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Planning
Materiality
5.6 Sarbox Scooter, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Scoping and Evaluation Judgments in the Audit of Internal
Control over Financial Reporting
12.1 EyeMax Corporation . . . . . . . . . . . . . . . . . . . . . . . . . 369
Evaluation of Audit Differences
12.2 Auto Parts, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
Considering Materiality When Evaluating Accounting Policies and
Footnote Disclosures
other caSeS that di ScuSS topi cS related to thi S Secti on
7.1 Anne Aylor, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
Determination of Planning Materiality and
Tolerable Misstatement
caSeS i ncluded i n thi S Secti on
229 copyright 2009 by Pearson education, inc., upper saddle river, nJ 07458
instructor resource Manual do not coPy or redistribute
The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and
Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective
handling of an administrative situation.
anne aylor, inc.
determination of Planning Materiality
and tolerable Misstatement
Mark S. Beasley Frank A. Buckless Steven M. Glover Douglas F. Prawitt
To provide experience with establishing planning [1]
materiality.
To provide experience with establishing tolerable [2]
misstatement for individual fnancial statement
accounts.
To illustrate factors considered when establishing [3]
planning materiality.
To illustrate diferent materiality bases considered [4]
when establishing planning materiality.
To illustrate factors considered when determining [5]
tolerable misstatement for individual accounts.
To illustrate reasons why the sum of tolerable mis- [6]
statements commonly exceeds planning materiality.
i nStructi onal objecti veS
KEY FACTS
Anne Aylor, Inc. (Anne Aylor) is a publicly traded company (New York Stock Exchange) that
had 60,879,663 shares of common stock outstanding with a trading price of $24.42 as of the
close of business on March 1, 2008. Anne Aylor is a leading national specialty retailer of better-
quality womens apparel, shoes, and accessories
At the end of fiscal 2007, Anne Aylor operated approximately 929 retail stores located in 46
states under the name Anne Aylor.
Net revenue for fiscal 2007 was $2.4 billion and net income was $97 million.
Substantially all of the companys merchandise is developed in-house by its product design and
development teams and sourced to 231 independent manufacturers located in 15 countries.
Merchandise is distributed to the companys retail stores through a single distribution center,
located in Louisville, Kentucky.
Anne Aylor is required to have an integrated audit in accordance with the standards of the Public
Company Accounting Oversight Board (PCAOB).
Donna Fontain, the audit partner, has performed a preliminary analysis of the Company and its
performance and believes the likelihood of management fraud is low.
Donnas analysis of Anne Aylors performance is documented in memo G3.
Current events have been documented by Donna in memo G4.
No material misstatements were discovered during the prior year audit of Ann Aylors financial
statements.
7.1
c a s e
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USE OF CASE
Information from Ann Taylor Stores Corporations 3/20/2008 form 10-K report was used in
developing this case (see www.anntaylor.com for more information on Ann Taylor Stores). The
information presented in this case is not identical to the information presented in the Ann Taylor
10-K to simplify some of the reporting issues. Many students will find the determination of planning
materiality and tolerable misstatement difficult to understand. This case assignment helps walk
students through that process. The case assignment is best used in an undergraduate and graduating
auditing course when audit risk and materiality are discussed. Instructors may want to consider
simplifying this case assignment by dividing it into two parts. Part one could require students
to determine planning materiality while part two could require students to determine tolerable
misstatement for individual balance sheet accounts.
The approach we recommend for this assignment is to first ask students to review the
case assignment materials and conduct a preliminary in-class discussion addressing question 1.
Students are then asked to complete question 2 outside of class. Once students have completed this
assignment, it is important to discuss the solution with them to maximize their learning experience.
Students will commonly provide diverse answers for this assignment. This provides an opportunity
to highlight the subjective nature of some of these judgments as well as to point out that many audit
approaches would be considered reasonable.
Cooperative learning activities can easily be adapted to this assignment. The cooperative
learning activity called Roundtable could be used for the preliminary in-class discussion (requirement
1). The basic process for this activity is to have students meet in small groups to state aloud and
write down on a single sheet of paper their ideas to a question asked by the instructor. For example,
students could be asked to explain why different materiality bases are considered when establishing
planning materiality. Once all students have had an opportunity to state their ideas and arrive at
a group consensus, the instructor can randomly call on individual students to share their groups
answer with the class.
The cooperative activity called Homework Review could be used to discuss the students
answers to requirement 2. The basic process for this activity is to have the students meet in small
groups to compare and discuss their responses on the planning materiality and tolerable misstatement
working papers. The tasks of explaining each response on the working papers and checking the
accuracy of each explanation should be rotated among group members. After students have had the
opportunity to review all their responses the instructor can randomly call on individual students to
share their responses with the class. It is important for the instructor to randomly call on individual
