The audits of entities operating in the country are subjected to the auditing and assurance standards issued by the Auditing and Assurance Standards Board (AAUSB). ASA 320 provides guidelines for the auditor to be followed for determination of materiality level. It is the amount that an auditor considers material for the purpose of the audit.
Materiality level has to be determined taken into consideration the nature of transactions in an organization thus, for transactions of particular nature the standard benchmark might not be the correct procedure to determine materiality level in an audit. To determine materiality levels in an audit generally certain percentages are used on profit before tax, revenue, net assets and on equity. However, specific account balances and classes of transactions for their nature might be treated differently. 5% of revenue with little higher percentage for profit before can be used as benchmark for determining materiality levels in audit of financial information.
In case of Fuchsia Enterprises the amount of gross revenue earned from sales for the financial year 2016-17 is $162,104. Thus, the suggestion of setting $15,000 as material amount for the financial report as whole seems quite high. Even if the standard benchmark of 5% is used for the amount of revenue then the preliminary materiality level comes at (162,104 x 5%) = $8,105. The following table would indicate the various standard benchmark and appropriate materiality levels for Fuchsia Enterprises.
|
Particulars |
Amount ($) |
Amount ($) |
Materiality level @5% |
|
Sales |
162,104.00 |
8,105.20 |
|
|
Total expenditure |
|||
|
Cost of sales |
49,208.00 |
||
|
Bank charges |
290.00 |
||
|
Depreciation |
29,620.83 |
||
|
Interest expense |
9,583.33 |
||
|
Printing |
308.33 |
||
|
Miscellaneous |
1,200.00 |
||
|
Wages |
43,808.33 |
||
|
Superannuation |
4,162.63 |
||
|
138,181.46 |
6,909.07 |
If the preliminary assessment is changed then the audit budget would increase as the extent of checking and verification of account balances and transactions would increase significantly. This is because the materiality level set at $15,000 is significantly higher compared to the materiality as per the benchmark provided in ASA 320. The materiality level for items of revenue will be $8,105 and for expenditures at $6,909.
Analytical review: Analytical review is the method to analyse ratios of an organization to identify significant fluctuations in financial reports to evaluate risk of material misstatements and frauds in financial statements.
Profitability ratios: Profitability ratio includes gross profit ratio, net profit ratio. Any significant fluctuations in profitability ratios shall be evaluated by the auditor to assess the risk of material misstatements in financial information (Lakis and Masiulevi?ius, 2017).
|
Particulars |
2016-17 |
2015-16 |
|
Profitability ratios |
||
|
Gross profit ratio |
||
|
Sales |
162,104.00 |
187,450.00 |
|
Less: Cost of sales |
49,208.00 |
63,595.00 |
|
Gross profit |
112,896.00 |
123,855.00 |
|
Gross profit ratio (Gross profit x 100/ Sales) |
69.64 |
66.07 |
|
Net profit ratio |
||
|
Sales |
162,104.00 |
187,450.00 |
|
Less: Total expenditures |
138,181.46 |
150,093.33 |
|
Net profit |
23,922.55 |
37,356.67 |
|
Net profit ratio (Bet profit x 100/sales) |
14.76 |
19.93 |
The gross profit ratio of the organization for 2016-17 is 69.64%. In 2015-16 it was 66.07% thus, there is no unnatural fluctuation in gross profit ratio. However, the net profit ratio of the company has reduced in 2016-17 at 14.76% compared to 19.93% of 2015-16. Considering that the company earned a higher margin of gross profit the reduction in net margin must be evaluated (Edgley, Jones and Atkins, 2015).
|
Particulars |
2016-17 |
2015-16 |
|
Efficiency ratios |
||
|
Inventory turnover ratio |
||
|
Sales |
162,104.00 |
187,450.00 |
|
Average inventory |
169,250.00 |
174,000.00 |
|
Inventory turnover ratio (Sales / Average inventory) |
0.96 |
1.08 |
|
Accounts receivable turnover ratio |
||
|
Sales |
162,104.00 |
187,450.00 |
|
Average accounts receivable |
106,717.50 |
103,585.00 |
|
Accounts receivable turnover ratio (Sales / Average accounts receivable) |
1.52 |
1.81 |
(Choudhary, Merkley and Schipper, 2018)
Efficiency ratios help an auditor to assess the ability of an organization to use its operating assets in day to day to business operations. Both inventory and accounts receivable turnover ratios of the company have reduced in 2017-18 compared to 2015-16. However, the reduction in inventory and accounts receivable turnover ratios are quite insignificant for the audit (Moroney and Trotman, 2016).
