Your firm has done the audit of Rhea Fashions Inc. for many years. You are in charge of the fieldwork for the current year’s audit. Rhea is a manufacturer of high-fashion clothing. Its shares are publicly traded, but a majority of the common shares are held by the members of the family that started the business during the 1950s. During the current year, Rhea’s business shrank substantially because of losing a major customer, a country-wide department store chain that went out of business. Rhea has not been able to replace the lost business. Since many of Rhea’s long-time employees were happy to take an early retirement offer, Rhea management’s strategy now is to continue to operate only a few unique clothing brands that represented about 50% of its sales volume in prior years. The materiality level used in the prior years was $80,000. The audit partner has determined that the appropriate materiality for the current year financial statement audit is $40,000.
a. Discuss the factors that the audit partner would have considered in deciding to reduce the materiality level.
b. What impact will the lower materiality level likely have on your audit procedures in the current year?
c. While reviewing the previous year’s audit file, you note that last year’s staff uncovered one error. Rhea had failed to accrue approximately $50,000 of customer volume discounts because of a calculation error in computing the customer’s total sales. Since the error was less than materiality, no adjustment was made to the prior year’s financial statements. Explain the impact this error had on the prior year’s financial statements, the impact it will have on the current year’s financial statements when it reverses, and on your audit, given your new materiality level.