Auditing Group Accounts: Materiality, Analyzing Ratios, And Cash Flows

Materiality

The annual report of a company depicts the overall results that company has achieved during the financial year. It is published for the stakeholders to get knowledge about the affairs of the entity. The report is prepared so that it can be used by the users to help them in making powerful decisions. However, the report is prepared by the entity itself for its own results. Hence, it is difficult for the stakeholders to believe on the reliability of the same. To establish credibility of the report it has become necessary and mandatory as per law to get the financials audited. This function of auditing is to be performed by a professional and independent Chartered Accountant. The opinion laid by the professional is unbiased and hence generate trust of the users over the financials issued (Pool, 2017).

            The current report accommodates the study of a company named REH Company (Reece Limited). The company is listed on Australian stock exchange. The company deals in plumbing and bathroom products. The concept of materiality is defined in the upcoming section of the report with the help of this company. Later, the analysis of the cash flow statement of the company and the auditor’s report is also done. In between, the key ratios relevant for the analysis of company’s balance sheet and profit and loss account are observed to get an understanding of prevalent trend. The going concern risk is also checked for. Written representation must be called from management. Further external confirmation must be obtained from the two parties with whom agreement is made (REH, 2017).

SECTION 1

Materlity

            When the independent professional conducts an audit function, he is not able to check 100 % of the transactions that takes place. This is the inherent limitation an audit faces. As a result only a reasonable assurance can be provided by the auditor. This reasonable assurance however is not given on the basis of ambiguous transactions. Selection of transactions is done on the basis of the importance they hold in influencing the decision of user.

That level of importance is called materiality. The level at which the auditor believes that the misstatements, including the omissions are able to bring a change in the decision of users, is set as the materiality level. The materiality level can be reached by the misstatements either individually or as a sum total. This all is a simplified version of materiality as defined by ASA 320, Materiality in Planning and Performing Audit. This standard makes the auditor responsible for determining the materiality before commencing any audit (Moroney & Trotman, 2016).

            Materiality is not a matter of fact and that is why there is no fixed amount that can be called materiality threshold in every case. It is highly judgemental and depends on the functioning of the entity. It is a matter of professional decision of the auditor. Materiality is calculated in quantifiable terms to be called as materiality threshold. To compute materiality, the foremost requirement is of a base amount.

Key Ratios and Trend Analysis

There can be different base amounts that are used in different audits. The selection of a particular base amount depends on the volatility of the same in case of that entity. E.g. revenue, expenses, equity, net earnings, etc. are all base amounts. The most commonly used is although net earnings. But if in case of a certain entity, the net earnings are highly volatile and are drastically different for every financial year, and then a different base is required to be used (Choudhary, Merkley & Schipper, 2018).  The main purpose of the REH Company is to increase the overall outcomes and eliminate the quantifiable issues in the financial statement (Karapetrovic, & Willborn, 2010).

After a base amount is selected, a percentage is to be applied to calculate the basic amount of materiality. Concrete adjustment for the past company failures, cases of non-compliances, risk level assumed, etc. is to be made from this base materiality level. The percentages taken fall in a window of 5-10%, if the base is revenue, or of ½-2% if rest other bases are taken. For the company Reece Limited, the net income is increasing every financial year and that too at an acceptable level. So the base taken is net income of $211,791,000. The percentage is assumed to be 6%. So the materiality level comes to be $12,707,460. To make the contingent adjustments incorporated, the revised materiality level is taken as $13,000,000.

Any Significant Matter for Audit

            From the notes to accounts attached to the financial report of Reece Ltd information of a business combination effected on 31 January 2017 is available. The company has acquired of all the shares of Tarpit Communications Pty Ltd. To acquire the entire equity of Tarpit, the company has entered into a Share Sale Agreement with Barolo Pty Ltd and Numanar Pty Ltd. The purchase price was agreed at AUD 3.77 million. This is sure to have an impact on the financials. Auditor need to formulate procedures to look into the accuracy of the combination. He must check the reliability of the sale agreement (Knechel & Salterio, 2016)

SECTION 2

            ASA 300, planning an Audit of Financial Report, explains the requirement of making an audit plan. The audit plan can be made only after the entity’s environment is understood by auditor. For appropriate planning, it is also required for the auditor to analyse the relationship that exists in the entity. The relationship is between the financial and non- financial data. The preliminary analytical reviews are performed by the auditor to attain this understanding only. These reviews help the auditor to assess the risk of material misstatement that may exist in the entity (Jans, Alles & Varsarhelyi, 2014). The table presented below represents the various ratios that are significantly related to the balance sheet and income statement (Messier, Glover, & Prawitt, 2008).

	CURRENT RATIO	NET MARGIN (%)	RETURN ON ASSETS (%)	RECEIVABLES TURNOVER	FIXED ASSETS TURNOVER	DEBT EQUITY RATIO
2014	1.85	6.93	10.03	7.03	4.05	0.21
2015	2.02	7.94	11.67	7.34	4.56	0.17
2016	2.04	8.44	12.60	7.36	4.73	0.12
2017	2.17	8.72	12.92	7.16	4.72	0.09

The above table shows that the company has improved its return ratios. It means that the profitability of the company has been improved. However, the turnover ratios have declined. This has questioned the efficiency of the company. The current ratio however has risen above the standard benchmark. This trend in the ratio certainly states that the company is improving as far as the profitability is concerned.  So it is ultimately a positive sign for the success of the company and achievement of company’s goals. This can even show stagnancy of stock. The key risk areas have assessed as follows: The REH Company needs to lower down its financial leverage by reducing the debt funding. However, it will have to also consider the overall profitability and solvency on both side (Knechel, & Salterio, 2016).

