Materiality

06/02/2010

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Materiality
I use the following analogy to explain the auditor’s preliminary judgment of materiality.

“Imagine this desk in the front of the room is a pile of sand. And imagine I tell you there are one or more bowling balls buried in the sand. Your assignment is to tell me how many bowling balls there are. What tools would you use and how long would it take you to find all the bowling balls?” Students answer that using a rake they could find all the bowling balls within a couple of minutes.

“Now imagine this pile of sand contains one or more dimes and your job is to tell me how many dimes there are.” Students realize they would have to sift through the entire pile of sand teaspoon by teaspoon and the task would take many hours. The size of the item being sought affects the tools chosen and the time necessary to complete the search.

In the same way, the auditor’s preliminary judgment of materiality affects both the nature of the tests performed and the time that must be budgeted. During planning, auditors decide if they are looking for “bowling balls” (misstatements of $1 million or more) or “dimes” (misstatements of $5,000 or more).

Articles:
“Revisiting Materiality,” Willie Gist & Trimbak Shastri, CPA Journal (November 2003): 60-63. Describes how auditors apply the concept of materiality during planning, when determining sample sizes, and when evaluating misstatements.

“Current Materiality Guidance for Auditors,” Thomas McKee & Aasmund Eilifsen, CPA Journal (July 2000): 54-57. Describes common quantitative approaches for determining an overall preliminary judgment of materiality and for determining tolerable misstatements for individual account balances. 

Research Studies:
“Measuring Stockholder Materiality,” S-Y Cho, R.L. Hagerman, S. Nabar & E.R. Patterson, Accounting Horizons (Supplement 2003): 63-76. Based on stock price fluctuations surrounding earnings announcements, differences in earnings as small as 0.2 percent of pretax income can influence stock market reactions.

“The Effect of Misstatements on Decisions of Financial Statement Users: An Experimental Investigation of Auditor Materiality Thresholds,” Brad Tuttle, Maribeth Coller & R. David Plumlee, Auditing: A Journal of Practice & Theory (March 2002): 11-27. Based on behavior of undergraduate students participating in an experimental market, financial statement misstatements equal to or less than 10% of net income do not appear to affect prices investors are willing to pay for securities.

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Audit Risk

06/02/2010

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Audit Risk

Auditors should be able to look at a client’s industry, business operations, assets, and internal controls, and make reasonable judgments about where material misstatements are most likely to occur in the financial reporting process. I believe case studies are the best way to try to teach such higher-order thinking skills. Fortunately, the accounting education journals contain several good case studies that require students to predict which accounts are most likely to be materially misstated. My personal favorite among the cases listed below is “Northern Frontier Park” by Fred Phillips and Roger Martin. 

I always assign my students to read Jonathan Weil’s Wall Street Journal article (3/25/04) because it points out what happens if auditors don’t assess risks properly – they waste all their time testing the wrong accounts.

Articles:
“Guidance on Auditing High-Risk Clients,” Jill D’Aquila, Kim Capriotti, Robert Boylan and Ruth O’Keefe, CPA Journal (October 2010): 32-37. This article describes several audits in which auditors failed to respond appropriately to identified audit risks. The article identifies factors that contribute to high audit risk and steps auditors can take to reduce audit risk.

“New Auditor Risk-Assessment Guide,” Thomas Weirich & Alan Reinstein, Journal of Corporate Accounting & Finance (May/June 2009): 27-36. This article summarizes the seven auditing standards proposed by the PCAOB in October 2008. The new standards address audit risk, planning and supervision, materiality, audit evidence, and evaluating audit results.

“Understanding the Changes in Risk Assessment Standards,” Ronald Clark, CPA Journal (July 2009): 48-51. A good overview of the “Risk Assessment Suite” of Statements on Auditing Standards Nos. 104-111.

“Behind Wave of Corporate Fraud: A Change in How Auditors Work,” Jonathan Weil, Wall Street Journal (March 25, 2004): A1+A14. This article asserts that many audit failures occur because auditors do not correctly identify the high-risk accounts and transactions.

