One of the Five Techniques of Earnings Management Identified by the Securities

question 19

Essay

One of the five techniques of earnings management identified by the Securities and Exchange Commission relates to materiality.Independent auditors have traditionally used arbitrary quantitative benchmarks to define how large an amount must be to be considered material.
During the course of auditing the financial statements of a company,an auditor finds some misstatements in the client's financial statements.When combined,the misstatements,result in a 4% overstatement of net income and a $.02 (4%)overstatement of earnings per share.The auditor's materiality threshold is 5%,that is,an item in the financial statements must be misstated by more than 5% to be considered a material deviation from generally accepted accounting principles.On the basis of the established materiality threshold,the auditor concludes that the deviation from GAAP is immaterial and the accounting is permissible.
Define the term "materiality" and explain whether the auditor is justified in the conclusion that the accounting proposed by the client is permissible.

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Definitions:

Note Receivable

A written promise for the amounts to be received within a certain period of time, which represents a right to receive payments from another entity.

Payment of Account

The process of settling an amount owed to a creditor or vendor, often referred to as making a payment on an account.

Accounts Receivable Turnover

A financial ratio that measures how many times a company collects its average accounts receivable within a period.

Days' Sales in Receivables

A financial metric that calculates the average number of days it takes a company to collect payment after a sale has been made.