Statement of Cash Flows and Going Concern Risk

Inventory

            The current ratio has improved because of increased current asset. The same is affected by risen inventory. There may be a risk that inventory is stagnant yet overvalued.

ASSERTION: valuation

AUDIT PROCEDURE: the auditor must call for physical verification of inventory and check with the stock register.

            There may be high risk that the company’s claim of the ownership of assets lying with third parties is false

ASSERTION: Rights & Obligations

            AUDIT PROCEDURE: external confirmations must be obtained from third parties to reduce the risk of forged ownership (Hecimovic, 2017).

            Chances are there that the person handling cash have paid it to the creditors and still showing them as creditors. For the next time when the management allows for cash payment to the creditor, the cash handler abscond it (Van Beijsterveld, & Van Groenendaal, 2016).

AUDIT PROCEDURE: external confirmation must be obtained from the creditors. This assertion is used to identify the true and fair view of the assets and libiliteis of company by matching the book value and market value of the assets and liabilities.

SECTION 3

Cash Flow Statement

            The activity providing highest cash inflows is operating activities. The cash inflow accounted is $214,809. The activity that uses the highest cash is financing activity. The cash outflow reported is $138,624. The deeper analysis is shown in the following table: However, the primary cash receipts and primary cash payments have been showcased in this report for identifying the cash inflow and outflow from the three different activities named operating, financial and investing (Moroney, & Trotman, 2016).

PRIMARY CASH RECEIPTS	PRIMARY CASH PAYMENTS
Sales	Payments for purchases
Interest received	Finance costs
Proceeds from sale of property	Payment of income tax
Proceeds from borrowings	Payment for property
	Purchase of controlled entity
	Payment of dividend
	Repayment of borrowings

Non-cash receipts and cash payment

The non-cash receipt would be Goodwill, increased in the business values strategic alliance and noncash payment would be depreciation, charges on the assets and impairment loss. When the annual report of the company for the financial year 2017 is analysed, there is no evidence of any non-cash financing and investing activity. The company has not issued any convertible instrument. Moreover no asset is purchased off cash. As far as going concern is discussed, there seems no risk regarding the same. The business has just acquired another company. Further the profitability has improved. The cash position is also well off. So there is seriously no risk for the business continuation. Nonetheless, company has high cash outflow from its financial activities which may be negative indicator for the future growth and sustainable business practice of RHE organization.

            The financial accounts for the company have been audited by a professional auditor namely Pitcher Partners. They have issued an unqualified and clean opinion. Their report states that the company has prepared its financials that give a true and fair view of the company’s affairs as far as the company’s performance and position is concerned. It is mentioned that the company has complied with the Corporations Act 2001. There is no qualification exerted by the auditors. Just a few key audit matters are identified by the auditor and mentioned in the report for better knowledge of the shareholders.

The key audit matters relate to the valuation of inventories and the impairment of intangible assets. Although, there is no audit issue identified by the auditors. However, notes to accounts and other details have been shared by company in its annual report to justify the recorded assets and liabilities. The management representation letter has also been issued by the key managerial persons and directors to justify the shared information with the auditors. On the basis of the same, auditors give his report as per the shared information.  The unqualified audit report given by Auditors is the proof that company has been reflecting the true and fair view of its assets and liabilities in long run.  The existence test and materiality level check will also showcase that company has valued all of its assets and liabilities at his market value.

Conclusion

            Audit is the process which is used to analysis and viability of the financial statements of company. Auditors check the financial statements of company with a view to analysis the true and fair view of the financial statements.  The audit report given by Pitcher Partners has reflected that company has complied all the rules and applicable accounting standards. The unqualified audit remark with zero disclaimers divulges that company has been prepared financial statements which reflect true and fair views of its assets and liabilities in long run. 

The cash flow statement of company also reflects that company has high cash inflow and outflow from its business.  The existence test implemented by the auditors has shown that company has reported only those assets and liabilities which it has been keeping at the time of reporting of its financial statements. Now in the end, it could be inferred that company has establish harmonization in its domestic and international reporting frameworks and auditors have also passed unqualified audit report for the prepared financial statements. 

References                     

Choudhary, P., Merkley, K. J., & Schipper, K. (2018). Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability.

Hecimovic, A. D. (2017). Assurance of natural resource management: a case study. 66(4), 39-43.

Jans, M., Alles, M. G., & Vasarhelyi, M. A. (2014). A field study on the use of process mining of event logs as an analytical procedure in auditing. The Accounting Review, 89(5), 1751-1773.

Karapetrovic, S., & Willborn, W. (2010). Quality assurance and effectiveness of audit systems. International Journal of Quality & Reliability Management, 17(6), 679-703.

Knechel, W. R., & Salterio, S. E. (2016). Auditing: Assurance and risk. Routledge. 63(2), 56-76.

Messier, W. F., Glover, S. M., & Prawitt, D. F. (2008). Auditing & assurance services: A systematic approach. Boston, MA: McGraw-Hill Irwin.

Moroney, R., & Trotman, K. T. (2016). Differences in Auditors’ Materiality Assessments When Auditing Financial Statements and Sustainability Reports. Contemporary Accounting Research, 33(2), 551-575.

Pool, R. (2017). Independent Audit Report. Contemporary Accounting Research, 4(2), 55-65.

REH, 2017, Annual report,

Van Beijsterveld, J. A., & Van Groenendaal, W. J. (2016). Solving misfits in ERP implementations by SMEs. Information Systems Journal, 26(4), 369-393.