students to ensure that all students take responsibility for learning the material.
PROFESSIONAL STANDARDS
Relevant professional standards for this assignment are AU Section 310, Appointment of the
Independent Auditor, AU Section 311, Planning and Supervision, AU Section 312, Audit Risk
and Materiality in Conducting an Audit, and AU Section 350, Audit Sampling.
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QueSti onS and SuGGeSted Soluti on
Review Exhibits 1 and 2; audit memos G 3, and G 4; and audit schedules G 5, G 6-1, and G [1]
6-2. Based on your review, answer each of the following questions:
Why are different materiality bases considered when determining planning materiality? [a]
Financial information is prepared for multiple users for different purposes and thus not
all elements of the financial statements are equally relevant to all users. For example,
stockholders will be more concerned with long-term revenue and profit growth than
creditors and thus revenues and earnings will be more important to stockholder decisions
than creditor decisions.
Why are different materiality thresholds relevant for different audit engagements? [b]
Materiality is a relative rather than an absolute concept. The materiality threshold that will
influence users of the financial statements will vary depending on the context in which the
entity operates. For example, the magnitude of a misstatement that will influence financial
statement users will vary depending on how the entity is performing relative to the industry.
Misstatements of a smaller magnitude will be more influential for an entity just achieving
the industry average compared to an entity significantly over- or under-achieving relative to
the industry average.
Why is the materiality base that results in the smallest threshold generally used for planning [c]
purposes?
The dual entry nature of accounting results in misstatements affecting at least two accounts.
Most misstatements affect both a balance sheet and income statement account. Therefore
auditors must design the audit to find the smallest misstatement that would influence users
of the financial statements. Reasonable assurance that the financial statements are free of
material misstatements cannot be provided unless the audit is designed to detect the smallest
misstatement that would influence users.
Why is the risk of management fraud considered when determining tolerable [d]
misstatement?
A high likelihood of management fraud makes it more likely that individual account
misstatements will have the same directional effect on net income (i.e., asset accounts will
be overstated and liability accounts will be understated). On the other hand, a low likelihood
of management fraud makes it more likely that individual account misstatements will have
an offsetting effect on net income (i.e., some asset and liability account misstatements will
overstate net income while other account misstatements will understate net income).
Why does the auditor not use the same tolerable misstatement amount or percentage of [e]
account balance for all financial statement accounts?
The objective of an audit is to provide reasonable assurance that the clients financial
statements are fairly presented in all material respects at the lowest possible cost. The nature
and cost of evidence available by account varies. Therefore, to minimize cost, auditors may
want to assign a higher tolerable misstatement to accounts lacking competent evidence
or costly to audit. The higher the tolerable misstatement for an account the less evidence
that will be needed. Conversely, the lower the tolerable misstatement for an account the
more evidence that will be needed. The tolerable misstatement assigned to an account is
constrained by the dollar size and importance of the account to users. Auditors cannot assign
as much tolerable misstatement to small or very important account balances.
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Why does the combined total of individual account tolerable misstatements commonly [f]
exceed the estimate of planning materiality?
For many audits it is not likely to expect that every account will be misstated by an amount
equal to its tolerable misstatement. It is more likely to expect that most accounts will be
misstated by an amount less than its tolerable misstatement while a few accounts may be
misstated by an amount greater than its tolerable misstatement. Additionally, it is not likely
that all account misstatements will have the same directional effect on net income. It is
more likely that some account misstatements will overstate net income while other account
misstatements will understate net income and thus will offset each other.
Why might certain trial balance amounts be projected when considering planning [g]
materiality?
Planning for an audit is normally conducted well before the financial statement audit year
is completed. Early planning helps the auditor expeditiously perform the audit and ensure
that sufficient competent evidence is collected. As part of the planning process the auditor
is required to prepare a written audit program (or set of audit programs) that establishes
audit procedures to be performed during the audit engagement. When establishing audit
procedures the auditor must consider the risk of material misstatement. Materiality is a
relative concept that is influenced by the magnitude of reported financial statement amounts.
Therefore, to establish materiality thresholds for the current year audit the auditor should
have expectations of year-end amounts.
Based on your review of the Exhibits (1 and 2), audit memos (G 3, and G 4), and audit [2]
schedules (G 5, G 6-1, and G 6-2), complete audit schedules G 5, G 6-1, and G 6-2.
A solution to the assignment is documented on audit schedules similar to the audit schedules
provided to students on the pages that follow. Due to the subjective nature of some of the
judgements, alternative solutions could be considered equally acceptable.
233
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Anne Ay|or, |nc. Relererce: S 5
P|ann|ng Hater|a||ty Assessment Prepared oy: [initial}
Year Ended: January 31, 2009 0ale: [date}
Rev|eWed oy:

