Understanding BAO3306 Auditing And Materiality Analysis For Murray River Organics

Key information

Murray River Organic is the leading producer manufacturer, seller and marketer for the certified natural, organic and ‘better – for – you’ products of foods. The company survive healthy, natural and organic food as well as the snacks market all over the world. Basically the entity’s customers include retail customers like organic food stores, supermarkets, mass market, convenience stores and e-commerce retailers. On the other hand, the industrial customers of the entity include bakeries, confectionary manufacturers and cereal manufacturers. Further, the entity operates in international as well as domestic market all over 18 countries.

The company plants, harvest, grows, packs, processes and supplies the vine fruits those are dried organically like seedless raisins, sultanas, currants, Muscat raisins and clusters. Previously the entity was known as Murray River Organics Pty Ltd and was incorporated in the year 2009. The entity operates as the subsidiary of Murray River Organics Group Limited. For analysing the materiality and audit risk the report will consider the publicly issued annual report of the company for the year ended 2017 (Organic Foods | 3175 | Murray River Organics 2018). 

Key information

1. Our understanding of the client

ASA 210 that deals with the responsibilities of the auditor regarding agreeing with the terms of audit engagement with the management. The objective of the auditors is accepting the audit engagement if only the basis on which the audit is to be carried out is agreed upon. One of such basis is audit engagement and audit fee (Legislation.gov.au 2018). As per the given information it is found that the audit fee for this particular audit is $ 170,000 and the same is communicated to the audit client through engagement letter. Hence, it can be assumed that the audit will be carried out by the auditor and they have been agreed upon the terms of the audit engagement.

The financial statement of the company includes the consolidated profit or loss statement, consolidated financial statement position statement, and consolidated changes in equity statement and consolidated cash flow statement. The entity is for-profit entity with regard to preparation of consolidated financial statement. The accounting standards used while preparing the financial statements included the AAS (Australian Accounting Standards) and is complied with the IFRS (International Financial Reporting Standards). Further, the company used historical cost approach except for the agricultural produce, financial instruments and some non-current assets (Ryoo et al. 2014).

As per ASA 230 regarding audit documentation the term means record of the audit procedure carried out, relevant evidence obtained related to audit and the conclusions reached by the auditor. The auditors are required to prepare the audit documentation on timely manner. Audit documentation depends on the nature, extent and timing of performed audit procedures for complying with the AAS (Australian Auditing standards).

Audit materiality

Further, the audit is required to document the discussions regarding significant matters discussed with the management and those who are charged with the governance (Auasb.gov.au 2018). Various documents those will be documented by the auditor while performing the audit for Murray River Organic are confirmations from the client, engagement letter, correspondence, memoranda, audit programs, schedules and representation letter.

AUASB issued ASA 250 for considering the regulation and laws while auditing the financial report.  The regulations and laws to which the company is subject to have direct impact on its financial report for determining the disclosures and amounts reported. Other regulations and laws shall be complied by the management. The auditors are responsible to obtain the reasonable assurance that financial report is free from all types of material misstatement including errors or frauds.

While carrying out the audit the auditor shall consider the applicable regulatory and legal framework. However, due to inherent limitations some unavoidable material misstatement risks are there that may not be detected by the auditor even if audit is performed with proper planning. Hence, the auditor shall analyse the regulatory and legal framework applicable to the company and the industry under which it operates (Auasb.gov.au 2018). The auditor shall further evaluate the way in which the company is company is complying with the required framework. It is identified that the while preparing the financial statements the company entity prepared those in compliance with the requirement of Accounting Standards and Interpretations, Corporation Act 2001 and other laws applicable to the company.

