Anne Aylor Inc.
A. Why are different materiality bases considered when determining planning materiality?
Different materiality bases are considered when determining planning materiality because the magnitude and nature of financial statement misstatements or omissions have different influences on different financial statement users. For example, investors are more interested in the accuracy of numbers involving net income because they are mainly concerned with the company’s ability to increase shareholder wealth. For an audit company, the primary concern when planning materiality is to take into account all expected financial statement users. These different expected users all have different concerns in regards to where financial statements contain misstatements. Debtors such as banks who provide loans to help companies like Anne Aylor raise capital are mainly concerned with company’s maintaining debt covenants involving current assets. Anne Aylor has a debt covenant to maintain a current ratio over 2.0, which according to the company’s projected 2012 balance sheet, will not be met. These debtors are more concerned with Anne Aylor overstating assets or understating liabilities in order to meet these debt covenants and avoid potential interest rate changes.
B. Why are different materiality thresholds relevant for different audit engagements?
Different materiality thresholds are relevant for each audit engagement because various industries contain more risk than others. Also, certain companies have varying amounts of risk due to their history of past misstatements and past year’s financial health of the company. For example, Smith & Jones uses different tolerable misstatement percentage thresholds that are based solely on the likelihood of management committing fraud. Donna Fontain, through conducting preliminary analysis has determined that risk of management fraud to be low, therefore according to our standards tolerable misstatement should be set to 75% of planning materiality. Also, debt covenants play a large part in determining materiality thresholds. Anne Aylor is in danger of violating its debt covenant by not maintaining the minimum current ratio of 2.0. In a situation such as this, a smaller planning materiality should be used in regards to current assets and current liabilities. Smith & Jones would lower the materiality threshold for these accounts to provide reasonable assurance that these accounts have not been artificially adjusted to help the company meet these requirements. Another reason for different materiality thresholds in different audit engagements is a company’s performance in comparison to its competitors. For example, a large misstatement for a company such as Wal-Mart causes far less concern than a large misstatement in a local retail store. Anne Aylor is a publicly traded company with over a billion dollars in net sales; therefore misstatements must be relatively large to significantly affect financial statement users’ opinions.
C. Why is the materiality base that results in the smallest threshold generally used for planning purposes? Audit firms determine the amount of testing they must perform based on the materiality base and the risk of the industry. For planning purposes, an audit firm wants to assume the maximum amount of testing that could be necessary in an effort to make sure they allocate enough time and resources to perform the audit. Also, planning materiality needs to be based on the smallest amount established from relevant materiality bases to provide reasonable assurance that the financial statements, taken as a whole, are not materially misstated for any user according to Smith & Jones policy statement. An auditor’s role in setting materiality is to obtain reasonable assurance that the financials are free of material misstatement. This being said reasonable assurance will not be met if the...
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