Cases:
“Waste is Our Business, Inc.: The Importance of Non-financial Information in the Audit Planning Process,” Jeffrey Cohen, Ganesh Krishnamoorthy & Arnie Wright, Journal of Accounting Education (September 2008): 166-178. Students must consider both financial and non-financial performance measures to identify account balances with high risk of material misstatement.

“Assessing Audit and Business Risks at Toy Central Corporation,” Christine Earley & Fred Phillips, Issues in Accounting Education (May 2008): 299-307. Students must evaluate the business risks and accounting issues facing a toy manufacturer and determine how these matters will translate into assertion-specific audit risks.

“Aerospace Lighting, Inc. (ALI): Linking Business Strategy to Audit Planning,” Roger D. Martin & Fred Phillips, Issues in Accounting Education (August 2006): 313-321. Students must identify the business risks and potential audit issues at an aerospace company.

“Instructional Case: Northern Frontier Park,” Fred Phillips & Roger D. Martin, Issues in Accounting Education (November 1998): 1005-1018. Students must identify the high risk accounts of a wildlife preserve that is about to be sold by existing shareholders to the entity’s CFO.

Research Studies:
“Inherent Risk,” C.W. Houghton & J.A. Fogarty, Auditing: A Journal of Practice & Theory (Spring 1991): 1-21. Based on review of 480 Deloitte audits in 1984, material misstatements are most likely to occur in non-systematically processed transactions (e.g., year-end accruals, financing leases, mergers and acquisitions) and in accounts that were materially misstated in the prior year.
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Client Investigation & Acceptance

06/02/2010

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Client Investigation & Acceptance
“At Deloitte & Touche, the word went out last June that audits of IPOs had to be O.K.’d by the firm’s head office.  D&T … declined to audit about 60 companies trying to go public last year, more than half the 103 IPOs they actually evaluated.” (Business Week, March 1, 1993)

After displaying the above quotation on the screen, I ask the students why D&T would turn away 60 companies who were interested in buying D&T’s services. Most of the students are aware that public accounting is a competitive business and partners work hard to attract new clients. The following articles and cases help students understand the risks involved in auditing a new client and the procedures auditors follow to assess those risks before accepting an engagement.

Articles:
“Beware: Precautions for Accepting Retention as a Successor Auditor,” Jennifer Beltrami, CPA Journal (December 2011). This article describes procedures to perform before accepting a new audit client.

“Client Acceptance: What to Look for and Why,” John Hardy and Larry Deppe, CPA Journal (May 1992): 20-27. Although a few years old, this article contains a good discussion of issues to consider before accepting a new audit client and includes a nice checklist of items to include in a client acceptance memorandum.

“The New Standard on Predecessor Successor Communications,” Kay Tatum and Paul Munter, CPA Journal (April 1998): 47-53. This article describes the requirements of SAS No. 84 – Communications Between Predecessor and Successor Auditors.

“More Accounting Firms Are Dumping Risky Clients,” Elizabeth MacDonald, Wall Street Journal (April 25, 1997): A2. Big Six firms are resigning from risky clients and doing more thorough background checks on new clients.

Cases:
“Vinand Petroleum, Inc.: Initial Audit Engagement and Fraud Risk Case for a Specialized Industry,” Vincent Owhoso & Andrea Weickgenannt, Issues in Accounting Education (May 2010): 331-346. Students must identify the risks associated with accepting an engagement to audit an oil and gas company.

“Famous Presidents Savings: Client Acceptance and Retention,” Stanley Earl Jenne, Issues in Accounting Education (November 1999): 657-674. Students must decide whether to accept and then retain an engagement to audit a relatively high-risk savings and loan client.
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Analytical Procedures

06/02/2010

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Analytical Procedures

Although analytical procedures are required during the final stage of the audit and are often used as substantive tests, I prefer to talk about analytical procedures when I teach audit planning. During planning, auditors should develop expectations about significant account balances. Recorded balances that differ materially from the auditor’s expectations are not necessarily misstated, but should receive extra attention during fieldwork. The MiniScribe case by Green & Calderon is my favorite among the cases listed below. The Hirst & Koonce CAR article is good for master’s students.


