An office of one Big Four firm determines a preliminary estimate of materiality this way:
An audit partner:
1. Judges overall materiality for the financial statements taken as a whole to be an amount falling within a range of 5 percent (lower limit) to 8 percent (upper limit) of net income, and
2. Instructs staff to document any proposed adjusting journals entries (PAJEs) that equal or exceed an amount falling within the range of 10 percent of the lower materiality limit to 20 percent of the upper materiality limit.
For example, assuming net income is $85 million, then:
Lower limit Upper limit
Overall materiality = 0.05 x $85 million 0.08 x $85 million
= $4.25 million $6.80 million
PAJE = 0.10 x $4.25 million 0.20 x $6.80 million
= $0.425 million $1.36 million
The partner's selection of overall materiality and a PAJE threshold falls toward the lower limit on higher risk engagements and the upper limit on lower risk engagements, since materiality and audit risk are inversely related.
Required: Select an annual report from the SEC's EDGAR system (http://www.sec.gov), from a public company's home page, or from a library, and prepare a report that:
1. Calculates a range (lower and upper limits) for overall materiality and for a PAJE threshold, and
2. Uses information captured within the annual report and other services (for example, analysts' reports, Factiva, the company's home page, etc.) to identify risks and, thereby, to judge whether overall materiality and the PAJE threshold should, in your judgment, fall toward the lower limits (high risk) or upper limits (low risk) calculated in requirement 1.
Estimation of Materiality and Audit Risk
The materiality can be defined as the omission or misstatement of an item in the financial statements in the surrounding environment. Financial statements can be said materially misstated when they contains misstatement that affect enough the presentation of accounts in accordance with the generally accepted accounting principles (GAAP) (Bragg, 2009). The materiality is defined by the reasonable person as per the business environments and surroundings. The overall materiality for the financial statement is taken as a whole that will be used to estimate the materiality.
The estimated amount of materiality falls within a range of 5 percent (lower limit) to 8 percent (upper limit) of net income. This range is estimated by the Big Four Firms. They also instruct their staff to document any proposed adjusting journal entries (PAJSs) with an amount falling within the range of 10% of the lower materiality limit to 20% of the upper materiality limit. This limit will also be used in order to identify the materiality in the financial statements of Ford Motors that is audited by PricewaterhouseCoopers, an audit firm among Big Four Firms (Ford Motor Company, 2009).
Range for Overall Materiality & A PAJE
The net income of Ford Motors for year 2009 is $2717 million, so, range for the overall materiality and PAJE will be calculated as below -
Lower range Upper range
Net income $2717 million $2717 million
The expert calculates the range for overall materiality and PAJE threshold.