Pr|mary Users of F|nanc|a| 8tatements (||st}:

$rockno|oers, cusromers, |enoers, supp||ers, emp|o,ees.


L|ke||hood of Hanagement Fraud (check one}:
LoW L||e||rood ol Varagererl Fraud
\ Reasorao|y LoW L||e||rood ol Varagererl Fraud
Voderale L||e||rood ol Varagererl Fraud

Hater|a||ty ases (|n thousands}:
ase
Actua|
2|2|2008
F|nanc|a|
8tatement
Amounts
Projected
1|31|2009
F|nanc|a|
8tatement
Amounts
P|ann|ng Hater|a||ty Leve|s
Lower L|m|t Upper L|m|t
Percent
0o||ar
Amount Percent
0o||ar
Amount
lrcore 8elore Taxes S 97,2J5 S''0,000 2 $ 2,200 7 $ 7,700
Nel Reverues 2,J96,5'0 2,465,000 0.5 12,325 2 49,300
Currerl L|ao|||l|es J'2,876 J27,000 2 6,540 7 22,890
Currerl Assels 507,89' 522,000 2 10,440 7 36,540
Tola| Assels ',J9J,755 ',400,000 0.5 7,000 2 28,000

P|ann|ng Hater|a||ty (|n thousands}: S 7,700
Exp|aral|or:
Anne Aylor stock is traded on the hew York 3tock Exchange with 29 million shares
of common stock outstanding and a market capitalization of approximately $1.18
billion as of March 1, 2006. Revenue and earnings growth are important for the
company to maintain and increase its market capitalization. A 5.6 million reduction
in Anne Aylor's earnings and revenues would still result in a growth of at least
136 in earnings and 6 in revenues for fiscal year 2005. 7his expected growth
rate compares favorable with major competitors. 7herefore, a misstatement of $5.6
million or less is not expected to have a significant influence on financial statement
users.

6umu|at|ve Hater|a||ty Amount to be A||ocated to Accounts (|n thousands}:
P|arr|rg Valer|a||ly: S 7,700
Vu|l|p||cal|or Faclor (3 |l |oW |||e||rood ol raragererl lraud, 2 |l reasorao|y |oW
|||e||rood ol raragererl lraud, ard 1 |l r|gr |||e||rood ol raragererl lraud):

X 2
S 15,400


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Anne Ay|or, |nc. Relererce: S 6-'
To|erab|e H|sstatement for a|ance 8heet Accounts Prepared oy: [initial}
Year Ended: January 31, 2009 (a|| amounts are |n thousands} 0ale: [date}
Rev|eWed oy:

