SOLUTIONS MANUAL

to accompany

MODERN AUDITING
&
ASSURANCE SERVICES

4th edition

Prepared by

Philomena Leung, Paul Coram, Barry Cooper

and Peter Richardson

© John Wiley & Sons Australia, Ltd 2009

Solution Manual to accompany Modern Auditing and Assurance Services 4e

Chapter 8
Materiality and Audit evidence

Review Questions

8.11 Under what circumstances would the auditor request the accounts to be
adjusted for individually immaterial errors?

ASA 320 requires an auditor to assess whether the uncorrected misstatements that
have been identified during the audit are material individually or in aggregate.
Therefore when errors are individually immaterial but are collectively material all the
errors should be adjusted for. For example if materiality is set at $100 000 and two
errors which both reduce profits have been found for $40 000 and for $70 000 then
both will be adjusted for because the total error is $110 000 which is material.

8.12 Explain the term ‘materiality’ in the context of financial reporting? What
is the audit significance of the concept of materiality?

In relation to financial information, materiality means:

“… the information which, if omitted, misstated or not disclosed, has the
potential to adversely affect decisions about the allocation of scarce
resources made by users of the financial report or the discharge of
accountability by the management, including the governing body of the
entity.” (AASB 1031)

In applying this definition, the auditor is required to consider both:

 the circumstances pertaining to the entity; and
 the information needs of those who will rely on the audited financial report;
when:
 determining the nature, timing and extent of audit procedures; and
 evaluating the effect of misstatements on the fair presentation of the financial
report (ASA 320).

8.13 List and describe the major steps taken by an auditor in applying
materiality to an audit.

ASA 320 states that the role of materiality in the audit is to:
 establish a preliminary materiality level to plan audit procedures and
select audit strategies;
 assess the qualitative and quantitative materiality factors when
evaluating the results of audit procedures;
 re-assess the preliminary materiality level used in planning the audit,
based on the outcomes of audit procedures to determine whether there is a

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 Chapter 8: Materiality and audit evidence

need to extend audit procedures; and

 evaluate the effect of uncorrected misstatements in the financial report
and the impact on audit risk.

From the auditor’s perspective, material information is that which is important or

essential, with the emphasis on the needs of users. The auditor considers materiality
in:
 determining the nature, timing and extent of audit procedures; and
 evaluating the effect of misstatements on the fair presentation of the financial
statements.

With the above in mind, the auditor will apply materiality at the financial statement
level to determine whether the statements contain errors or irregularities that,
individually or in aggregate, prevent the statements from being presented fairly, in
accordance with accounting standards. Both quantitative and qualitative tests are
applied. Materiality issues could also include legal and statutory requirements,
regardless of the amounts involved.

8.14 Discuss the quantitative guidelines in terms of materiality.

In assessing the quantitative importance of a misstatement, it is necessary to relate the

dollar amount of the error to the financial report. In planning the audit the auditor
generally is concerned only with misstatements that are quantitatively material; when
evaluating audit evidence the auditor must consider both quantitative and qualitative
misstatements.

The following apply in assessing the quantitative importance of a misstatement:

 As a general rule, when an amount is equal to or greater than 10% of profit, it
is presumed to be material.
 An amount that is equal to or less than 5% of profit may be presumed to not be
material.
 For an amount between 5% and 10%, materiality is a matter of judgement.

There are further considerations that refine the above general rules and these are
detailed in AASB 1031.

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

8.15 Describe the two main alternative audit strategies that may be adopted in
performing an audit.

ASA 330 describes requirements for auditors to follow in addressing risks identified.
The two main alternative audit strategies are a predominantly substantive approach
and a lower assessed level of control risk approach. A predominantly substantive
approach is one where the majority of audit evidence is obtained by substantive audit
procedures that provide direct evidence as to the fairness of management’s financial
statement assertions. A lower assessed level of control risk approach is one that relies
on internal controls to support the use of a reduced level of substantive procedures.
This approach requires that the auditor tests internal controls to verify that control
procedures are actually operating as laid down.

8.16 What is the overall objective of a general-purpose financial report audit?

How does the auditor usually meet this objective?

