Lakeside Case 2 DQ 1

(Guidelines from your text Section 4.2 have been applied here – they are no longer explicit in the accounting or auditing standards)

As you will appreciate from the readings and study of this Module, the question of materiality is one of the more complex issues in auditing – even a relatively straightforward question like this will enable you to begin to understand why it is dealt with by the more senior, experienced members of an audit team!

Materiality has been traditionally held to be any factor that would influence the decisions of those parties relying on the financial report (see AASB 108 and ASA 320 for complete definition). Identifying a proper base amount for comparison is an important aspect in determining whether an uncertainty is material. Net income (profit) is the most obvious base amount, although it depends (in relation to the nature of the uncertainty) which component of the financial report is affected (Income Statement or Balance Sheet. The situation questioned by King & Co involves an investment in fixed (non-current) assets. For the purposes of illustration, comparing the potential loss to total assets, investment in stores and owners’ equity would also seem relevant bases for your calculation … if for no other reasons than to get a sense of how fluid the concept can be.

The auditor needs to decide, independently, whether the 6^th store represents a potential material loss for Lakeside. The potential closing of the 6^th store is certainly an unusual occurrence and for that reason should be evaluated against Lakeside’s net worth of $1,000,000 and the $3.6 million in total assets – you “know” these as a result of your reading in Cases 1 & 2 and the analytical procedures on the financial statements presented in Case 3. In making these comparisons the auditor needs to anticipate the potential loss. The most conservative estimate (the maximum potential) of the total loss is $186,000, while Rogers feels $86,000 is more likely (that is, $186,000 less Rogers’ most optimistic recoverable amount of $100,000). If you use the text guidelines, they suggest the most conservative approach. This would be $186,000/$1,000,000 = 18.6%; even using Rogers’ optimistic estimate, the figure is still 8.6% (that is, $86,000/$1,000,000)! Of course, this is worse if you use the net income figure ($244,000 after tax, see Case 3). If you use total assets, 5.2% or 2.4% using Rogers estimate (finally bringing the figure under 5%). Whichever way, it is difficult to avoid the decision that the problem is material, if you decide that the issue is indeed uncertain! The calculations above are shown in tabular form below as well.