Auditing-Ongoing Project 5

Auditing-Ongoing Project 5

Seminar 6

a. Some common numerical thresholds and benchmarks for overall materiality judgment are 5% or net income and 1% of assets. The materiality level at which items are considered clearly trivial-a materiality level where the auditor believes errors below that level would not, even when aggregated with other misstatements, be material to the financial statements-is generally 5% to 10% of overall materiality. Calculate these numerical thresholds for Ford and Toyota, assuming 5% for misstatements considered clearly trivial.

• Ford Motor Company and Toyota Motor Company

Ford: SECTOR BALANCE SHEET DATA AT YEAR-END 2014 Total assets $ 210,443, and Net Income $3,187 is in millions. On January 1, 2014, we changed our accounting method for determining the obligation for long-term disability benefits (see Note 1). We have applied the change in accounting method retrospectively to periods covered in this Report, and the amounts below reflect this change. The following table sets forth selected financial data for each of the last five years (dollar amounts in millions, except for per share amounts): (p. 27)

Retrieved from http://corporate.ford.com/microsites/sustainability-report-2014-15/doc/sr14-form-10-k.pdf

Toyota: http://www.toyota-global.com/investors/ir_library/sec/pdf/20-F_201403_final.pdf

Overall materiality Threshold: Net income 5% & Assets 1%

Ford: Net income: 5% x 3,187,000 = 159,350

Assets: 1% x 210,443,000 = 2,104,430

Toyota: Net income: 5% x 1,823,119 = 91,156

Assets: 1% x 41,437,473 = 414,375

5% for misstatements considered clearly trivial

Ford: Net income: 5% x 159,350 = 79,675

Assets: 5% x 2,104,430 = 1,052,215

Toyota: Net income: 5% x 91,156 = 45,578

Assets: 5% x 414,375 = 20,719

b. Assume that you discover a $10,000,000 error in inventory. What difficulties would you encounter in deciding whether or not that amount was material?

The FASB Statement of Financial Accounting Concepts No. 2 defined Materiality as: “The omission or misstatement of an item in a financial report is material if, the light surrounding circumstances, the magnitude of the item is such that is probable that the judgment of a reasonable person relying on the report would have been changed or influenced by the inclusion or correction of the items.” Materiality is problematic since it requires the auditors’ professional judgement about the relative importance and effect of financial reporting and disclosures choices. (McKee & Eilifsen, 2000). Therefore the auditor should be skeptical in regards to the materiality level (Ford and Toyota) of the aggregations at which items are considered clearly trivial (the materiality level for a clearly trivial items occurs when the auditor believes errors below that level would not, even when aggregated with other misstatements, be materiality to the financial statements).( Chapter 7, p. 289). Even if Fords’ and Toyotas’, numbers were in millions for the 5% for misstatements is considered clearly trivial, and $10,000,000 error in inventory– the auditor should consider the inventory amount as a high risk, and take into consideration of the implementing more substantive and analytical procedures, make materiality assessments, the auditor should consider both quantitative and qualitative effects, and reassess hers/his considerations for possible errors on his/her part or for possible misstatements of inherent risk on the financials.

There is such difficulty and conflict surrounding materiality decisions that, during 1998, the largest accounting firms in the U.S. independently formed a “Big Five Audit Materiality Task Force” to identify and understand practice issues relating to audit materiality. (McKee & Eilifsen, 2000).

McKee, T. E., & Eilifsen, A. (2000). Current Materiality Guidance for Auditors.

Retrieved from http://brage.bibsys.no/xmlui/bitstream/handle/11250/166032/A51_00.pdf?sequence=1

c. The numerical thresholds differ across the two companies. Why does that present a problem for the auditor? For third party users?

Audit firms have policies that specify which benchmarks are appropriate, and consistently in the application and benchmarks and thresholds is important in demonstrating the reasonableness of materiality judgements. Therefore, professional judgment is very important in selecting benchmarks or thresholds appropriate for the client setting. (In this case it would be Ford and Toyota). Also, it is important to recognize that the benchmarks and thresholds represent starting points for materiality judgment, and they should be used with other judgmental factors, such as clients’ risk, management integrity, or even the possibility of fraud. Once the auditor has determined the overall materiality amount based on the quantitative assessment, the auditor needs to consider qualitative factors to assess whether the materiality amount makes sense for the particular audit client (Ford & Toyota). (Chapter 7, p. 288).

Even though Ford and Toyota are in the same industry, their net income and assets differ because one company is more profitable than the other company, the size of the company, how the company is financed, the volatility of the benchmarks, their liabilities, lawsuits, and etc. would have to be taken into consideration. Therefore, it would make it quite difficult for an auditor to make a reasonable materiality judgement due to the vast numerical thresholds that differ across the two companies.

For third party users?

If the auditor is finding it difficult to make a reasonable materiality judgment, this will definitely propose an issue for third party users, because they will not be able to understand the complexity involved in the vast numerical threshold that differ across the two companies, and inevitably make it difficult for the third party users to compare Ford and Toyota. The third party users would have to know how to read and understand all the different aspects, management notes, financials and industry averages of Fords’ and Toyotas’ 10-k, or annual reports, and prior annual reports, and specifically understand thresholds.

d. What is the SEC’s position on the use of numerical thresholds?

In making materiality assessments, auditors considers both quantitative effects and qualitative effects. In Staff Accounting Bulletin (SAB) NO.99, the Sec states that

The use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that—without considering all relevant circumstances-a deviation of less than the specified percentage with respect to a particular item on the registrants’ financial statements is unlikely to be material. The staff has no objection to such a “rule of thumb” as an initial step in assessing materiality. But quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot be used as a substitute for a full analysis of all relevant considerations. (Chapter 7, p. 291.)

Johnstone, K., Gramling, A., & Rittenberg, L. E. (2015). Auditing: A Risk Based-Approach to Conducting a Quality Audit. Boston, MA: Cengage