MATERIALITY, TOLERABLE ERROR AND NOMINAL AMOUNT COMPUTATION

Company Name: Audit Date: Prepared By: (Audit Mana er! Appro"ed By: (En a ement Partner!

A# Computation o$ P%annin Materia%ity

2. Identify the Materiality Benchmark a. Select the most relevant materiality benchmark ( check one): Measurement Percentage Income from continuing operations (after tax) "ormali#e$ income from continuing operations (after tax) %otal revenues %otal assets "et assets or total e'uity b. In$icate the benchmark amount (monetary value). c. In$icate the source of the benchmark (check one): Interim financial statements (urrent year pro)ection (indicate date below) (omputation (show below) 5. 5. &. &. 5. ! ! ! ! !

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Materiality Form (Revised October !!"# %&' $age

*thers (describe below)

$. In$icate the reason for the benchmark selection (check one): +or,profit company operating un$er normal circumstances (ompanies -ith volatile.unstable income (ompanies operating at breakeven level (ompanies reporting losses *rgani#ations that $o not report earnings/ e.g. not,for,profit an$ governmental entities *thers 3. (alc)late Materiality 0enchmark 1mount (from Step 2b) x Measurement Percentage (from Step 2a) 2 Materiality 1mount

B# Computation o$ To%era&%e Error 1. Determine the amo)nt of $lanning Materiality (*re+ta,# (from step A3)

Determine . to be )sed in com*)ting for tolerable error Ri'( A''e''ment 3reater than 4igh 4igh "ormal Per)enta e 55! 6 ! 5 !

/-

(alc)late 0olerable 1rror %olerable 7rror ! Pre,tax 1mount of Materiality (from Step B.1) 8 2 %olerable 7rror 1mount (Pre,%ax)

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Materiality Form (Revised 2e*tember !!"# &' $age

C# Determination o$ Nomina% Amount (PA*E and PR*E Li'tin +)ope'! 9etermine listing scopes for propose$ a$)usting an$ reclassifying entries (5! ,5 ! of pre,tax materiality amount). %$ro*osed ad3)sting entries ($451s# $ro*osed reclassifying entries ($R51s#

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Materiality Form (Revised 2e*tember !!"# /&' $age

,UIDANCE ON PLANNIN, MATERIALITY, TOLERABLE ERROR AND NOMINAL AMOUNT COMPUTATION I# Ba)( round Materia%ity is the magnitu$e of a misstatement (inclu$ing an omission) of the financial statements or relate$ $isclosures that -oul$ affect the )u$gment of a reasonable person using those statements. Materiality shoul$ be consi$ere$ by the au$itor -hen (a) $etermining the nature/ extent an$ timing of au$it proce$ures: an$ (b) evaluating the effect of misstatements. 1u$itors are responsible for $etermining that financial statements are free from materia% misstatements (they have no $uty to $etect immaterial errors). 1ccor$ingly/ $uring the course of the au$it/ the au$itor i$entifies potential misstatements that/ indi"idua%%y or )o%%e)ti"e%y/ are material. %his re'uires au$itors to $etermine a specific amount of materiality for each engagement. %his amount is also use$ to evaluate the significance of misstatements (propose$ a$)ustments an$ reclassifications) note$ $uring the au$it. I$eally/ the materiality )u$gment for the year -ill remain constant $uring the course of the au$it. 4o-ever/ the preliminary )u$gment (;planning materiality<) that is establishe$ to i$entify.respon$ risks an$ set au$it scopes might $iffer from the materiality amount use$ later to evaluate results an$ assess propose$ entries. %his coul$ occur/ for example/ -hen the preliminary expectations about the results of operations (-hich un$erlie planning materiality) are substantially $ifferent from the actual results. %he assessment of -hat is material is a matter of professional )u$gment. In $esigning an au$it plan/ the au$itor establishes an acceptable materiality level so as to i$entify 'uantitatively material misstatements. 4o-ever/ both the amount ('uantity) an$ nature ('uality) of misstatements nee$ to be consi$ere$. 7xamples of 'ualitative misstatements -oul$ be/ among others: (a) the ina$e'uate or improper $escription of an accounting policy -hen it is likely that a user of the financial statements -oul$ be misle$ by the $escription: an$ (b) failure to $isclose the breach of regulatory re'uirements -hen it is likely that the conse'uent imposition of regulatory restrictions -ill significantly impair operating capability. %he au$itor shoul$ consi$er materiality at both the overall financial statement level an$ in relation to classes of transactions/ account balances an$ $isclosures. To%era&%e error is the ma-imum amount that an in$ivi$ual account balance (or group of relate$ accounts) coul$ be misstate$ that -hen aggregate$ -ith other misstatements in the financial statements -oul$ not create an unacceptable risk of material misstatement of those statements. %olerable error is establishe$ to coor$inate the scopes of the various au$it tests so they provi$e reasonable assurance that a material misstatement/ if it exists/ -ill be $etecte$. %hat is/ the au$it team $esigns each test of a balance to i$entify errors (misstatements) that/ in the aggregate/ excee$ tolerable error. %olerable error reflects (a) materiality/ (b) the magnitu$e of expecte$ error in the financial statements/ (c) the number of accounts.balances that may be misstate$ an$ ($) an allo-ance for potential error that may remain un$etecte$. 3enerally/ tolerable error $ecreases as the number an$ magnitu$e of expecte$ errors increases. PA*E and PR*E listing scopes are establishe$ to $efine the minimum amount of an in$ivi$ual misstatement that/ -hen $iscovere$/ is to be poste$ to the +ummary o$ Propo'ed Entrie'. Its sole purpose is to avoi$ summari#ing errors that/ in$ivi$ually or collectively/ are not significant. Li'tin ')ope' are not &en).mar(' $or 'ettin te'tin ')ope', to%era&%e error i' u'ed $or t.at purpo'e . A 'u e'ted PA*E %i'tin ')ope i' /01230 o$ t.e pre1ta- materia%ity amount# %his scope may be