Articles:
“The Use of Analytical Procedures,” Edward Blocher and George Patterson, Journal of Accountancy (February 1996): 53-55. Good description of the three uses of analytical procedures: in planning, as a substantive test, and during final review.

“When Judgment Counts,” Timothy Bell & Arnie Wright, Journal of Accountancy (November 1997): 73-77. Describes three potentially serious judgment problems – allowing unaudited account balances to influence expectations, not fully considering the pattern reflected by multiple unexpected fluctuations, and placing undue reliance on unsubstantiated management explanations.

“Analytical Procedures: A Defensive Necessity,” Frank Coglitore & R. Glen Berryman, Auditing: A Journal of Practice & Theory (Spring 1988): 150-163. Based on a review of SEC enforcement actions, describes many examples of financial statement misstatements that might have been detected through proper use of analytical procedures.

Cases:
“Comptronix, Inc.: An Audit Case Involving Fraud,” James Boockholdt, Issues in Accounting Education (February 2000): 105-128. Students calculate financial statement ratios and use industry comparisons to discover that a high-tech audit client is understating expenses and overstating assets.

“Lakeview Lumber, Inc.: A Study of Auditing Issues Related to Fraud, Materiality and Professional Judgment,” Deborah Lindberg, Issues in Accounting Education (August 1999): 497-515. Students use common-size statements, ratios, and industry comparisons to identify unusual account fluctuations in the financial statements of a home improvement store.

“Style, Inc.” Sally Wright, Issues in Accounting Education (November 1998): 1059-1077. Students analyze the financial statements and key operating statistics of a retail department store chain to identify four embedded misstatements.

“Using Real-World Cases to Illustrate the Power of Analytical Procedures,” Brian Patrick Green & Thomas Calderon, Journal of Accounting Education (1994): 245-268. This case presents MiniScribe’s 1982-1987 financial statements and requires students to perform analytical procedures to detect evidence of fraud.

Relevant Research:
“Can Financial Ratios Detect Fraudulent Financial Reporting?” K.A. Kaminski, T.S. Wetzel & L. Guan, Managerial Auditing Journal (2004): 15-28. Examines 21 financial ratios of 79 firms who committed fraud and a matched sample of non-fraud firms. The ratios have limited ability to distinguish the fraud firms from the non-fraud firms.

“Audit Analytical Procedures: A Field Investigation,” Eric Hirst & Lisa Koonce, Contemporary Accounting Research (Fall 1996): 457-486. A field study, based on interviews with 36 Big Six auditors, describing how auditors use analytical procedures at the planning, substantive testing, and overall review stages of the audit.

 
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Financial Statement Assertions

06/02/2010

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Financial Statement Assertions

I like to explain auditing in terms of financial statement assertions because the assertions provide a structured framework for thinking about auditing. There are only three things that can cause an account balance to be misstated: (1) the account contains entries that don’t belong in it, (2) the account is missing items that should be recorded in it, or (3) entries have been recorded at improper amounts. Testing an account balance, therefore, requires verifying that each recorded transaction occurred and belongs in the account (existence or occurrence), searching for omitted items that should be recorded in the account (completeness), and testing whether the entries have been recorded for the proper dollar amounts (valuation or allocation). 

My students often confuse tests of existence with tests of completeness. The exercise described in the Spring 2007 Auditor’s Report helps clarify the difference.

Articles:
“Financial Statement Assertions,” Paul M. Clikeman, Internal Auditor (April 2004): 23-25. This article uses the inventory account to demonstrate substantive audit procedures to test existence (or occurrence), completeness, valuation (or allocation), rights (or obligations), and presentation and disclosure.

Classroom Activities:
“A Five-Minute Demonstration of Assertion-Based Auditing,” Paul M. Clikeman, The Auditor’s Report (Spring 2007). This five-minute class exercise uses an analogy based on a textbook’s table of contents to explain existence, completeness, and valuation.
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