Account
Actua|
2|2|08
a|ances
Projected
1|31|09
a|ances
To|erab|e
H|s-
statement Exp|anat|on
Casr ard casr
equ|va|erls
S '4J,'J5 S '42,000 $ 100
A low tolerable misstatement [7M} is assigned
relative to the account balance since low cost
competent evidence is available to test
account items.
Accourls rece|vao|e, rel '6,944 '8,000 125
A high 7M is assigned relative to the account
balance since high competence evidence is
not available to test the valuation of account
items.
Vercrard|se |rverlor|es 250,697 26',000 2,000
A high 7M is assigned relative to the account
balance to reduce the cost of testing for the
existence of account items and only low
competent evidence is available to test the
valuation of account items.
0elerred |rcore laxes,
currerl
29,'6' J0,000 200
A high 7M is assigned relative to the account
balance to reduce the cost of evidence
necessary to test account items.
Prepa|d ard olrer,
currerl assels
67,954 7',000 500
A high 7M is assigned relative to the account
balance since this account has low relevance
to users and this will allow primary reliance on
low cost analytical tests.
Properly ard equ|prerl,
rel
56',270 544,000 4,100
A high 7M is assigned relative to the account
balance to reduce the cost of evidence
necessary to test account items.
0oodW||| 286,579 286,579 2,100
A high 7M is assigned relative to the account
balance to reduce the cost of evidence to test
the valuation of this account.
0elerred |rcore laxes,
ror-currerl
2J,J'4 27,000 200
A high 7M is assigned relative to the account
balance to reduce the cost of evidence
necessary to test account items.
0lrer rorcurrerl assels '4,70' 20,42' 200
A high 7M is assigned relative to the account
balance since this account has low relevance
to users and this will allow primary reliance on
low cost analytical tests.
Accourls payao|e '25,J88 'J0,000 1,000
A high tolerable misstatement is assigned
relative to the account balance since only
moderately competent evidence is available to
establish the completeness of account items.
Page Tola| 10,525
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Anne Ay|or, |nc. Relererce: S 6-2
To|erab|e H|sstatement for a|ance 8heet Accounts Prepared oy: [initial}
Year Ended: January 31, 2009 (a|| amounts are |n thousands} 0ale: [date}
Rev|eWed oy:

Account
Actua|
2|2|08
a|ances
Projected
1|31|09
a|ances
To|erab|e
H|s-
statement Exp|anat|on
Accrued lerarcy 44,945 48,000 225
A high 7M is assigned relative to the account
balance to reduce the cost of testing for the
completeness and valuation of account items.
0|ll cerl|l|cales ard
rercrard|se cred|ls
redeerao|e
54,564 57,000 400
A high 7M is assigned since only moderately
competent evidence is available to establish
the completeness of account items.
Accrued sa|ar|es ard
oorus ard olrer
experses
87,979 92,000 700
A high 7M is assigned relative to the account
balance to reduce the cost of testing for the
completeness and valuation of account items.
0elerred |ease cosls 2J0,052 2J9,000 1,800
A high 7M is assigned to reduce the cost of
testing the completeness and valuation of
account items.
0elerred |rcore laxes ',960 2,000 10
A high 7M is assigned relative to the account
balance to reduce the cost of evidence
necessary to test account items.
0lrer ||ao|||l|es 9,J8J '0,000 100
A high 7M is assigned relative to the account
balance to reduce the cost of testing for the
completeness and valuation of account items.
Corror sloc| cap|la|
accourls
78',608 8'0,560 800
A low 7M is assigned relative to the account
balance since low cost competent evidence is
available to test account items.
Rela|red earr|rgs 766,408 780,J07 0
ho 7M is assigned since this residual account
contains the net of misstatements included in
all other accounts.
Accuru|aled olrer
corprerers|ve |oss
{J,460j {J,867j 40
A high 7M is assigned relative to the account
balance to reduce the cost of testing the
valuation of account items.
Treasury sloc| {705,072j {765,000j 800
A low 7M is assigned relative to the account
balance since low cost competent evidence is
available to test account items.
Page Tola| 4,875
Tola| 15,400