 The overall objective of a financial report audit is ‘to enable the auditor to
express an opinion whether the financial report is fairly prepared, in all
material respects, in accordance with an identified financial reporting
framework’ (ASA 200). To meet this objective, it is necessary to identify
specific audit objectives for each transaction class and account balance. In
preparing the financial statement, the management of the entity can be said to
be making a set of assertions about each transaction class and account balance,
which are referred to as financial report assertions.

 The auditor formulates an opinion on the financial statements, taken as a

whole, on the basis of evidence obtained through the verification of assertions
related to individual account balances or transaction classes. The objective is
to restrict audit risk at the account balance level so that, at the conclusion of
the audit, the audit risk in expressing an opinion on the financial statements as
a whole will be at an appropriately low level. Hence the overall audit risk is
disaggregated to each account balance or transactions class.

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 Chapter 8: Materiality and audit evidence

8.17 Discuss what is meant by ‘sufficient appropriate audit evidence’.

ASA 500 discusses sufficiency and appropriateness.

Sufficiency relates to the quantity of audit evidence. Factors that may affect the
auditor’s judgment as to sufficiency include:
 materiality and risk;
 economic factors; and
 size and characteristics of the population.

Appropriateness refers to the quality of audit evidence. For evidence to be

appropriate, it must be relevant and reliable.
 Relevance means that evidence must be sufficient with respect to each of the
auditor’s objectives.
 Reliability of evidence is influenced by a number of factors, such as the source
and nature of the information, and its timeliness and objectivity.

8.18 What are the different types of substantive procedures available to an

auditor?

ASA 500 refers to the following procedures:

 Inspection of Records or Documents (including tracing and vouching)
 Inspection of Tangible Assets
 Observation
 Enquiry
 Confirmation
 Recalculation
 Reperformance
 Analytical Procedures

Some of these procedures can be carried out by using Computer Assisted Audit
Techniques (CAATs)

8.19 Discuss different types of evidence and levels of reliability.

ASA 500 discusses the reliability of different types of audit evidence:

 Evidence is more reliable when it is obtained from independent sources
outside the entity.
 Evidence that is generated internally is more reliable when the related controls
imposed by the entity are effective.
 Evidence obtained directly by the auditor is more reliable than audit evidence
obtained indirectly or by inference.
 Evidence is more reliable when it exists in documentary form, whether paper,
electronic, or other medium.
 Evidence provided by original documents is more reliable than audit evidence
provided by photocopies or facsimiles.

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

8.20 How might an auditor use CAATs?

When carrying out substantive procedures the auditor may also use audit software to:
 perform the calculations and comparisons used in analytical procedures.
 select a sample of accounts receivable for confirmation.
 scan a file to determine that all documents in a series have been accounted for
 compare data elements in different files for agreement.
 re-perform a variety of calculations, such as totalling the accounts receivable
subsidiary ledger or inventory file.

The use of CAATs as tests of controls is covered in chapter 9.

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 Chapter 8: Materiality and audit evidence

Professional Application Questions

8.21 For each item comment on its reliability as audit evidence.

1. Highly reliable. From a knowledgeable third party, in writing and received

directly by the auditor.
2. Reliable. From a knowledgeable third party and in writing but obtained from the
client who may have altered the document.
3. Low reliability. In writing but prepared by and obtained from the client.
4. Reliable. Prepared by and held by the client but authenticated by a knowledgeable
third party in writing.
5. Reliable. Third party documents which, although held by the client, are restricted
as to access.
6. Reliable. From a knowledgeable third party and in writing but obtained from the
client who may have altered the document.
7. Reliable. Prepared and held by the client but subject to good internal control being
held by an employee who has an interest in its authenticity.
8. Reliable. Prepared by and held by the client but authenticated by the collective
agreement of the Board of Directors.

8.22 (a) Identify the types of audit procedures that an auditor might use for
obtaining audit evidence
(b) For each type of audit procedure, give an example of a specific
procedure that an auditor might perform when auditing the property,
plant and machinery balance in the balance sheet/statement of
financial position.

From the categories of procedures identified in ASA 500:

Inspection of Records or Documents

 Inspect the title deeds of property to confirm that property recorded in the
balance sheet actually belongs to the company (rights assertion).