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Materiality Form (Revised 2e*tember !!"# 6&' $age

re$uce$ -hen numerous errors are anticipate$ or -hen the client expects to be informe$ of even minor errors. =hen propose$ a$)ustments (kno-n misstatements)/ together -ith likely misstatements/ are assesse$ at the en$ of the au$it/ they are consi$ere$ in relation to the materia%ity amount (an$ other/ 'ualitative factors) to $etermine -hether they are material to the financial statements.

II# Computation o$ P%annin Materia%ity Materiality is compute$ in three steps: 1. 0. (. A# >n$erstan$ the management?s vie-s on materiality. I$entify the most appropriate benchmark. (alculate materiality. Under'tand t.e Mana ement4' 5ie6' on Materia%ity 1s part of our preliminary $iscussions -ith key management/ -e shoul$ un$erstan$ an$ $ocument their vie-s on materiality. %his is important because: 1n entity?s concept of materiality may help us assess the control environment: that is/ if its materiality threshol$ is $ifferent from ours/ -e may have concerns about the ability of internal control to prevent certain errors that -e regar$ as material. %he management may expect that our -ork -ill be base$ on a lo-er level of materiality than -e -oul$ other-ise $evelop. +or example/ if a company?s inventory is collateral for a bank loan/ the bank may expect that our au$it -ill provi$e assurance that the inventory is accurately state$. *r/ if management@s bonus plan is tie$ to earnings/ management may expect us to au$it for immaterial misstatements.

B#

Identi$y t.e Mo't Appropriate Materia%ity Ben).mar( Materiality benchmarks are measures that are relevant to users (especially investors an$ cre$itors) of financial statements. 0ecause several approaches use$ by investors an$ cre$itors relate to earnings/ -e usually presume that the most relevant benchmark for a for,profit company normally is current year income from continuing operations (after income tax). 4o-ever/ that presumption may be overcome by other facts about ho- the financial statements are use$ (e.g./ as evi$ent from analysts@ reports an$ management@s communication -ith analysts). 3enerally/ loan covenants an$ regulatory an$ listing re'uirements shoul$ not affect our selection of a benchmark. 1 len$er negotiates covenants to protect itself in the event the borro-er?s health $eteriorates/ an$ not to $efine the best materiality benchmark. +or example/ the existence of an inventory covenant $oes not imply that the len$er believes inventory is the best benchmark or that the len$er is unintereste$ in income from continuing operations or other potential benchmarks.

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Materiality Form (Revised 2e*tember !!"# 7&' $age

Li't o$ Ben).mar(' +ollo-ing is a list of various benchmarks an$ circumstances that may overcome the presumption that income from continuing operations is the best materiality benchmark. (2! 7or pro$it )ompanie' operatin under norma% )ir)um'tan)e' %he most relevant benchmark is current year income from continuing operations after tax.

(8! 7or )ompanie' 6it. "o%ati%e9un'ta&%e in)ome >se normali#e$ income from continuing operations (after tax) -hen users (i.e./ management/ stockhol$ers/ etc.) of financial statements focus on income as a key measure/ since the current year income for companies -ith volatile.unstable income often is not representative of expecte$ income. Norma%i:ed in)ome is usually the average of recent years? earnings (e.g. three years). It is also the income that the company -oul$ earn un$er ;normal< circumstances (say/ by a$)usting reporte$ results for the effects of unusual items).

