Three former university classmates are meeting for dinner to celebrate completing their first year as junior auditors at three different public accounting firms. After reminiscing about the time they all skipped their auditing class to go to a playoff hockey game, one of them recalls, “It was great the Canucks won that game, even though they didn’t make it to the next round. But the auditing class we missed that night was on materiality. I have learned a lot on the job, but materiality is still the one decision we make at work that makes no sense to me. And that makes me nervous because materiality is such a key factor in deciding what accounts to focus our audit work on and how much testing to do.”
During the ensuing discussion they realize that their three firms use three different approaches to setting materiality for planning purposes. In Firm 1, the level of materiality is set for the whole audit based on 5–10% of normal earnings, or other benchmarks if earnings are not useful. In Firm 2, a similar method is used to come up with the starting materiality amount but then adjustments are made for anticipated misstatements and prior year misstatement reversals, resulting in using a smaller amount for the purpose of planning the audit. In Firm 3, a similar starting point is used but the amount is then allocated to different accounts based on their size and any special user-based considerations, such as whether the amount is used in a debt covenant.
Discuss the implications for audit practice of having so much variability in setting materiality. What is the impact of the CAS 320 on the three different approaches described in this scenario?