Inspection of Tangible Assets

 Physically inspect a sample of items listed on the non-current asset register to
confirm that they exist (existence assertion).

Observation
 Observe procedures carried out to when the items on the non-current asset
register are compared to actual assets held (existence and completeness
assertions).

Enquiry
 Discuss with management the asset replacement policy, the outcome of these
discussions will help to confirm the appropriate useful lives for each asset
(valuation and allocation assertion).

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

Confirmation
 Obtain written confirmations from third parties of any assets that they hold on
behalf of the company (completeness and existence assertions).

Recalculation
 Select a sample of assets and obtain details depreciation policy and calculate
the depreciation charge for the period comparing to actual depreciation
charged (valuation and allocation assertion).

Reperformance
 A review of maintenance ledger accounts can be performed to look for items
that should be capitalised, this effectively reperforms the internal control
procedure designed to ensure that all transactions recorded in the correct
account (classification assertion).

Analytical Procedures
 Take the previous period’s total depreciation charge and based on the
company’s depreciation policy, asset sold and new acquisitions in the period,
calculate expected depreciation charge for the year which should then be
compared to the actual charge in the income statement for reasonableness
(valuation and allocation of the asset and accuracy of the expense).

8.23 For each procedure explain to which of the three types it belongs to [(a)
Tests of details of transactions; (b) Tests of details of balances; (c)
Analytical procedures]

1. (a)
2. (a)
3. (b)
4. (c)
5. (b)
6. (b)
7. (a)
8. (c)

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 Chapter 8: Materiality and audit evidence

8.24 (a) Discuss the differences in the purpose, method of calculation and
relative use of judgement of:
(i) materiality as used at the planning stage of the audit;
(ii) materiality as used at the final review stage of the audit.
(b) Outline the materiality guidelines as described in AASB 1031.
(c) Under what circumstances might an error be judged to be material
because of its nature rather than its amount? Give examples.
(d) Are any of the errors in items 1 to 4 material? In each case, explain
how you reached your conclusion.

(a)
Purpose Method of Relative use of
calculation judgement
Materiality as used Planning the level As a percentage of Low since the
at the planning of testing on each a relevant base specific
stage of the audit account balance such as profit or net misstatements are
and transaction assets. not yet known and
class. only quantitative
misstatements need
be considered.
Materiality as used Determining As a percentage of High since the
at the final stage of whether the a relevant base actual
the audit financial report is such as profit or net misstatements are
materially assets. now known and
misstated. qualitative factors
must be considered
as well as the size
of the
misstatement.

(b) ● AASB 1031 states that the usefulness of financial reports is impaired both by
the exclusion of material information and the inclusion of immaterial
information.
 Information is material if it potentially affects decisions by users as to
the allocation of scarce resources or the discharge of accountability by
management.
 Materiality refers to the nature as well as the amount of an item.
 The amount of an item is relative to appropriate base amounts in the
balance sheet, profit and loss account or cash flow statement. As a guide,
items greater than 10% of an appropriate base amount are presumed to be
material while items less than 5% are presumed not to be material.

(c) ● The nature of an item affects materiality where it has a particular effect on
users’ decisions or where the amount is not readily determinable.
 For example, directors’ remuneration, transactions with related parties,
proximity to breach of a covenant are examples of where the nature of an item
has a particular effect on users.

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

 Restrictions on an entity’s powers, changes to operating segments

affecting risk characteristics and changes in legislation affecting the entity’s
operations are examples of material items with no immediate quantifiable
effect.

(d) 1. Material as it is greater than 10% of the relevant base being operating profit
after tax.
2. Not material as it is less than 5% of the relevant base being operating profit
before tax.
3. Not material being more than 10% of a relevant base being operating profit
before tax.
4. Material being greater than 5% of the relevant base of operating profit before
tax and being an amount capable of precise determination not subject to
judgement or estimation.

8.25 (a) Describe the relationship between the above five categories and how
these need to be considered when designing audit strategies.
(b) How would consideration of the audit risk model affect the audit
strategy and therefore the extent to which these types of procedures
are performed?

