materilaity case

Understanding Adjustments

• Adjustment made to fix an issue involves:

  • Credit to Accounts Receivable (AR) and a debit to Bad Debt Expense.

  • Alternatively, a credit to the allowance for doubtful accounts and a debit to Bad Debt Expense.

• The impact of the debit to Bad Debt Expense results in a reduction of net income, which is significant for users as it serves as a material benchmark.

Materiality Threshold Challenges

• Calculating the materiality threshold can be frustrating due to its complexity.

• The importance of understanding the context in which materiality is applied is emphasized.

Analysis of Financial Metrics

• Review of the balance sheet shows:

  • Company has significant assets but low net returns on those assets.

  • The range for materiality thresholds based on assets or revenue is considerably larger than thresholds based on net income.

  • Example: With net income of 41 million, a materiality threshold over 4.1 million is challenging.

• With assets of 1 billion, materiality range is:

  • 2% of 1 billion results in a range of 20 million to 50 million.

Earnings Trend Observation

• Discussion on the trend of net income from 29 to 41 million:

  • A favorable trend, indicating strong financial performance, which is attractive for investors.

  • Any disruptions to this trend may raise red flags for financial analysts and investors.

Impact of Adjustments on Financial Statements

• Booking a $7 million adjustment has notable implications:

  • Preliminary 2024 net income could decrease from 41 million to 34 million.

  • This alteration in income significantly shifts the expected earnings trend, alerting users of financial statements.

• The importance of booking adjustments for integrity in financial reporting is reinforced by referencing the net income trajectory.

Current Ratio Considerations

• Current ratio adjustments must be monitored:

  • Potential change from 2.01 to 1.99, affecting compliance with loan covenants.

  • Banks may respond to changes in current ratios by demanding loan repayment or charging higher interest rates.

Qualitative and Quantitative Materiality

• The necessity to assess adjustments through qualitative and quantitative lenses:

  • Qualitative reasons include the impact on financial credibility and trends.

  • Quantitative factors cover the numerical significance in relation to the entire industry.

True/False Statements on Materiality

1. Management uses significant judgment when determining materiality thresholds for an audit.

   • Answer: False. Management should know the threshold but cannot precisely determine it.

2. Auditing standards provide complex equations for auditors to consider when determining materiality thresholds.

   • Answer: False. Standards do not provide exact equations.

3. Due to materiality considerations, auditing profession lacks precise guidance on quantitative materiality.

   • Answer: True. This expresses the professional challenge in establishing precise materiality guidelines.