1. Our assessment of significant accounts

By going through the financial statement of entity for the year ended 30^th June 2017 and analysing various items assessed as material are as follows –

• Inventories – inventory represent the available goods for the purpose of sale and the raw materials used for the producing the goods available for the purpose of sale. It is considered as one of the most crucial asset under any business as the inventory turnover represents the primary source for the creation of revenues which in turn provides earnings for the shareholders of the company. It is recorded as the current asset under the balance sheet of the company and it is considered as the buffer among the producing and fulfilment of order. When the inventory is sold the carrying cost of the item is transferred to cost of goods sold recorded in the income statement. It is identified from the annual report of the company that the inventory has been increased to $ 27,068,584 from $ 10,894,400 (Wild 2017).
• Trade and other receivables – in the ordinary course of business trade receivable is amount of bill raised to the customer for the delivery and sale and of services. However, in accounting the trade receivable sometimes is referred as the account receivable. In business context, trade receivables are considered as one of the larger assets of any entity that is carried on in the balance sheet under current assets. Trade receivables are the current assets as they are considered as monetary amount receivable by the business from the customers that are collectible within the time frame of two to three months from the date of sale (Gorondutse, Ali and Ali 2016). It is identified from the annual report of the company that the trade receivables has been increased to $ 88,91,091 from $ 42,35,160.
• Plant, property and equipment – It is the long-term or the non-current assets that is included under the asset section of the balance sheet. Generally, it includes building, machinery, vehicles, office equipment, fixtures and furniture those are used for the business operation. Asset recorded under plant, equipment and property are considered as tangible long lived asset. They are also represented as plant assets or fixed asset. Generally, PPE are reported at cost after deducting the amount of depreciation and impairment loss, if any. It is identified from the annual report of the company that the PPE has been increased to $ 82,240,620 from $ 48,486,749.
• Borrowings – borrowings represents the money borrowed from the banks that is secured by the registered mortgage over the buildings and lands. It also includes the liabilities related to hire purchase secured for the assets included under hire purchase. Further, the lease obligation of the company is secured by underlying assets that had carrying value amounting to $ 21,819,609 (Edgley 2014).
• Sales revenue – sales revenue being the major source of income is material by its nature irrespective of the amount involved. As the operating expenses of the company are met from the sales revenues and management’s bonus and incentives are sometimes dependent on the revenue level of the company, this item is susceptible to misstatement. It is identified from the annual report of the company that the revenue has been increased to $ 48,521,720 from $ 11,957,553 (Huang, Marquardt and Zhang 2015) 

1. Our planning materiality

Audit materiality is one of the most crucial concepts for the auditors. Misstatements that may include omissions are regarded as material if in aggregate or individually they are likely to influence the user’s economic decisions on the basis of the financial statements. In audit, the term materiality includes quantitative as well as qualitative aspects. In quantitative aspect, the auditor shall consider the below mentioned 5 steps –

• Setting the preliminary judgement for materiality. It is basically done at the audit planning stage. However, generally it is considered as 5% of net income or revenue.
• Considering the performance materiality on the basis of line items like inventories or account receivable.
• Projecting the misstatement in the account or cycle
• Projecting total misstatement in aggregate
• Comparing step 4 with step 1 to determine if the overall financial statements are misstated materially (Mock and Fukukawa 2015).

However, the audit materiality is not only quantitative by nature. Various qualitative factors are there to be considered under materiality. For, instance, if sufficient disclosures are not provided by the entity while disclosed the transactions related to related party or contingent liabilities, it may be considered as material. Apart from that, inaccurate description regarding accounting policy may also be considered as material if the entity chose to amortize the asset over 50 year’s period; however, in the disclosure note it is mentioned as 10 years only (Eilifsen and Messier 2014).

Types of materiality

Various types of materiality are there mentioned as below –

• Identified misstatement – it is the actual misstatement that can arise from representative sample ( IMR) or other than the representative samples (IMO)
• Likely misstatement – it is the projected or extrapolated impact of the IMRs
• Likely aggregate misstatement – it is the sum of IMO and likely misstatement
• Further possible misstatement – it is the likely misstatement owing to the non-sampling risk as well as the sampling risk.
• Maximum possible misstatement – it is the sum of likely aggregate misstatement and further possible misstatement (Byrnes, Brennan and CFE 2015)

Preliminary estimate for the materiality at financial level are called as planning materiality. It is the maximum amount at which the auditors think that the financial statement can be misstated through unknown or known fraud or error and will not have the impact on decisions of the reasonable users of financial statement. However, the clarified auditing standards require quantification of the level of materiality that is estimated for guiding the decision of the auditors. This estimate will only guide and it is not the specific determination of what is or what is not material under audit.

