Auto Parts Incorporated Case Study

Dear Auto Parts Inc. Manager,

This memo is in regards of the accounting policy change for recording the tooling supplies that your organization keeps on inventory. To understand the nature of the situation, and determine what actions must be taken or considered, we will address materiality, accounting rules and regulations, and disclosure. We must first refer to materiality and how it affects the decision. Understanding materiality, what issues or circumstances affect it, and why, will assist us in further evaluating the change.

Materiality is a concept in auditing used to determine what information is relevant to the overall audit process, so we can provide reasonable assurance that the financial statements are free of significant errors. Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users made on the basis of the financial statements. What misstatements are considered material, and the materiality threshold, is based on our professional judgement and is dependent on an entity’s individual status. These thresholds are determined when applying materiality which entails three major steps.

The first step in applying materiality is to establish overall materiality. This is done by both quantitative and qualitative factors. We first look at financial statement benchmarks and quantitative percentage ranges from industry averages and determine overall materiality. These ranges are, three and five percent for net income before taxes, quarter of a percent to two percent for total assets, half a percent to five percent for total revenues, three to five percent for net assets, and one to five percent for overall equity. We will then analyze qualitative factors and consider if they could have an effect on materiality. The factors include, but are not limited to, looking at material misstatements in prior years, high risk of fraud, if the entity is close to violating a covenant loan agreement, or if the entity operates in a volatile business environment. These factors will help us determine the appropriate percentage within the given ranges to establish the specific materiality levels for the entity.

Once we declare overall materiality we can move on to the second step, determining tolerable misstatement. Tolerable misstatement provides a range for individual account balances rather and is commonly set between 50 and 75 percent of overall materiality. Similar to determining overall materiality, qualitative factors are also considered in this step of materiality application. Once we determine the levels at which materiality is set we use them to evaluate audit findings. This step is done towards the end of the audit and determines whether financial statements are fairly presented. During the audit process we will likely find errors