(;! 7or )ompanie' operatin at &rea(e"en %e"e%' =hen users (i.e./ management/ stockhol$ers/ etc.) of financial statements focus on income as a key measure/ materiality for breakeven companies shoul$ be base$ on norma%i:ed in)ome &e$ore ta- $rom )ontinuin operation' since measuring materiality base$ on current income that is close to breakeven levels -ill usually result in inappropriately lo- levels of materiality in relation to the si#e of the entity?s financial statements. =hen income is less important/ materiality may be base$ on tota% e<uity, tota% re"enue' or tota% a''et'#

(=! 7or )ompanie' reportin %o''e' =hen users (i.e./ management/ stockhol$ers/ etc.) of financial statements focus on income as a key measure/ materiality for loss operations shoul$ be base$ on norma%i:ed in)ome $rom )ontinuin operation' (a$ter ta-!# 1n important consi$eration is the actual composition of the losses. %hat is/ the engagement team shoul$ $etermine -hether the losses are actually attributable to abnormal.unusual items that mask the un$erlying operating income/ such as asset reali#ation.losses/ foreign exchange losses/ amorti#ation of $eferre$ start,up costs that shoul$ be remove$ from the loss to attain normali#e$ income from continuing operations (after tax). =hen the losses are expecte$ to continue for an exten$e$ perio$ (e.g. start,up operations)/ consi$er using an alternative benchmark that better reflects the focus of financial statement users/ such as tota% re"enue', tota% a''et' or net a''et'9tota% e<uity. not report earnin ' (i#e# not1$or1pro$it or ani:ation' and

(/! Or ani:ation' t.at do o"ernmenta% entitie'! C#

Materiality shoul$ be base$ on total contributions an$ revenues/ net assets or total assets.

Ca%)u%ate Materia%ity Materiality is the pro$uct of the benchmark times the measurement percentage.

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Materiality Form (Revised 2e*tember !!"# "&' $age

III# Computation o$ To%era&%e Error %olerable error is the threshol$ of misstatement that -e seek to $etect -hen applying a test to an in$ivi$ual account or group of relate$ accounts. It is establishe$ to coor$inate the scopes of the various tests so they provi$e reasonable assurance that a material misstatement/ if it exists/ -ill be $etecte$. %hat is/ each test is $esigne$ to search for errors -hich/ in the aggregate/ excee$ tolerable error. %olerable error usually is smaller than materiality because multiple errors may exist -hose total coul$ excee$ materiality. 3enerally/ tolerable error $ecreases as the number an$ magnitu$e of expecte$ errors increase. %he concept of tolerable error also contemplates a ;cushion< for errors that may exist but -ill remain un$etecte$ or un$erestimate$. %olerable error is compute$ as a percentage of the pre,tax e'uivalent of materiality. Such percentage shoul$ be base$ on the result of engagement risk acceptance assessment performe$/ i.e./ -hether the engagement risk acceptance -as assesse$ as ,reater t.an >i ., >i . or Norma% . %he tolerable error amount is use$ to plan -hich specific accounts -ill be teste$ or -ill be sub)ecte$ to au$it proce$ures. %olerable error shoul$ not be confuse$ -ith ;P1A7 listing scope (nominal amount).< %he sole purpose of setting a listing scope is to avoi$ the effort of summari#ing inconse'uential errors on the +ummary o$ Propo'ed Entrie'. %olerable error is compute$ as follo-s: 1. 9etermine the pre,tax amount of materiality. 0. 9etermine the percentage to be use$ in computing for tolerable error. (. (alculate tolerable error Points to consi$er in applying the tolerable error %olerable error is a pre,tax amount. >se net,of,tax e'uivalent for testing income tax accounts an$ other items that are not taxable.tax,$e$uctible. %esting scopes nee$ to be increase$ in response to increase$ risk of errors.

I5# Determination o$ PA*E and PR*E Li'tin +)ope' (Nomina% Amount! Propo'ed Ad?u'tin *ourna% Entrie' (P1A7s) are entries to correct misstatements of net income or net -orth (net assets.e'uity). Propo'ed Re)%a''i$i)ation *ourna% Entrie' (PBA7s) transfer balances among financial statement captions but $o not affect net income or net -orth. >nless management or those charge$ -ith governance -ishes to be informe$ of every misstatement -e fin$/ a minimum amount (nomina% amount! may be establishe$ for proposing a$)ustments (CP1A7 listing scopeC) an$ reclassifications (CPBA7 listing scopeC)/ an$ in$ivi$ual entries of lesser amounts are not poste$ to the +ummary o$ Propo'ed Entrie'. %he sole purpose of setting these scopes is to avoi$ the effort summari#ing errors that/ in$ivi$ually or collectively/ are clearly not significant. T.e %i'tin ')ope' are not &en).mar(' $or 'ettin te'tin ')ope', to%era&%e error i' u'ed $or t.at purpo'e# PA*E Li'tin +)ope may be re$uce$ -hen -e anticipate numerous errors or the client expects to be informe$ of even minor errors. 1lthough some engagements use the same listing scope for all misstatements/ the PBA7 listing scope may be larger than that use$ for P1A7s/ particularly -hen the planning materiality )u$gment is base$ on earnings an$ these earnings are small in comparison to total assets. 4o-ever/ it may not be feasible to set

