Question

During the audit of LEGOND Group, auditors discover a $5,000 understatement of expenses which, although it was a relatively small dollar amount, turned a $3,000 net loss into a $3,000 net profit. This would most likely be which of the following?

1) Both quantitatively and qualitatively material
2) Neither quantitatively nor qualitatively material
3) Quantitatively material
4) Qualitatively material

Answer 1

The understatement of expenses that changes a net loss to a net profit is considered qualitatively material because it affects users' decision-making even though the amount may not be large.

Step-by-step explanation:

During an audit, when an understatement of expenses changes the company's financial status from a net loss to a net profit, the situation is considered to be qualitatively material. The size of the error, in this case, $5,000, may not be large in itself (quantitative materiality), but the fact that it changes the loss to profit has a significant qualitative impact. Materiality in auditing is not solely a mathematical determination; it encompasses the influence on the decision-making process of users of the financial statements.

To illustrate this with a simple example from an accounting profit calculation, suppose a firm has $1 million in sales revenue and incurs expenses including $600,000 on labor, $150,000 on capital, and $200,000 on materials. The firm's accounting profit would be calculated as the total revenues minus the explicit costs, resulting in:

Accounting Profit = $1,000,000 - ($600,000 + $150,000 + $200,000) = $50,000.