Determining Planning Materiality For Audit – Factors And Sources

Understanding Inherent Risk and Audit Risk

In the given case, the auditors are required to determine the attached inherent risk in the company. Based on the audit risk the auditor of the company is required to base their audit procedure and determine the level of the substantive audit procedures that will be applied for the transactions of the company. The auditors of the company make use of the assertions for the various account balances which help them in determining the audit risk of the company. The concept of materiality is very important as it helps the auditors to base down their decisions. The materiality for the audit is determined based on the professional judgment of the auditors.

There are various sources which can use in determining the planning materiality of the company. The PM can be determined based on applying a certain percentage to the turnover, equity, total assets etc.

There are certain factors that are affected at times of determining the benchmark for identifying the planning materiality:

• The various elements of the financial statements.
• The item that arose the attention of the users of the financial statements.
• The nature of the entity, its life cycle, the economic environment and the industry factors.
• The volatility benchmark of the factor that is expected to be used by the auditors.
• The ownership structure of the entity and the basis through which the same has been financed.

In the given case, the auditor of the company is required to choose among the various available sources in determining the materiality for planning the auditor work. Considering the trail balance of the company for the year ended 30^th September 2011, the profit before tax can be considered as the source that can be used in determining the planning materiality of the company for audit purposes. By looking at the income statement for the last two years, it is evident that the company is a consistent profit making company. The profit earned by the company in the last two years are consistent and by looking at the turnover and other expenses of the company it is evident that going forward, the management of the company will be able to maintain the consistency. Profit before tax is a viable source for determining the planning materiality for profit generating companies. If the profit earned by the company is not consistent, the audit prefers going in for other sources like turnover and gross profit.

Thus considering all these factors, the planning materiality of the company will be calculated as follows:

Particular	2011
Profit before tax	$        1,429,814
Threshold	5%
Planning materiality	$              71,491

 The auditor in this case can even choose the revenue of the company as the basis for computing the planning materiality. The revenue in this case needs to be annualized and then multiplied with the threshold factor.

Particular	2011 (9 months)	2011 (12 months)
Revenue Stores	$              640,782	$                854,376
Revenue Wholesale	$        27,255,417	$          36,340,556

Answer A

Financial Ratios

Current Ratio	30 September 2011	31 December 2010
Current Assets	$                     22,303,997	$             23,459,330
Current liabilities	$                     10,483,051	$             17,050,817
Current Ratio	$                                  2.13	$                          1.38

Quick Ratio	30 September 2011	31 December 2010
Current Assets	$                     22,303,997	$             23,459,330
Less: Inventory	$                     (5,924,136)	$             (6,263,242)
Less: Prepayments	$                     (1,112,028)	$                (666,054)
Quick Assets	$                     15,267,833	$             16,530,034
Current liabilities	$                     10,483,051	$             17,050,817
Quick Ratio	1.46	0.97

 Looking at the financial ratio of the company, it is evident that the financial position of the company has improved as compared to the prior period.  The current ratio of the company has improved from 138% in the prior period with 213% in the current period. This improvement is very well evident from the quick ratio of the company as well. However, the company in the current year has witnessed losses. The company in the current period has witnessed a loss of $1.8 million which is majorly on account of additional advertisement expenses that has been incurred by the company. The company in the current period has incurred advertisement expenses worth $4.1million as compared to $1.5 million in the prior period. The company is incurring these expenses with an intention to increase its sales. Further there has been a dramatic increase in the insurance premium of the company the insurance premium increased by approx 33% in the current period as compared to the prior period. The revenue numbers of the company has also reduced by 18% in the current period as compared to the prior period.

Sources for Computing Planning Materiality

The major business risk that is evident from the above figures and by looking at the trial balance of the company is the decreasing sales numbers of the company. The revenue numbers of the company has also reduced by 18% in the current period as compared to the prior period. The company has been incurring huge advertisement cost to increase the sales in the company but in spite of incurred $4.1m expenses on the advertisement cost, there has been a decrease in sales by 18%.