(a) In obtaining an understanding of the entity and its environment, including its
internal control the auditor is attempting to identify and assess the risk of material
misstatements in order to design and perform further audit procedures (ASA 315).
As part of this planning process analytical review procedures can be employed to
help indicate aspects of the entity of which the auditor was unaware, and will
assist in assessing risks to help determine the nature, timing and extent of further
audit procedures (ASA 520).

The auditor then designs and performs audit procedures responsive to the assessed
risks and in determining the specific procedures to carry out the auditor will
consider:
 the significance of the risk;
 the likelihood that a material misstatement will occur;
 the characteristics of the class of transactions, account balance, or
disclosure involved;
 the nature of the specific controls used by the entity and in particular
whether they are manual or automated; and
 whether the auditor expects to obtain audit evidence to determine if the
entity’s controls are effective in preventing, or detecting and correcting,
material misstatements (ASA 330).

In identifying the key risks the auditor must address the financial statement
assertions (ASA 500) which fall into the following categories: assertions relating
to classes of transactions; assertions relating to account balances; and assertions
relation to presentation and disclosure.

These considerations will determine the extent to which the audit procedures are
mainly substantive procedures (substantive approach), or where tests of controls

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 Chapter 8: Materiality and audit evidence

are combined with substantive procedures (combined approach). Whether internal

controls can be relied upon will have a significant impact on audit strategy, the
auditor will, subject to positive results from the tests of controls, be able to reduce
the level of substantive testing performed (the combined approach). Where
controls are not effective the auditor will rely on substantive procedures to obtain
evidence.

It should be noted that the interrelation of the balance sheet and income statement
means that evidence obtained in relating to assertions about transactions may
support, or otherwise, the audit objectives relating to assertions about account
balances (eg if the auditor is happy about the occurrence assertion for sales
transactions this gives some comfort over the existence assertion for receivables.

(b) ASA 200 discusses the audit risk model which can be used to inform the extent to
which a predominantly substantive approach is carried out or whether a combined
approach (tests of controls followed by reduced substantive tests) is used.

If control risk is assessed as relatively high then the internal control system is not
considered to be effective so the auditor will not rely on the internal controls as a
source of evidence. In order to reduce overall audit risk the auditor will need to
reduce detection risk by performing more extensive substantive procedures. This
is therefore the predominantly substantive approach.

If control risk is considered low then the auditor believes that the internal control
system is effective and can be relied upon for audit evidence, this allows the
detection risk to be set relatively higher. The auditor will therefore take a
combined approach, firstly testing the system to confirm the original control risk
assessment and then secondly performing reduced substantive testing (some audit
evidence already having been provided by the control system).

Where the auditor initially assessed control risk as low but this is not supported by
the results of the tests of controls the auditor will alter the audit strategy to now be
one of a predominantly substantive approach.

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

8.26 (a) Identify the key assertion(s) at risk in relation to the balances
described in each of the situations above.
(b) Describe the audit procedures you would perform in order to gather
sufficient, appropriate audit evidence on each of these assertions.

1. (a) Existence / Valuation and allocation

(b) In this case an independent expert has performed the work on the key risk
areas. The auditor would need to consider ASA 620, Using the Work of an
Expert:
 The auditor should assess the appropriateness of the expert’s work.
 The auditor should review the source data used by the expert and ensure
that it is sufficient, relevant and reliable. The auditor should also test the
data used by the expert.
 If the results of the expert’s work do not provide sufficient appropriate
audit evidence, or if the results are not consistent with other audit
evidence, the auditor should resolve the matter (e.g. more work or audit
qualification etc.)

Other Work
Select a sample of fixed asset additions and disposals and vouch to supporting
documentation.

2. (a) Existence / Valuation and allocation

(b) The main problem here is existence. The following alternatives are possible
when direct confirmation with debtors is unlikely to provide satisfactory
results:
 Review for subsequent payments by the debtors – payment of the
amount owing is good evidence to suggest that the amount exists and is
fairly stated.
 Review for evidence of delivery of goods to customer.
 Review invoices (very weak evidence)
 When the auditor does not carry out a debtors confirmation, the
reasons for doing so should be documented in the audit workpapers.

