Appropriateness of the Figure for the Preliminary Assessment of Materiality

Being an immediate member of the audit team of a firm, it has been requested that an audit planning for a small client has to be done. The client has provided the preliminary trial balance and this would be used for identifying accounts which are likely to require significant attention in the audit. The main aim of this paper therefore is to prepare a report for an audit senior, addressing the five issues as discussed below.

It has been suggested by the audit partner that the preliminary assessment of materiality for the financial report as a whole be set at $15,000. However, this figure is not appropriate for this client. This is because this amount will exceed 5% of total revenues as required by the general rule of materiality level assessment. Setting materiality at $15,000 would result into a materiality percentage level of 18% ($15,000 / $82, 479), which is considered unacceptable for the financial statements taken as a whole. The preliminary assessment of materiality level in the financial reports is the maximum amount by which misstatements due to error and fraud should not be exceeded. For determining the level of materiality for the financial reports taken as a whole, the auditor must use a single base. For instance, he can use the higher of total assets or total revenues of the company. After determining the base, the auditor should multiply the dollar amount of the base by a certain percentage factor (Louwers, Ramsay, Sinason, Strawser and Thibodeau 2015, pp. 68).

Changing the preliminary assessment of materiality would have significant effect on the budget of the audit. For instance, more audit procedures and tests would have to be performed. These require additional audit resources in terms of human resources, time and money. The audit firm may incur extra costs since there may be a need to engage experts in making valuation of fixed assets and other items which require specific professional expertise. These additional costs have an adverse impact on the audit budget (Singleton and Singleton 2010, pp. 46).

An analytical review involves comparing the detail balances from one financial period to another, with a view to substantiating reasonableness of the items without performing a systematic examination of the individual transactions that comprise the account balances (Singleton and Singleton 2010, pp. 46). However, an analytical review is based on the primary assumption that comparability of account balances and balances from period to period is able to give and show a true reflection of the company’s performance in a manner that is free from significant errors or misstatements (Louwers, Ramsay, Sinason, Strawser and Thibodeau 2015, pp. 68). The table below shows the analytical review of the income statement items from the trial balance of Coral Enterprises.

Analytical Review of Income Statement Items (Trend Analysis) Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
Item	30-Nov-16	30-Jun-16	Change (Amount)	Percentage Change
Sales	$           82,479	$        187,450	$    (104,971)	-56%
Cost of sales	$           25,438	$          63,595	$      (38,157)	-60%
consultancy fees	$           24,688	$          57,000	$      (32,312)	-57%
Interest income	$                  20	$                 50	$             (30)	-60%
bank charges	$                145	$               350	$           (205)	-59%
Depreciation	$             6,902	$          15,738	$        (8,836)	-56%
Interest expense	$             4,792	$          11,500	$        (6,708)	-58%
Printing	$                154	$               375	$           (221)	-59%
Repairs and maintenance	$                600	$            5,050	$        (4,450)	-88%
Wages	$           21,904	$          53,000	$      (31,096)	-59%
Superannuation	$             1,664	$            4,770	$        (3,106)	-65%

From the above trend analysis of the income statement items of Coral Enterprises, there are four accounts which have been identified to have been possibly misstated materially. These are sales, interest income, cost of sales and repairs and maintenance. All these items have been discussed below.

Analytical Review in Form of a Trend Analysis

The annual sales for Coral enterprises have significantly dropped by 56%. Therefore, the auditor needs to subject this item to more audit procedures and tests in order to ascertain the correct amounts of the sales of the company as these appear to be misstated materially (Louwers, Ramsay, Sinason, Strawser and Thibodeau 2015, pp. 68). One assertion that is at risk of misstatement with regard to the sales of the company is recording, since the item seems to be under-recorded in the financial statements of Coral Enterprises (Messier, Glover and Prawitt 2008, pp. 96).

The interest income for Coral enterprises appears to have been materially misstated since it has dropped significantly by 60%. The auditor therefore, must consider subjecting this item to more substantive and analytical audit procedures and tests in order to ascertain the correct amount of the interest revenue that the company received during the financial year then ended, since the recorded amount appears to be misstated materially. One assertion that is at risk of misstatement with regard to the interest income of the company is completeness. It appears that the item has not been appropriately recorded in the financial statements of Coral Enterprises in the correct amounts (Hayes, Gortemaker and Wallage 2014, pp. 88).

According to the trend analysis performed above, it appears that the cost of sales of Coral Enterprises has been misstated materially. This is because the cost of sales have declined significantly by 60%. It is therefore necessary for the auditor to subject the company’s cost of sales to substantive and analytical audit procedures for the purpose of ascertaining the correct amount of cost of sales for the company during the financial year then ended. This amount seems to have been inappropriately recorded in the financial statements of Coral Enterprises. Regarding the cost of sales for Coral Enterprises, cut off is the key assertion which is at risk of material misstatement. It should be ensured that all costs relating to sales have been recorded in the corresponding period during which they were incurred (Hopwood, Leiner and Young 2011, pp. 54).

