In general, how do auditors develop an estimate of financial statement materiality? For Auto Parts, Inc., what is your estimate of financial statement materiality? Are there qualitative factors that might impact your decision about the materiality of the accounting treatment and the related disclosure?

Question

What will be an ideal response?

Answer 1

A misstatement in the financial statements is commonly considered material if knowledge of
the misstatement would affect the decision of a reasonable user of the financial statements. The
determination of materiality requires professional judgment. While professional standards provide
relatively little specific guidance on how to assess what is material to a reasonable user, auditing firms have developed policies and procedures to assist auditors. These policies and procedures
often suggest that the auditors apply a percentage to various bases (e.g., net income before tax,
total assets, total revenues, etc.). Because materiality is a relative rather than an absolute concept,
the materiality assessment for one client may differ significantly from that of other clients of
similar size. Student assessments of materiality will likely differ. In the SEC’s Staff Accounting
Bulletin (SAB) No. 99 the staff specifically mention a 5% threshold and indicate they have, “no
objection to such a ‘rule of thumb’ as an initial step in assessing materiality.” Academic research
confirms that 5% of net income before tax represents a generally accepted upper bound for
public companies.1

For private companies, research suggest the upper bound is around 10%.
For the current year audit of Auto Parts, this rule of thumb would yield an estimate of planning
materiality of approximately $300,000 ($6 million X 5%). Based purely on a quantitative analysis,
it appears that the amount of tooling inventory in question (the $300,000 recorded as an asset)
falls very near to the materiality threshold of 5%.
When we discuss question #4 we normally will come back to question #2, or combine our
discussion of questions #2 and #4 as we discuss qualitative factors in question #2. Several qualitative
factors would (and did in the actual case) influence the auditor’s assessment of materiality. While the
SEC staff do not object to percentage thresholds, they also warn, “quantifying, in percentage terms, the
magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately
be used as a substitute for a full analysis of all relevant considerations. The staff reminds registrants and
the auditors of their financial statements that exclusive reliance on this or any percentage or numerical
threshold has no basis in the accounting literature or the law.” The following list identifies some of the
qualitative factors:
? Degree of misstatement. The policy change implemented in 2018 will also not result in a
misstatement in 2018 and any correction to 2017 would be very slight. In fact, the change in
accounting policy results in a better treatment of tooling supplies in the most recent financial
statements. Given that net income is not misstated, the auditor faces an issue that involves a matter
of presentation and disclosure.
? Impact on trends. Auto Part’s earnings per share have steadily increased over the past five years
with a cumulative return of 140% over that period. Capitalizing on-hand supplies and not
disclosing the accounting change will suggest a pretax earnings growth of 20% [($6,000,000-
5,000,000)/$5,000,000] while capitalizing and disclosing the accounting change may suggest
a pretax earnings growth of approximately 13.4% [($6,000,000-5,000,000-330,000))/
[5,000,000]).2

Additionally, capitalizing and not disclosing the accounting change will suggest a
return on assets of 11.7% ($6,000,000/[($47,000,000 + $56,000,000]) /2]) while capitalizing
and disclosing the change may suggest a return on assets of 11% ($6,000,000-$330,000/
[($47,000,000+$56,000,000-$330,000) /2]). Auto Part’s will show an impressive pretax earnings
growth whether the accounting change is disclosed. The impact of the disclosure on Auto Part’s
return on assets is minimal.
? Client’s justification. Auditors are always concerned about the underlying motivation in a proposed
change, particularly when it results in an increase in net income. If the auditor believes that the
client is making the change for the “wrong” reasons (i.e., improve earnings trend instead of to better
comply with the matching principle) then they might use a lower assessment of audit materiality
with respect to the policy change in question. To assess the client’s motivation, the auditors would
consider things such as the effect of the change on the client’s trend in reported earnings. In the
Auto Parts case, there may be a concern that management wants to continue to report high earnings
growth. If, for example, a new accounting policy would change the current year earnings from a negative trend to a positive trend, the auditors may consider reducing the level of audit materiality
with respect to the policy. As previously noted, disclosure of the policy change will not significantly
affect the earnings trend.
? Management Integrity/Audit History. In a situation like Auto Parts where the client has expressed a
preference that may conflict with the auditor’s preference, auditors carefully consider management
integrity and the client-auditor relationship extended over several previous audit engagements. If,
over time, an audit client has been confrontational and aggressive, then this policy change may be
symptomatic of a larger problem. This may encourage the auditor to take a “hard line” on such issues
and use a lower materiality assessment. Alternatively, if (1) the auditor-client relationship has been
positive, (2) similar issues have not been common in prior year engagements, and (3) the auditor
believes that management has a high degree of integrity, then the auditor would certainly take these
factors into consideration when assessing the degree of materiality associated with an accounting
policy change. In the actual case, the auditors had a positive history with the client, and the auditors
believed management possessed a high degree of integrity.
Other qualitative factors students may include:
whether the misstatement arises from an item capable of precise measurement or whether it
arises from an estimate and, if so, the degree of imprecision inherent in the estimate
whether the misstatement hides a failure to meet analysts’ consensus expectations for the
enterprise
whether the misstatement affects the registrant’s compliance with loan covenants or other
contractual requirements
whether the misstatement has the effect of increasing management’s compensation - for example,
by satisfying requirements for the award of bonuses or other forms of incentive compensation