	Balance Sheet
	30 September 2011	% of Total Assets	31 December 2010	% of Total Assets
Current Assets
Cash	$                    245,965	1%	$               1,753,765	7%
Trade Receivables	$              10,499,174	44%	$             10,701,064	44%
Inventories	$                 5,924,136	25%	$               6,263,242	25%
Financial Assets	$                 3,987,453	17%	$               4,075,205	17%
Prepayments	$                 1,112,028	5%	$                   666,054	3%
other assets	$                    535,241	2%
Total Current Assets	$              22,303,997	93%	$             23,459,330	95%
Non-current assets
Property, plant and equipment	$                 1,449,330	6%	$                   852,965	3%
Deferred Assets	$                    346,949	1%	$                   277,559	1%
Total Non-current assets	$                 1,796,279	7%	$               1,130,524	5%
Total assets	$              24,100,276	100%	$             24,589,854	100%
Current liabilities
Payables	$              10,023,185	42%	$               8,413,818	34%
Interest bearing liabilities			$               8,240,091	34%
Current tax liabilities	$                    159,866	1%	$                   207,893	1%
Provisions	$                    300,000	1%	$                   189,015	1%
Total current liabilities	$              10,483,051	43%	$             17,050,817	69%
Non-current liabilities
Deferred tax liabilities	$                    198,647	1%	$                   170,284	1%
Loan	$                 9,021,836	37%
Interest bearing liabilities			$               1,500,000	6%
Provisions	$                    401,658	2%	$                     79,567	0%
Total non-current liabilities	$                 9,622,141	40%	$               1,749,851	7%
Total liabilities	$              20,105,192	83%	$             18,800,668	76%
Net Assets	$                 3,995,084	17%	$               5,789,186	24%
Stockholders’ equity
Issued Capital	$                 5,448,026	23%	$               5,448,026	22%
Reserves	$                  (247,638)	-1%	$                (259,498)	-1%
Accumulated Losses	$              (1,205,304)	-5%	$                   600,658	2%
Total stockholders’ equity	$                 3,995,084	17%	$               5,789,186	24%

 While looking at the common size balance sheet, the auditor can make out the area where they can make out the major section where they can focus and carry out their substantive audit procedures. By looking at the above common size balance sheet, it is evident that 44% of the total assets is contributed by the trade receivables. Thus, if the auditor is likely to comment on the financial position of the company, they can focus on the trade receivable (44%), inventories (25%) and financial assets (17%). Thus, if the auditors focus on these areas they will able to cover 85% of the total assets which is sufficient for the auditor to project an opinion on the financial statement of the company.

During the course of the audit and by looking at the financial position and performance of the company, the auditor is required to focus on the revenue numbers and trade receivable of the company. By looking at the common size balance sheet of the company, it is evident that 44% of the total assets are contributed by the trade receivables. Thus, if the auditor is likely to comment on the financial position of the company, they can focus on the trade receivable (44%) and inventories (25%). The auditor in this case is required to carry out substantive audit procedures for the revenue numbers and trade receivables. The auditor should carry out cut off testing at year end to ensure that the correct sales figures are booked in the correct period. In order to confirm the completeness the trade receivable numbers, the auditors and validate the list of the trade receivable and if required and sent the direct confirmation of the balances to the top ten parties and if required cane even test the aging of the debtors to ensure that there are no old debtors lying in the books which are not been recovered from long.

The auditors in this case have determined the PM based on the profit before tax numbers and thus accordingly they can work on the audit.

To Suzie Pickering,

Looking at the financial position of the company, the major area where there is the possibility of the material misstatement is the trade receivable and the revenue numbers. The revenue numbers of the company has also reduced by 18% in the current period as compared to the prior period. The company has been incurring huge advertisement cost to increase the sales in the company but in spite of incurred $4.1m expenses on the advertisement cost, there has been a decrease in sales by 18%. The auditor in this case is required to focus on the completeness and existence of these accounts.

References

AICPA.org, Materiality in Planning and Performing an Audit, Viewed on 2^nd April 2017, Retrieved from https://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-C-00320.pdf

Alt?nta?, T., 2010, “ATTITUDES TO AUDIT RISK MODEL AND MATERIALITY: EVIDENCE FROM TURKEY”, Sosyal Bilimler Dergisi. Available at – https://dergipark.gov.tr/download/article-file/100735 

Chiang, C.K.H., Prescott, S. and Northcott, D., 2010, “The challenges of auditing environmental matters in financial reports”. Available at – https://apira2010.econ.usyd.edu.au/conference_proceedings/APIRA-2010-144-Chiang-Auditing-environmental-matters.pdf 

Emil, P.I., Ancuta, S.G. and Timea, F.M., 2010, “Qualitative factors of materiality-a review of empirical research”, Annales Universitatis Apulensis: Series Oeconomica. Available at – https://www.oeconomica.uab.ro/upload/lucrari/1220101/27.pdf