Scoping 1844

  • As a non-accelerated filer with a 404 compliance deadline (currently) set for year end 2007, and given the following circumstances, what would be the appropriate approach to scoping.
    We acquired one company that came onto our books in April 2006 and then made another very significant - in terms of revenue - acquisition that became effective in October of 2006. For the April 2006 acquisition I’ve been monitoring their effect on consolidated numbers by applying a rolling last 12 months to date calculation (i.e., Oct '05 - Sept '06). I guess my question is, with the EA’s plan to use our 2006 10k for scoping purposes, how should these acquisitions factor into my scoping decisions. If we use the forecasted numbers for '07 (as opposed to the 10k) a couple of our subs will definitely drop out of scope, which of course is a plus. I hope I’ve stated this issue clearly. This being new territory for me combined with the fact I’m a one man audit shop, any advice would be appreciated.

  • Hi and welcome to the forums%0AYou will be expected to re-scope each location throughout 2007 in order to ensure that each location is correctly scoped in and out. I would assume that your auditors have only recommended using your 2006 10 K as a starting point. Final scoping should be based on year -end results/ forecasts.%0AEach location will have to meet 5% of one P-and-L metric AND one balance sheet metric consisting of either:total assets or total equity AND total revenue or total pre-tax income from your consolidated balances, or, 5% of both.%0A Limited scope locations are subject to other qualitative and quantitative factors (your EA should be able to guide you here).

  • Milan or Kymike
    Can you guys confirm EMM’s logic on scoping?
    Best regards,

  • Chaava,
    If it helps - my rationale for scoping according to this method comes from in-house training received during my time as an ext auditor in PwC. It is based on AS2 ( I am aware that it may change to a more risk based approach with AS5, but that standard is not officially in place yet)
    KPMG - our auditors, have also agreed with this approach.
    Can you let me know what it is that you question in regards to the approach? I would be keen to know if there are any criticisms/ suggestions that could be consider before I re-scope for 2007.

  • EMM%0ANo offenses to you. %0AI am also inclined towards your rationale. I just wanted to confirm whether this rationale is pervasive. I approached Milan because he is ex protiviti and he could confirm best practices on this. %0AWe cannot stick to a uniform 5% criteria on all determinant components. Agreed that we can take 5% of EBITA and Net Worth. We have to use a lower percentage for revenue and total assets viz. 1%…%0AI am also into 2007 scoping and just wanted to run this across the forum.

  • Thanks Chaava,%0AUnless I hear otherwise, I am inclined to stick with the 5% rule of thumb.%0A I am hoping to use a risk based assessment of the busines for 2007 if the new proposed guidance is introduced for 2007 companies with a 31 December year-end. This is because we currently have a very small family -run entity in scope (less than 20 employees). %0AAll of our risk asessments have shown them as low risk due to trans-Atlantic segregation of duties.%0A All of our risk assessments have shown that they are low risk, but, under AS2, they have to be included as in-scope. Our feeling is, that all the effort of having them comply is a bit of a waste of time and resources.%0ALets see what Milan has to suggest…

  • We have not yet started our scoping process for 2007.%0AI would agree that, while the 10K is a good starting point, if forecasts for the current year show significant changes for any operating division or location, then you should consider using the forecast information for your scoping. You would continue to monitor the actual data to see if it varies much from forecast.%0AUnder the new guidance, there is less emphasis placed on coverage (most used 67% - 75+% as a minimum in the past) and more placed on risk. I agree with this approach as you really shouldn’t care so much whether or not you have 75% of a low risk area (AP for many companies) covered as you do about having 90+% of high risk areas covered.%0AHaving said all of that, we are not going to quit testing in locations that have been in-scope in the past - once in scope, always in scope - unless there is a significant permanent decline in the business (sale or closure of a portion of the business). We may cut back on the amount of testing or number of key controls tested, however, reflecting a change in risk and materiality to our consolidated financials.

  • Denis and Milan%0AAre you okay with the threshold of 5% of EBITA and Net Worth for scoping?

  • Denis and Milan%0AAre you okay with the threshold of 5% of EBITA and Net Worth for scoping? %0AIt’s a decent rule of thumb.%0AI’ve always regarded scoping and materiality as a bit of a (black) art rather than a science and one does have to use a bit of professional judgement on what ‘feels right’.%0AIn addition to 5% of EBITDA and Net Assets I would also use 0.5-1% of Turnover. In the past I have tended to bias my view on materiality towards Turnover - but that may just be an E-and-Y thing.%0AGoing back to the original post. If you are making an acquistion it is not necessary to include it within management’s assessment until the year after you acquire it. So if you acquired in October '06 and you have a December year-end you would not have to include it in SOX scope until year-end December '07.%0AOf course it’s always better to get after these things sooner rather than later but you do have an out with the auditors.