Generally, a single base like highest of total revenue of total asset is chosen for establishing the materiality level in financial statement (Kharisova and Kozlova 2014). Once the base for materiality is determined the amount is normally multiplied by the percentage factor that is sometimes determined to be the base for determining the allowance for unknown as well as known fraud and error that will be taken as a whole in the financial statement. In next step, the percentage.

factor on the basis of risk involved in the financial statement is multiplied by the planning materiality for determining the tolerable misstatement or the performance materiality. It is the maximum amount of known error that can be accepted the by the auditor in financial statement without making any adjustment (Legoria, Melendrez and Reynolds 2013).

General range for planning materiality is 50% to 75% and it depends on the moderate risk involved in the financial statement. It is commonly used for calculating the tolerable misstatement level at level of financial statement. Significantly low risk can enable the auditor for calculating the tolerable misstatement at high level for instance 80% to 90%. However, lower risk at level of financial statement will lead to fewer individually significant items that will be required to be audited 100%. When the risk is high at the level of financial statement the lower level for the tolerable statement is generally resulted using the factor for instance, say 10% to 30%.

This will lead to lower limit for individuals significant items and will gather more evidence from auditing the account balance with smaller amounts, unusual transactions or general journal entries. All percentage factors mentioned here are based on professional judgement of the auditor’s resulted from the assessment level of risk at financial statement level (Legoria, Melendrez and Reynolds 2013). However, none of the factors are mentioned in the auditing standards. Here, in the case of Murray River Organic Group Limited, materiality will be established at 0.5% of total revenue.

Audit risk

From the annual report of the entity for the year ended 30^th June 2017 it can be identified that the amount of revenue was $ 48,521,720. Hence, the amount of materiality will be (0.5% * $ 48,521,720) = $ 242,609. If the tolerable misstatement is established at 75% of materiality, the tolerable misstatement will be amounted to ($ 242,609 * 75%) = $ 181,957.

1. Our assessment of what can go wrong

Various audit risk involved with the item considered as significant for material misstatement are as follows –

• Inventories – various risks involved with inventories are as follows –

• Susceptibility to theft – theft is the biggest risk involved with inventory control, particularly the high value inventories.
• Loss of inventories – tight control for inventories in combination with the well trained personnel assist in preventing the losses. Inventories are recorded as asset under the balance sheet of the company. Whenever the inventories are written off owing to loss it will reduce the amount of equity technically as equity = asset – liabilities. Loss can take place in various forms including physical loss and errors at the time of receiving the product (Brasel et al. 2016).
• Complexity involved in the process of recording closing inventories – another risk factor involved with inventory is the complex process of recording the year end inventories. When the inventory management audit is carried out for the client past year’s data shall be checked to identify whether any misstatement exists. Misstatement can be caused due to changes in the valuation procedure of inventories like FIFO, LIFO or average method

• Trade receivables – various risks involved with inventories are as follows –

• Occurrence or existence – existence is considered as a major risk for receivables as it comprises of various small accounts. To confirm the balance the auditor is required to send the confirmation to the customers for verifying the due amount. However, for the unreturned confirmations any alternative procedure like phone or e-mail shall be applied.
• Completeness – it involves the risk that the amount due on account of receivables may not have been recorded in full. The reason is that the auditor cannot verify the transaction that is not recorded through looking into the cut-off transactions. However, this risk can be mitigated through assessing the procedures of sales and analysing the entity’s ability with regard to the procedures for transaction.
• Valuation – valuation risk is the major risk associated with receivables for various companies. As the receivables shall be recorded at net realizable value the entity shall estimate the amount of collectability after deducting the amount allowed as doubtful debt. The auditor is required to determine whether the method used by the entity is reasonable (Adu 2013).