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Materiality Form (Revised 2e*tember !!"# 8&' $age

a uniform PBA7 listing scope that -oul$ be appropriate to the various financial statement captions that might be affecte$ by reclassifications. Instea$/ $ecisions to list reclassifications may be ma$e on a case, by,case basis after consi$ering the nature an$ si#e of the relevant captions an$ $isclosures. +or example/ a reclassification that is not relevant to a loan covenant or footnote $isclosure might be propose$ only if it excee$s a certain percentage of a caption. 5# Con'iderin Li(e%y (Un(no6n! Mi''tatement' In performing au$it proce$ures/ the au$itor shoul$ like-ise $etermine the extent of likely misstatements -hich might exist in consi$eration of the total population. =hen test of $etails is performe$ using non, statistical representative samples/ the au$itor may use proportiona% e-trapo%ation techni'ues in con)unction -ith professional )u$gment to asses the allo-ance for sampling risk necessary to estimate the maximum possible misstatement in the population. (Please refer to the attache$ I%%u'trati"e +amp%e) 5I# E"a%uatin Mi''tatement' In evaluating the fair presentation of the financial statements/ the au$itor shoul$ assess -hether the aggregate of uncorrecte$ misstatements that have been i$entifie$ $uring the au$it is material. %he aggregate of uncorrecte$ misstatements comprises: (5) specific misstatements i$entifie$ by the au$itor inclu$ing the net effect of uncorrecte$ misstatements i$entifie$ $uring the au$it of the previous perio$s (kno-n misstatements): an$ (&) the au$itor?s best estimate of other misstatements -hich cannot be specifically i$entifie$ (i.e. pro)ecte$ errors.likely misstatements). %he au$itor nee$s to consi$er -hether the aggregate of uncorrecte$ misstatements is material. If the au$itor conclu$es that the misstatements may be material then it nee$s to consi$er re$ucing au$it risk by exten$ing au$it proce$ures or re'uesting management to a$)ust the financial statements. Management may -ant to a$)ust the financial statements for the misstatements i$entifie$/ even -here they are not material. In or$er to $etermine if error i$entifie$ are material the au$itor shoul$ maintain a recor$ of all of the error that have been foun$/ even if they are clearly not in$ivi$ually material. 1 number of separate immaterial errors may still re'uire a$)ustment/ if they are material in aggregate. 0y pro)ecting errors the au$itor shoul$ be able to $etermine an expecte$ level of errors for the financial statements. =here this in$icates that the financial statements may be materially misstate$ then the au$itor shoul$ increase the scope of its au$it -ork/ to re$uce the au$it risk an$ increase the accuracy of the au$it pro)ections. If the aggregate of the uncorrecte$ misstatements that the au$itor has i$entifie$ approaches the materiality level/ the au$itor -oul$ consi$er -hether it is likely that un$etecte$ misstatements/ -hen taken -ith aggregate uncorrecte$ misstatements coul$ excee$ materiality level. . It '.ou%d &e noted t.at in e"a%uatin t.e e$$e)t o$ mi''tatement', i$ t.e a re ate un)orre)ted mi''tatement' t.at t.e auditor .a' identi$ied approa).e' t.e materia%ity %e"e%, t.e auditor 6ou%d )on'ider 6.et.er it i' %i(e%y t.at undete)ted (%i(e%y! mi''tatement', 6.en ta(en 6it. a re ate un)orre)ted mi''tatement' )ou%d e-)eed materia%ity %e"e%# %hus/ as aggregate uncorrecte$ misstatements (kno-n plus likely misstatements) approach the materiality level the au$itor -oul$ consi$er

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Materiality Form (Revised 2e*tember !!"# 9&' $age

re$ucing au$it risk by performing a$$itional au$it proce$ures or by re'uesting management to a$)ust the financial statements for i$entifie$ (kno-n) misstatements. If management refuses to a$)ust the financial statements an$ the results of exten$e$ au$it proce$ures $o not enable the au$itor to conclu$e that the aggregate of uncorrecte$ misstatements is not material/ the au$itor shoul$ consi$er the appropriate mo$ification to the au$itor?s report.

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Materiality Form (Revised 2e*tember !!"# '&' $age