Simply because of the significance of the account sales must be verified in details to evaluate whether there is any material misstatement in the amount of sales recorded in the books of account. Also the fact that despite increase in gross profit ratio for the financial year ending on April 30, 2017 the organization end up quite low in its net profit ratio compared to the previous year also raise suspicion about the amount of sales recorded in the books of accounts. Thus, sales of $162,104 for 2016-17 shall be verified properly (Lakis and Masiulevi?ius, 2017).
The gross profit ratio of the organization for 2016-17 is 69.64% is quite high compared to the 66.07% of previous year. Despite the increase in gross profit ratio the organization end up only earning a net profit margin of 14.76% in the period compared to almost 20%, i.e. 19.93% of net profit in 2015-16. This definitely raises suspicion about the amount recorded as cost of sales and thus, in order to evaluate whether there is any misstatement the account must be verified properly (Sultana and Mitchell Van der Zahn, 2015).
The amount of depreciation for 2016-17 is $29,620 whereas in 2015-16 it was $15,738. Since the organization has not made any addition to Machinery, Motor Vehicle and Furniture during the course of 2016-17 thus, the reason for increase in amount of depreciation in the year has to be evaluated. There could be misstatement in reporting the amount of depreciation in the profit and loss account. Since the amount of difference between the depreciation amounts of two years is quite significant thus, it has to be evaluated correctly (Gaynor et. al. 2016).
The amount of consultancy fees earned by the organization in 2016-17 has reduced to $49,375 from $57,000 of previous period. The reason for the same has to be properly evaluated. Is it mainly due to the difference in accounting period between two financial statements or due to other reason? Evaluation by the auditor will be helpful in determining whether there is any material misstatement in financial information (Knechel and Salterio, 2016).
The sales orders received has to be evaluated with the actual deliveries made in the period. The accounting entries recorded subsequent to the credit and cash sales have to be evaluated properly to check whether these have been correctly recorded in the books of accounts of the organization. In case of any sales return whether the same has been accounted for and due effects have been given to the relevant cash or accounts receivable accounts for such returns.
Verification of cost of sales requires the auditor to verify the inventory management system, i.e. procurement and issue of materials and goods. The auditor would evaluate the inventory valuation model used by the entity to determine cost of sales and closing inventory. Whether the inventory has been correctly debited subsequent to the procurement and credited subsequent to issue for sales has to be verified. Apart from that subsequent to sales return whether inventory has been recorded in books of accounts as return shall be evaluated properly. In case of any error in recording the procurement, issue and return of inventories then the amount of cost of sales would be affected and so would be the profit and loss of the organization (Chan and Vasarhelyi, 2018).
The amount of depreciation recorded in the books of accounts of the organization for the period ending on 30th April, 2017 is $29,620.83 whereas in 2015-16 the amount of depreciation charged in the profit and loss account was $15,783.00. A closer verification of the Trial Balance of the organization reveals that there has been no acquisition of additional fixed assets such as Machinery, Motor Vehicles and Furniture during the period between July 014, 2016 and April 30, 2017. Thus, the reason for such increase in the amount of depreciation must be evaluated to determine whether there is any material misstatement in the books of accounts of the organization during the period ending on April 30, 2017 (Badolato, Donelson and Ege, 2014).
As per s307C of Corporations Act, 2001 an auditor must express his opinion on the financial information of an organization. The auditor must state whether the financial information is correctly reflects the performance and position of the organization as on a particular date. In order to conduct an audit as per the requirements of Corporations Act, 2001 an auditor must conduct an audit in accordance with the auditing standards applicable in the country. ASA 240 guidelines the responsibilities of an auditor to consider fraud in an audit of financial statements irrespective of the feeling of an auditor about the client and its staffs (Cao, Chychyla and Stewart, 2015).