• Plant, property and equipment – audit risk involved with PPE are as follows –

• Completeness and existence – it involves the risk that the amount on account of PPE may not have been recorded in full. Further risk involved with PPE is that the account balance for the assets actually exists on the balance sheet date.
• Valuation and rights – the valuation risk is that the assets may not have been valued properly and depreciation and impairment has not been provided appropriately. Further risk involved with PPE is that the company has rights on the assets it has recorded in the balance sheet and the obligation for the assets has been recorded properly.

• Borrowings – various risks associated with borrowings are procedures of borrowings and lending, internal control and the system related to forecasting the cash flows, counterparty selection, interest calculation and recognition of borrowing in the accounting system. Further, risk associated with the arrangement of security and access.
• Sales revenue – various audit risks involved with the sales revenue are as follows –

• Classification – the classification assertion involved with revenue is that the transactions related to revenues are recorded under correct account balance.
• Completeness and cut-off – completeness risk states that the company recorded the business events to which it is subjected to. Further, the cut –off risk is that the transaction related to sales revenues have been recorded under the correct period of accounting (Chou, Wang and Lin 2017).

1. Conclusion

From the above discussion and analysis it is concluded that some accounts of the company were found as subject to misstatement. These accounts are – inventories, trade and other receivables, plant, property and equipment, borrowings and sales revenue. However, the audit risk associated with the mentioned accounts can be mitigated as follows –

• Inventories – the auditor shall physically verify the inventories to confirm that the inventory balance recorded in the balance sheet actually exists.
• Trade and other receivables – To confirm the balance the auditor is required to send the confirmation to the customers for verifying the due amount
• Plant, property and equipment – balance of PPE shall be verified with the physical existence
• Borrowing – balance shall be confirmed with the creditors
• Sales revenue – balance shall be confirmed with the sales transactions and sales registers

1. References

Adu, F.A., 2013. Working capital management in trading and manufacturing firms in Accra and its effect on liquidity and profitability-a focus on inventory and trade receivables(Doctoral dissertation).

Brasel, K., Doxey, M.M., Grenier, J.H. and Reffett, A., 2016. Risk disclosure preceding negative outcomes: The effects of reporting critical audit matters on judgments of auditor liability. The Accounting Review, 91(5), pp.1345-1362.

Byrnes, P., Brennan, C.G. and CFE, P.M.V., 2015. Managing Risk and the Audit Process in a World of Instantaneous Change. Audit Analytics, p.129.

Chou, L.T.L., Wang, Y.F. and Lin, C.C., 2017. Financial Restatements and Audit Fees. Journal Of Accounting Review, 65, pp.83-116.

Edgley, C., 2014. A genealogy of accounting materiality. Critical Perspectives on Accounting, 25(3), pp.255-271.

Eilifsen, A. and Messier Jr, W.F., 2014. Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), pp.3-26.

Gorondutse, A.H., Ali, R.A. and Ali, A., 2016. Effect of Trade Receivables and Inventory Management on SMEs Performance,“. British Journal of Economics, Management & Trade, 12(4), pp.1-8.

Huang, R., Marquardt, C.A. and Zhang, B., 2015. Using sales revenue as a performance measure.

Kharisova, F.I. and Kozlova, N.N., 2014. Applying the category of «Assertions (or preconditions)» In audit of financial statement. Mediterranean Journal of Social Sciences, 5(24), p.180.

Legislation.gov.au., 2018. ASA 210 – Terms of Audit Engagements – April 2006 . [online] Available at: https://www.legislation.gov.au/Details/F2006L01364 [Accessed 3 Oct. 2018].

Legoria, J., Melendrez, K.D. and Reynolds, J.K., 2013. Qualitative audit materiality and earnings management. Review of Accounting Studies, 18(2), pp.414-442.

Mock, T.J. and Fukukawa, H., 2015. Auditors’ risk assessments: The effects of elicitation approach and assertion framing. Behavioral Research in Accounting, 28(2), pp.75-84.

Organic Foods | 3175 | Murray River Organics., 2018. Organic Foods | 3175 | Murray River Organics. 

Ryoo, J., Rizvi, S., Aiken, W. and Kissell, J., 2014. Cloud security auditing: challenges and emerging approaches. IEEE Security & Privacy, (1), pp.1-1.

Wild, T., 2017. Best practice in inventory management. Routledge.