Valuation
 Select a sample of long outstanding and doubtful accounts and
review collectability by reference to correspondence files and discussions
with client staff.

3. (a) Valuation and allocation

(b) Obtain copies of the latest accounts of the investee companies (audited if
possible). Compare the percentage shareholding with the percentage value of
net assets to ascertain reasonableness.

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 Chapter 8: Materiality and audit evidence

8.27 Indicate (a) the type of evidence obtained by each procedure, and (b) the
assertion or assertions to which it pertains.

(a) Type of Evidence (b) Assertion

1. Confirmation Existence / valuation and allocation
2. Mathematical Accuracy / valuation and allocation
3. Analytical Completeness / occurrence / accuracy / cut-off
4. Oral Valuation and allocation
5. Documentary Rights and obligations
6. Electronic Completeness
7. Oral Related to presentation and disclosure
assertions of completeness / classification and
understandability
8. Written representation Valuation and allocation
9. Physical Completeness / existence
10. Documentary Classification of transaction and completeness
of balance

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

8.28 (a) Explain to which audit assertion each of the procedures performed by
the assistant is directed.
(b) Identify the assertions on which you believe the assistant should
perform further testing on. Ignore disclosure issues.

(a) Assertions tested (b) Assertions for further testing

1. Trade creditors
The primary assertion tested is existence,
i.e. that each of the recorded amounts
exists. The tests also contribute to the
rights and obligations and valuation and
allocation assertions in providing
evidence that the amounts are owed to the
creditor and are recorded in the correct
amount.
A further test needs to undertaken to
verify completeness. This requires tracing
from goods received notes to invoices,
having first established the numerical
continuity of GRNs. Additionally the
assistant should agree suppliers’
statements with recorded amounts
investigating items appearing on the
statements but not in the creditors’ ledger.

2. Payroll expense
The primary assertions tested are those of
accuracy and cut-off in that, for the
sample, the amounts paid have been
correctly determined and recorded in the
payroll and posted to the ledger.
3. Sales
The primary assertion tested is
completeness, i.e. that each order has
been delivered and invoiced to the
customer. The tests also contribute to the
accuracy assertion in providing evidence
that the amounts are recorded in the
correct amount and the tracing to the
correct ledger account give evidence over
classification.
A further test needs to be undertaken to
verify the existence of employees and of
the labour services being paid for by the
payroll. A similar sample may be used
but needs to be tested to personnel
records to verify the existence of the
employee concerned and to the clock
cards or other record of attendance or
piecework completed to verify that
payment is in respect of work done.
A further test needs to be undertaken to
verify the occurrence of recorded sales
transactions. This test is done by
vouching recorded sales transactions
against dispatch notes and orders to
ensure that they relate to the delivery of
goods on receipt of orders.

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(a) Assertions tested
4. Fixed assets
The primary assertion tested is that of
occurrence of additions to fixed assets.
The tests also contribute to the rights and
obligations assertion in that the sales
invoice records the transfer of title and
valuation and allocation assertion in
checking the cost recorded on the invoice.
© John Wiley and Sons Australia, Ltd 2009
Chapter 8: Materiality and audit evidence
(b) Assertions for further testing
A further test needs to be performed to
verify completeness, i.e. that no addition
to fixed assets has been omitted. This
usually arises through the purchase being
recorded as an expense and not as an
asset. This occasionally happens with
repairs and maintenance where a ‘repair’
constitutes an addition to an existing
fixed asset. The assistant should analyse
postings to repairs and maintenance
expense to verify that none should have
been capitalised. Another test is to obtain
a schedule of authorised fixed asset
additions such as from the directors’
minutes or capital expenditure budget and
inquiring into any items not appearing on
the list of fixed asset additions.
8.15
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Case Studies

8.29 (a) Consider items 1–3 independently. State whether the amounts
involved would be considered material for the purpose of issuing an
audit report. Give reasons.
(b) Explain the relevance, if any, of the planning materiality level to your
decisions in (a).

