is because in future these medical textbooks would more likely than not stop getting printed and be discontinued for use at universities. Given this situation, it is considered appropriate that the copyrights linked to the said medical textbooks be subject to a valuation exercise to determine any write-downs required due to any impairment loss i.e. loss in the value of the copyrights. However, since copyrights are intangible assets, their valuation is not something the auditor would necessarily possess an expertise in. The background of the given case, therefore, makes it clear that there is a necessity of using the work of an expert in the 2017 audit of the company.

Response to Question 2 (a): 

The preliminary figure for overall materiality is the maximum figure the financial statements can be misstated by without affecting any reasonable user’s decision. Factors that affect the determination of preliminary figure for overall materiality include, at the minimum, the following:
  • Materiality
  • Benchmarks that go into evaluation of materiality
  • Qualitative factors that influence materiality decisions
  • Distribution (whether wide or otherwise) to users of financial statements
  • Acceptable audit risk levels

Response to Question 2 (b): 

The factors identified in (a) above are relevant to the calculation of the preliminary amount of overall materiality because of reasons provided below:
  • Materiality is a relative concept and not an absolute concept and there are many users of financial statements. This calls for an assessment of who the likely users of the financial statements are expected to be and what decisions they will likely be making by reviewing the financial statements. Any decision by them gone wrong because of material misstatements in the financial statements could lead them into financial losses.
  • Benchmarks assume importance in the determination of materiality or otherwise of misstatements. Thus, in the audit of a manufacturing company, an auditor may want to employ working capital or current assets or income before taxes as the benchmark. 
  • Qualitative factors are important because certain misstatements will concern financial statement users more than certain other misstatements, even when the amounts of these misstatements would be equal. For instance, an error (unintentional) in posting cash receipts less by $500 may concern a financial statement user less than a fraudulent act (intentional) of posting cash receipts less by the same amount i.e. $500. Similarly, those misstatements which seem immaterial prima facie may actually become important if they are in a position to turn a profit figure into a loss figure or a loss figure into a profit figure.
  • A wider base of financial statement users would necessitate that the preliminary figure for overall materiality be set lower than if the base of financial statement users was not wide. In other words, if the financial statements were to be distributed to many number of users, there would likely be a larger number of decisions based on those financial statements and it would make sense to even misstatements that seem to be of low materiality are detected because whatever is of low materiality to one user may be of high materiality to another user.
  • Levels of acceptable audit risk are closely related with the degree of reliance placed by financial statement users on the financial statements audited. Thus, when financial statement users place heavy reliance on the financial statements, the auditors must keep the acceptable audit risk levels low. 

Response to Question 2 (c): 

  • Materiality cannot be applied with ease in practical situations or real life. So, if materiality is not established at appropriate amounts, the preliminary figure for overall materiality will not be an ideal preliminary figure.
  • Benchmarks will determine what amounts of specific factors of a company under audit will go into the determination of preliminary figure for overall materiality. 
  • Qualitative factors are important because often factors other than financial factors have a bearing on the degree of misstatements (whether intentional or unintentional) that can occur in the financial statements. Thus, the higher the number of qualitative factors that is negative, the lower would be the preliminary figure for overall materiality.
  • The wider the distribution of financial statements among users, the lower the preliminary figure for overall materiality should be, and vice versa.
  • The higher the placement of reliance on financial statements, the lower would be the preliminary figure for overall materiality, and vice versa. 

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