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

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.Bases are needed for evaluating materiality.

3. Qualitative factors will affect materiality decisions.

4.Expected dissemination of the financial statements will affect the preliminary assessment of materiality. If 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 expected to be widely disseminated (e.g. for a small proprietary company).

5 . The level of audit risk which the auditor considers acceptable will also affect

the preliminary assessment of materiality.

8-7

A preliminary assessment of materiality is set for the financial statements as a whole. Tolerable error (misstatement) is the maximum 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. Ordinarily, tolerable error for any given account would have to be lower than the preliminary estimate of materiality. In many cases, it will be considerably lower because of the possibility of errors in different accounts which, in total, cannot exceed the preliminary assessment about materiality.

8-9 Digger Wineries is the client with the greater inherent risk 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. Inventory counting would be relatively uncomplicated.

One off trailers are made to specification and these could be easily traced to customer orders.

Acordingly there do not appear to be many risks apparent from the information provided.

Comments on Digger Wineries: The company is involved in the export market, adding a number of risks including International competition, foreign exchange issues, more complexity in recording etc.

Inventory is specialised and wine is stored in vats. Experts would need to be involved to ensure that wine is properly identified, described and measured. Bottled wine the accumulation of costs to determine inventory values for bottled wine and cask wine is likely to be complex. Valuation of grapes on the vine requires specialist expertise. There are numerous categories of inventory adding complexity to the inventory recording process wine in vats, a broad range of bottled wines, casks, work in progress, packaging, and grapes on the vine. Inventory spoilage would be an issue.It seems that the likelihood of misstatement in inventory in Digger Wines without considering internal controls (i.e. inherent risk) would be much higher than that of Big Deal Trailers.8-11 The audit risk model is as follows (refer ASA 200 and ASA 315 for technical definitions):

PDR = AAR

IR x CR

Where PDR=Planned detection risk

AAR=Acceptable audit risk

IR=Inherent risk

CR=Control risk

Planned detection risk: A measure of the risk that audit evidence for a segment will fail to detect misstatements that could be material, should such misstatements exist. Acceptable audit risk: A 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: A measure of the auditor's assessment of the likelihood that

there are material misstatements in a segment before considering the effectiveness of internal control.

Control risk: A measure of the auditor's assessment of the likelihood that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the client's internal controls.

8-12 Planned detection risk (ASA 200) is the risk the auditor is willing to take that the audit evidence accumulated by the auditor will not detect material errors in the financial statements. When planned detection risk is increased from medium to high, the amount of evidence the auditor accumulates is reduced. This movement in PDR may result from assessments of low IR and CR, or a change in AAR. Conversely, an increase in planned detection risk may be caused by an increase in desired audit risk or a decrease in either control risk or inherent risk.

8-13 Inherent risk (ASA 200) is the susceptibility of an account or class of transactions to material misstatement, before considering the effectiveness of relevant internal controls. Instructors may refer to ASA 315 Appendix 3 (and perhaps Appendix 1 also) for examples of inherent risks that may arise in an audit.

Factors affecting assessment of inherent risk include:

Nature of the client's business

Results of previous audits

Initial vs. repeat engagement

Related parties

Non-routine transactions

Judgment required to correctly record transactions and

Makeup of the population

8-16 Acceptable audit risk 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. Acceptable audit risk has an inverse relationship to evidence. If aceptable audit risk is reduced, planned evidence should increase.

8-34

a.

MAJOR CONCERNSa.

REASONS FOR CONCERNb.INVESTIGATIONAPPROACH

1.Bright Chemicals Ltd is a publicly traded company.Low acceptable audit risk is associated with public shareholders and governmental regulating agencies.N/A

2.First-year audit.Unfamiliarity 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 company's internal controls.

3.Relationship with previous auditors was severed over accounting disputes.Attempt 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.

4.The company has prospered even though its industry as a whole has suffered dramatic setbacks in recent years.Normally companies follow the trends of their industry. The company's prosperity could indicate misrepresented financial statements or a downturn several years after the industry's experience.You should be more skeptical than usual and you should be especially alert to signs of a downturn in business or possible fraudulent financial reporting.

5.Executives receive relatively low salaries with a high proportion of income resulting from an unusually generous profit- sharing plan.Aggressive executives reliant on profit sharing for higher incomes have an unusually high motivation to create large profits for the company; in fact, their existence depends on it.You should be especially alert for the possibility of income generating transactions that are improper. You should develop audit procedures to test revenue transactions in detail.

6.The accounting records for the company are not highly sophisticated.The audit trail and the support for transactions may be nonexistent or difficult to achieve.You should be deliberate in your examination of detailed transactions. Lack of support for transactions should not be tolerated.

8-34(continued)a.

MAJOR CONCERNSa.

REASONS FOR CONCERNb.INVESTIGATIONAPPROACH

7.The personnel in the accounting department are being overworked 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.You should be deliberate in your examination of detailed transactions. Lack of support for transactions should not be tolerated.

8.The company recently installed a sophisticated computer system.Part 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.You must perform a review of the computer and properly audit the transactions through or around the computer.

9. 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. Unreliable accounting systems is an inherent risk.A detailed review of the system conversion, and a computer audit review of controls in the new system should be undertaken.

10.The first six months' profit decreased by only 10% 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.You should investigate the statistics, obtain a reasonable explanation of this situation, and perform proper audit procedures to verify the explanation you receive. ASA 520

11.Mercury Supplies, which was purchased from Bert Randolph's 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 Bert Randolph's brother also owns. After the purchase of Mercury Supplies, Saturn Holdings discontinued its purchases from Mercury SuppliesIf transactions were definitely non-arm's-length, there appears to have been potential for a fraud against Bright Chemicals. 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-arm's-length transaction with the potential for fraud.You 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. If possible, you should verify the reasonableness of the transactions between Mercury Supplies and Saturn Holdings prior to the purchase of the company by Bright Chemicals. In 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(continued)a.

MAJOR CONCERNSa.

REASONS FOR CONCERNb.INVESTIGATIONAPPROACH

12.Saturn Holdings buys a large volume of its products from Bright ChemicalsTransactions between Saturn Holdings and Bright Chemicals are non-arm's-length and could be tainted with fraud.You should investigate the terms of the sales between Bright and Saturn Holdings to determine that they are consistent with terms available in the market.

13. 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.A solicitors lertter shoul d be sent at year end to determine the nature of the litigation and its possible outcome and impact on te cmpany.Proper disclosure must be made.

14.Financial analysts believe that Bright is severely under-financed.Such underfinancing could lead to financial difficulties and possible bankruptcy 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 company's financing problems.