(a) 1. The amount of the fine is material as being more than 10% of the relevant base
of profit after tax on which, being non-tax deductible, it would have a direct
effect. The nature of the event is also unique and absolutely determined such
that its correction in the financial report would be necessary even if much
smaller.

2. Assuming the goods were also included in closing inventory, the cut-off error
results in an overstatement of operating profit before tax of the selling price of
the stock which is $350 000. This error is more than 5% of operating profit
before tax making it appropriate to consider the possibility of a material
misstatement. The amount is not subject to uncertainty or estimation.
Assuming the recording of the sale was in clear violation of the company’s
policy on revenue recognition, which has been consistently applied then there
is a strong argument for regarding the misstatement as material. On the other
hand, the company’s profitability in the current year is low representing a
return of little over 1% on capital employed. There comes a point where every
trivial error becomes material if judged against an exceptionally low profit
figure. Since this amount is less than 10% of this year’s profits it might be
appropriate to determine whether it is greater than 5% of average profits in
recent years.

Although independent of the materiality decision, there are other implications

of the error. Assuming inherent and control risk assessments over cut-off were
consistent for the company, the incidence of a material error at one store
suggests a higher risk assessment for that store requiring a need for more
extensive substantive testing than has already been performed.

3. Assuming the stock was physically on hand at the year end and included in
closing inventory, the failure to record the purchase results in an error in
operating profit before tax of $5 950 000. This is clearly material in that it
turns a profit into a loss.

(b) Planning materiality is based on preliminary drafts or even on projected profits

and other relevant bases. It is used as an aid in determining the level of substantive
procedures, together with risk assessments, to minimise the likelihood of failing to
detect material misstatements. When errors are discovered, their evaluation as to
materiality is based on more recent draft financial reports, on the particular
circumstances of the errors and on the cumulative effect of all uncorrected errors.
The only relevance of testing materiality is the possibility, in light of corrected
financial report numbers, it may be found to have been too high resulting in a need
to undertake further testing.

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 Chapter 8: Materiality and audit evidence

8.31 Considering the broad categories of types of audit procedures below, give
examples, where applicable, of specific audit procedures that could be
undertaken with regard to the valuation of the investment and discuss the
reliability of the evidence received from those procedures. Note that not
all the categories below are applicable to this scenario.

1. Analytical procedures
 On the audited accounts of Pegasus perform procedures to determine the
extent to which the financial statements show a decline in the business which
confirms the rumour.

2. Inspection
 Legal correspondence, if any, which might give insight into the circumstances.
 Press reports confirming the rumour.
 Minutes of any shareholder meetings of Pegasus.

3. Confirmation
 From the liquidator regarding the likely level of payout, whether shareholders
have any priority (unlikely) and details of any shareholders' meetings held.

4. Enquiry
 Enquiry of management with regard to their understanding of the situation and
expected outcome

5. Recalculation
 From information received by the liquidator calculate the value of the
investment based on expected returns to investors.

6. Observation
 No particular procedures to observe.

7. Re-performance
 No internal control procedures to re-perform.

8. Computer-assisted audit techniques

 Audit software can be used as part of the analytical procedures.

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

Research Question

What does the research say about the effectiveness of decision aids in improving
auditors’ materiality judgments?

The following papers consider decision aids and materiality:

Abdolmohammadi, M. and Usoff, C. (2001), A Longitudinal Study of Applicable

Decision Aids for Detailed Tasks in a Financial Audit, International Journal of
Intelligent Systems in Accounting, Financial and Management, 10, 139-54.

Bedard, J. C. and Graham, L. E. (2002), The Effects of Decision Aid Orientation on

Risk Factor Identification and Audit Test Planning, Auditing, Sep, 21, 2, p39-56.

DeZoort, T., Harrison, P. and Taylor, M. (2006), Accountability and auditors’

materiality judgments: The effects of differential pressure strength on conservatism,
variability, and effort, Accounting, Organizations & Society, 31, 4/5, 373-390.

Rose, A. M. and Rose, J. M. (2003), The effects of fraud risk assessments and a risk
analysis decision aid on auditors' evaluation of evidence and judgment, Accounting
Forum, Sep, 27, 3, p312-338.

© John Wiley and Sons Australia, Ltd 2009 8.18