Preliminary assessment of misstatement and materiality

Preliminary judgement is the maximum amount the auditor can accept the misstatement that will not have material impact on the decision provided by the auditor for the users of financial statements. As materiality is a relative factor it is important that it must have a base to establish the fact that whether the misstatement is material or immaterial. Base here is crucial as the users take their decisions based on that. Further, some of the misstatements are more important as com-pared to others even if the amount is not big. For instance, misstatements that involve fraud are likely to be more crucial to the users as compared to the misstatement with regard to unintentional errors. However, the base varies on the basis of business nature. Various bases used for establishing the level of materiality are revenue, net income and total assets. Materiality level is established by taking into consideration all the above mentioned factors (Eilifsen and Messier 2014).

If the quantitative factors are taken into consideration the materiality tolerance for Cyclamen Enterprise will be 1% to 5% of sales that is $ 197,950 *1% = $ 1979.50 to $ 197,950 * 5% = $ 9,897.51. Further, 50% to 75% of the materiality amount will be considered as tolerable misstatement. Therefore, in case of Cyclamen Enterprise tolerable misstatement will be amounted to around $ 5000. As per the auditor the preliminary assessment for materiality shall be set at $ 15,000. However, as per the calculation the materiality shall be set at $ 5,000 (Legoria, Melendrez and Reynolds 2013).  If the materiality level is reduced the auditor will have to check more items as per the level of tolerable misstatement. Hence, with changes of materiality amount in case of Cyclamen Enterprise the audit budget will increase as the auditor will be required to check more items.

It is the audit procedure that is carried out on the basis of accounting ratios and it tries to recognize significant changes. It includes analysing of trends and ratios and identifies the unusual items and fluctuation from the balance sheet as well as the income statement. The reliance that can be placed by the auditor on the analytical review depends on the materiality level and assessment of the control risks and inherent risks. Purposes for which the analytical review in audit is carried out are as follows –

• It provides overall review of financial statement in final audit review stage.
• It helps the auditor to plan the extent, timing and nature of the audit procedures.
• It works as a substantive procedure and its use can be more efficient and effective as compared to detail tests for reducing the detection risk for particular assertion involved in financial statement.

Sales reflect the performance and activities of the company as the potential investors and lenders assess the risks of their investments through the sales trends of the entity. In case of Cyclamen Enterprise the sales revenue has been increased from $ 187,450 to $ 197,950 over last one year time period. Further, as different recognition method for sales revenue is applied by different entities sales revenue must be verified for material misstatements.

Analytical review and audit procedures

The auditor is mainly concerned about 3 types of material misstatements with regard to sales – (i) sales made and recorded to the fictitious customers (ii) recognising the revenue even if the goods have not yet been shipped or the service have not yet been provided and (iii) goods are already shipped or the services are already provided but the revenue is not yet recognized. The major assertion involves with the sales revenue transaction is accuracy (Mock and Fukukawa 2015). The availability of authorized price list and trade terms minimizes the inaccuracy risks. Therefore the assertion involve with sales revenue is that the sales revenue transaction involves mathematical inaccuracy.

Cost of sales consumes maximum major proportion of the sales revenue. Further, the other expenses of the entity are met from the amount left after meeting the cost of sales from sales revenue. In case of Cyclamen Enterprise the cost of sales has been reduced from $ 63,595 to $ 61,051 over last one year time period.

Generally, the cost of sales increases with the increase in sales revenue and number of products or services sold and in the contrary it reduces with the reduction in sales revenue and number of products or services sold. However, the situation may be changed if the product or service selling prices have been enhanced or the company made any mistake in recording the COGS under appropriate period (Antonio 2014). Therefore, the assertion associated with COGS is cut-off that is the COGS is not recorded under correct accounting period.

Depreciation amount increases when the entity purchases any new asset or the entity has changed the method of depreciation. It is found from the income statement of Cyclamen Enterprise the cost of sales has been reduced from $ 63,595 to $ 61,051 over last one year time period. However, no new purchase was found in case of the fixed asset from the trial balance.

As it is found that the depreciation is increased though any new asset has not been purchased, likelihood is there that the company changed the depreciation charging method or misstated the amount. Assertion may involve in case of depreciation is occurrence that is the the depreciation recorded for all the assets are recorded for correct accounting period. Another assertion involves here is cut-off that is the depreciation is charged for proper accounts (Titera 2013).