  • Some thoughts…bear with me, there is a common thread to all of this…%0AAccording to Auditing Standard 2, an internal control deficiency exists when the design or operation of a control does not allow for the timely prevention or detection of misstatements. %0AThe standard defines two types of deficiencies:%0A. In a significant deficiency, there is more than a remote likelihood that the financial statements will be impacted in a manner that is consequential but not material.%0A. In a material deficiency, there is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. A 5% error in revenues is the usual threshold for labeling a deficiency as material because a smaller difference is not likely to sway a reasonable investor.%0AGiven this broad interpretation of materiality, application to SOX, and classification of a control deficiency, the following excerpts and comments to questions posed to the SEC might be helpful to clarify planning materiality for scoping considerations and determining reporting requirements:%0AFrom SEC Staff Accounting Bulletin, No. 99 - Materiality%0A1. Assessing Materiality %0AFacts: During the course of preparing or auditing year-end financial statements, financial management or the registrant’s independent auditor becomes aware of misstatements in a registrant’s financial statements. When combined, the misstatements result in a 4% overstatement of net income and a USD.02 (4%) overstatement of earnings per share. %0ABecause no item in the registrant’s consolidated financial statements is misstated by more than 5%, management and the independent auditor conclude that the deviation from generally accepted accounting principles (‘GAAP’) is immaterial and that the accounting is permissible.%0AQuestion: Each Statement of Financial Accounting Standards adopted by the Financial Accounting Standards Board (‘FASB’) states, ‘The provisions of this Statement need not be applied to immaterial items.’ In the staff’s view, may a registrant or the auditor of its financial statements assume the immateriality of items that fall below a percentage threshold set by management or the auditor to determine whether amounts and items are material to the financial statements? %0AInterpretive Response: No. %0AThe staff is aware that certain registrants, over time, have developed quantitative thresholds as ‘rules of thumb’ to assist in the preparation of their financial statements, and that auditors also have used these thresholds in their evaluation of whether items might be considered material to users of a registrant’s financial statements. %0AOne rule of thumb in particular suggests that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances, such as self-dealing or misappropriation by senior management. The staff reminds registrants and the auditors of their financial statements that exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law.%0AThe use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that without considering all relevant circumstances a deviation of less than the specified percentage with respect to a particular item on the registrant’s financial statements is unlikely to be material. %0AThe staff has no objection to such a ‘rule of thumb’ as an initial step in assessing materiality. But quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations. %0AMateriality concerns the significance of an item to users of a registrant’s financial statements. A matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important. In its Statement of Financial Accounting Concepts No. 2, the FASB stated the essence of the concept of materiality as follows:%0AThe omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.%0A…Under the governing principles, an assessment of materiality requires that one views the facts in the context of the ‘surrounding circumstances,’ as the accounting literature puts it, or the ‘total mix’ of information, in the words of the Supreme Court.%0AAlso…Evaluation of materiality requires a registrant and its auditor to consider allthe relevant circumstances, and the staff believes that there are numerous circumstances in which misstatements below 5% could well be material. Qualitative factors may cause misstatements of quantitatively small amounts to be material; as stated in the auditing literature.%0AIn a separate guidance document and authoritative source:%0ARules of Thumb%0AMateriality guidelines should not consist of an absolute amount that is applied to all entities. An absolute amount, such as USD100,000, may be immaterial to a large, multinational corporation but very material to a small company. %0AInstead, materiality is usually viewed as a relative amount that varies with the size of the entity. Therefore, rules of thumb are generally expressed as a percentage that is applied to some financial statement base. It is possible to use a rule of thumb whereby materiality percentages are typically represented by a sliding scale in which the percentage decreases as the size of the entity increases. In other words, as the size of the entity doubles, materiality increases but does not double in amount.%0AA number of financial statement bases are used to calculate planning materiality, including total revenue, total assets, pretax net income, and gross profit. Auditors generally select a base that is relatively stable, predictable, and representative of the entity’s size. A common rule of thumb for materiality is 5 percent to 10 percent of pretax net income. Because of the relative stability of total revenues and total assets, these bases are often used in practice to determine the amount of planning materiality.%0AConclusion%0AIt is acceptable to use a rule of thumb to provide a means to determine audit scope for planning purposes. However, as Denis states, consideration must also be given to qualitative factors and the exercise of sound professional judgment.%0AIn this case, I agree with Mike that, ‘…once in scope, always in scope - unless there is a significant permanent decline in the business (sale or closure of a portion of the business). We may cut back on the amount of testing or number of key controls tested, however, reflecting a change in risk and materiality to our consolidated financials.’%0AI suggest going with the 5% rule of thumb, but be adequately prepared to defend your position to the auditor and stakeholders. In the end, the decision as to the planned materiality level is best when the auditor concurs with the rationale and the methodology is applied consistently and appropriately.%0AHope this further helps,%0AMilan

  • Denis, Mike and Milan%0AWell guys, you have corroborated my stand on materiality. 5% of EBITA/Net Worth seems to be an universally accepted threshold. I have a detailed write-up on materiality in the scoping threads addressed somewhere else. From this year, I (the PMO Office (previously FRG was scoping) got the task of scoping business units this year and I would either employ a 1% of revenue/total assets or 5% of EBITA/Net Worth depending on the business unit’s bottomline, so as to reach the 90% revenue coverage.%0AThis is a pretty good forum.%0ACiao.

  • I agree with Denis.
    From a legal point of view, materiality depends on the facts and is to be determined on a case-by-case basis.
    An omitted fact is material if there is a substantial likelihood that its disclosure would have been considered significant by a reasonable investor.

    Having said that, as we always try to quantify qualitative elements, it is good to read:

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