Preliminary estimate of materiality

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 (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

Hierarchy of effects model

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