As wages forms a major portion of the operating expenses in case of any entity, the wages shall be analysed properly. Further, as the wages involve payment for the employees those are generally in big numbers likelihood is there the payment is been misstated for one or more employees. It is found from the income statement of Cyclamen Enterprise the wages has been reduced from $ 53,000 to $ 52,570 over last one year time period.

Importance of sales revenue auditing

As wage involves payment to number of employees, advance payment made to them and arrear payment due to them, it give ample chance to the management to misstate the wage payment. Further, as the amount of wage has been reduced as compared to the previous year likelihood is there that 1 or more employee retired during the year or payment to some employees are due or the amount has been misstated (Lessambo 2018). Therefore, the assertion involves here is accuracy that amounts and data associated to wage record have been appropriately recorded.

For preventing the fictitious sale the company shall segregate the duties including the billing function, order entry and shipping function. Further, it must be verified that the sales are recorded with approved shipping order and customer order (Ruhnke and Schmidt 2014). Further, to minimize the accuracy misstatement sales invoice shall be matched with customer order and shipping document with details like mathematical accuracy, price of the product and quantity. The sales invoices shall be verified with the sales report on daily basis.

For auditing the COGS the auditor shall perform the predictive test for each product line, business segments or divisions through reference of details with regard to the average unit cost and units shipped. Investigation shall be made for any difference in recorded amounts and predicted amounts. Vouchers related to COGS shall be traced through unit costs used for releasing the inventory under the cost records (Kogan et al. 2014). Further, the auditor shall check that the COGS have been charged to appropriate period under which the sales are made.

The auditor while auditing the depreciation must analyse the internal control related to the assets on which the depreciations have been charged. The key controls those are important for the auditors to check upon are the asset purchase authorisation procedure, amount involved in purchasing the assets, selling procedure and authorisation for asset, purchase date of asset and depreciation method used for the asset (Choudhary, Merkley and Schipper 2018). Further, the auditor must use his professional scepticism and select few sample calculation for depreciation to check that there is no computation error. The auditor may recalculate the depreciation for sample items, if required.

While auditing for wages the wage payment shall be matched with the employee register with details of their names, amount of monthly wages, advance payment made to them and arrear payment made or due to any employee. The auditor shall verify the entire payment voucher with the employee register (Christensen, Glover and Wood 2013). Further, if any new employee is engaged or retired during the year payment made to the new employee and stoppage of payment for retired employee shall be checked appropriately.

The auditor is responsible for planning and performing the audit for obtaining reasonable assurance that the financial statements are free from the material misstatements owing to fraud or error (Power 2013). Fraud is the intentional and purposeful misstatement committed to obtain some personal target. Frauds are committed to hide any fraudulent activities or getting higher amount of incentives. Fraud is not just identifying unusual transaction, however, auditors are also responsible to evaluate the behavioural patterns of management as well as employees to check if any indication is there that may have impact on the financial statements (Boyle, DeZoort and Hermanson 2015). Therefore, even if the staffs are faithful there always remains the likelihood of fraud and therefore, the audit partner’s suggestion is not appropriate.

Reference 

Antonio, G.R., 2014. Continuous auditing: Developing automated audit systems for fraud and error detections. Journal of Economics, Business & Accountancy Ventura, 17(1), pp.127-144.

Boyle, D.M., DeZoort, F.T. and Hermanson, D.R., 2015. The effect of alternative fraud model use on auditors’ fraud risk judgments. Journal of Accounting and Public Policy, 34(6), pp.578-596.

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

Christensen, B.E., Glover, S.M. and Wood, D.A., 2013. Extreme estimation uncertainty and audit assurance. Current Issues in Auditing, 7(1), pp.P36-P42.

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.

Kogan, A., Alles, M.G., Vasarhelyi, M.A. and Wu, J., 2014. Design and evaluation of a continuous data level auditing system. Auditing: A Journal of Practice & Theory, 33(4), pp.221-245.

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.

Lessambo, F.I., 2018. Audit Risks: Identification and Procedures. In Auditing, Assurance Services, and Forensics(pp. 183-202). Palgrave Macmillan, Cham.

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.

Power, M., 2013. The apparatus of fraud risk. Accounting, Organizations and Society, 38(6-7), pp.525-543.

Ruhnke, K. and Schmidt, M., 2014. Misstatements in financial statements: The relationship between inherent and control risk factors and audit adjustments. Auditing: A Journal of Practice & Theory, 33(4), pp.247-269.

Titera, W.R., 2013. Updating audit standard—Enabling audit data analysis. Journal of Information Systems, 27(1), pp.325-331.