It is immaterial whether a senior partner feels that the staffs of the client are trustworthy or not. Auditor must carry out his standard procedures to consider the risk of fraud in an audit of financial statements to accumulate substantial evidence to come to a conclusion on the risk of material misstatements due to fraud in financial information. Hence, in this case also the suggestion of the audit partner to not consider fraud risk in the audit of Fuchsia Enterprises is inappropriate and irrelevant. The audit must consider the aspect of fraud risk as per the guidelines provided in ASA 240 issued by the AAUSB (Louwers et. al. 2015).
Conclusion:
Summarizing the above discussion it is easy to understand that the preliminary assessment about the materiality level set by the audit partner at $15,000 is quite high considering the amount of revenue and other items of Trial Balance. Similar the view of the audit partner to not consider the fraud risks for the audit of the entity is also inappropriate. It would be harsh to suggest that there had been any particular indication of fraud from analytical review. However, the risk of material misstatement in the financial information is indicated from analytical review. This is because despite significant increase in gross profit ratio the net margin of the organization has deteriorated significantly.
Thus, the auditor is recommended to reduce the materiality level for account balances and should conduct the audit without any preconceived notion about the entity and its staffs. The audit should be conducted in accordance with relevant standards on auditing to ensure that the audit opinion is appropriate and valid. Also the huge increase in amount of depreciation despite no addition to fixed assets indicate possible area of misstatement in the financial statements of the organization.
References:
Badolato, P.G., Donelson, D.C. and Ege, M., 2014. Audit committee financial expertise and earnings management: The role of status. Journal of Accounting and Economics, 58(2-3), pp.208-230. [Online] Available at: https://www.sciencedirect.com/science/article/pii/S0165410114000470 [Accessed 15 September 2018]
Cao, M., Chychyla, R. and Stewart, T., 2015. Big Data analytics in financial statement audits. Accounting Horizons, 29(2), pp.423-429. [Online] Available at: https://www.aaajournals.org/doi/abs/10.2308/acch-51068?code=aaan-site [Accessed 15 September 2018]
Chan, D.Y. and Vasarhelyi, M.A., 2018. Innovation and practice of continuous auditing. In Continuous Auditing: Theory and Application (pp. 271-283). Emerald Publishing Limited. [Online] Available at: https://www.emeraldinsight.com/doi/abs/10.1108/978-1-78743-413-420181013 [Accessed 15 September 2018]
Choudhary, P., Merkley, K.J. and Schipper, K., 2018. Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability. [Online] Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2958405 [Accessed 15 September 2018]
Edgley, C., Jones, M.J. and Atkins, J., 2015. The adoption of the materiality concept in social and environmental reporting assurance: A field study approach. The British Accounting Review, 47(1), pp.1-18. [Online] Available at: https://www.sciencedirect.com/science/article/pii/S0890838914000729 [Accessed 15 September 2018]
Gaynor, L.M., Kelton, A.S., Mercer, M. and Yohn, T.L., 2016. Understanding the relation between financial reporting quality and audit quality. Auditing: A Journal of Practice & Theory, 35(4), pp.1-22. [Online] Available at: https://www.aaajournals.org/doi/abs/10.2308/ajpt-51453 [Accessed 15 September 2018]
Knechel, W.R. and Salterio, S.E., 2016. Auditing: Assurance and risk. Routledge.
Lakis, V. and Masiulevi?ius, A., 2017. ACCEPTABLE AUDIT MATERIALITY FOR USERS OF FINANCIAL STATEMENTS. Journal of Management, 2(31).
Lakis, V. and Masiulevi?ius, A., 2017. ACCEPTABLE AUDIT MATERIALITY FOR USERS OF FINANCIAL STATEMENTS. Journal of Management, 2(31).
Louwers, T.J., Ramsay, R.J., Sinason, D.H., Strawser, J.R. and Thibodeau, J.C., 2015. Auditing & assurance services. McGraw-Hill Education. [Online] Available at: https://app1.hkicpa.org.hk/students(NEW)/e-Newsletter/2009-05/images/FeaturedBooks_May_2009.pdf [Accessed 15 September 2018]
Moroney, R. and Trotman, K.T., 2016. Differences in Auditors’ Materiality Assessments When Auditing Financial Statements and Sustainability Reports. Contemporary Accounting Research, 33(2), pp.551-575.
Sultana, N. and Mitchell Van der Zahn, J.L., 2015. Earnings conservatism and audit committee financial expertise. Accounting & Finance, 55(1), pp.279-310.
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