The repairs and maintenance for Coral enterprises appear to have been materially misstated. This because there has been a significant drop of 88% in the company’s repairs and maintenance expenses. Therefore, the auditor must consider subjecting this item to more audit procedures and tests with a view to ascertaining that the item has been recorded appropriately in its correct amounts, as the amount recorded appears to be misstated materially. One assertion which is at a risk of misstatement with regard to the repairs and maintenance of Coral Enterprises is accuracy (Elder, Beasley and Arens 2011, pp. 21). The amount of this income statement item appears to have been under-recorded in the financial statements of the company (Messier, Glover and Prawitt 2008, pp. 96).

There are various audit procedures which can be performed by the auditor with respect to each of the above key assertions that are at a risk of misstatement relating to the audit of Coral Enterprises. These audit procedures for each account have been discussed below.

Four Income Statement Accounts That Appear To Be At Risk of Material Misstatement

The auditor must consider performing audit procedures that are aimed at testing for understatement in the sales revenue reported by the company in its financial statements, as indicated in the trial balance. In doing this, the auditor must make selections from reciprocal balances of sales. These are balances which are recorded by the company to the account of interest. For sales revenue, the auditor may consider examining the accounts receivables. He must confirm that the sales were recorded properly when sales were made on an account. The auditor needs to examine a sample of sales invoices to determine whether the sales made to customers were actually recorded in the sales revenue account. If from the examination of the company financial records and books the auditor finds that this was appropriately done, then he gains an assurance that the amounts of sales recorded are free from misstatements, and they are not therefore misstated (Hayes, Gortemaker and Wallage 2014, pp. 89).

The auditor must perform audit procedures that are purposed for testing for completeness of interest income reported by the company in its financial statements, as indicated in the trial balance. In order to do this, the auditor must vouch a sample of receipts to the interest income vouchers received by Coral Enterprises from its interest earning investments (Nigrini 2012, pp. 19). These receipt vouchers must be carefully checked by the auditor against the interest income account entries in the books of the company. This is aimed at giving the auditor an assurance that all the interest income received by the company were recorded appropriately in correct amounts (Elder, Beasley and Arens 2011, pp. 21).

The auditor must consider performing audit procedures that are aimed at testing cut off assertion of the cost of sales that is reported in the company’s financial statements. The audit procedure for the cost of goods has two components. For instance, the auditor must seek to determine the amount of inventory that were sold by Coral Enterprises during the financial year then ended. The auditor must also cost of the sold inventory on a unit basis (Elder, Beasley and Arens 2011, pp. 21). He can do this by selecting samples from a listing of the inventory items sold by the company during the financial period that ended. He should then drill down to the original source documents for verifying that the inventory was actually sold. These include purchase orders from clients and cash receipts issued. Finally, the auditor must request to view the invoices which substantiated the cost of the various items being examined, and would compare this cost with the amount recorded in the accounting records for the specific financial reporting period. This helps him in ascertain whether or not the amount of the cost of goods recorded actually relates to the reporting period in question (Eilifsen, Messier, Glover and Prawitt 2013, pp. 77).

With regard to repairs and maintenance, the auditor must seek to perform audit procedures for ascertaining the accuracy of these items of expense since the amount recorded in the financial report of Coral Enterprises seems to have material misstatements (Messier, Glover and Prawitt 2008, pp. 96). For instance, the auditor must examine the books of Coral Enterprises in order to gain audit evidence in support of the audit proposition that all expenditures relating to fixed assets of the company have been recorded appropriately in the correct amounts and in the proper reporting period. This examination is also aimed at giving an assurance that the company has properly expensed the non-capitalizable expenditures and that capitalizable expenditures for the company’s fixed assets have been capitalized (Arens, Elder and Mark 2013, pp. 33).

The audit partner has suggested that fraud risk should not be considered for this client (Coral enterprises). However, the suggestions of the audit partner on the fraud risk is regarded inappropriate. This is because however much trustworthy the client’s staff may seem to be, fraud risk must be considered by the auditor (Porter, Simon and Hatherly 2008, pp. 64). Although it is not a primary responsibility of the auditor to detect fraud, he must ensure that there are no material misstatements in the financial records of Coral Enterprises that may have been caused by fraud risks in the organization. Therefore, the auditor is required by the International Standard on Auditing (ISA) to gain evidence and ascertain that the financial information presented in the client’s financial statements are not materially misstatement due to fraud (Hayes, Gortemaker and Wallage 2014, pp. 88). This requirement cannot be ignored, as the auditor may be held liable for negligence and lack of due care in performance of the financial audit. According to the analytical review, there is an indication of fraud since there is a significant drop in the sales and interest income as well as other items of revenue of Coral Enterprises (Arens, Elder and Mark 2012, pp. 102).

Conclusion

As discussed above, materiality is a major issue that affects financial information presented in financial statements of a company. With regard to Coral Enterprises, there are four accounts that seem to be at risk of material misstatements. These are sales, interest income, cost of sales and repairs and maintenance expenses (Zadek, Evans and Pruzan 2013, pp. 45). The various key assertions for these account balances and the audit procedures which are required to be performed by the auditor have been discussed in the above sections.

Arens, A.A., Elder, R.J. and Mark, B., 2012. Auditing and assurance services: an integrated approach. Boston: Prentice Hall.

Arens, A.A., Elder, R.J. and Mark, B., 2013. Auditing and assurance services. Pearson Higher Ed.

Eilifsen, A., Messier, W.F., Glover, S.M. and Prawitt, D.F., 2013. Auditing and assurance services. McGraw-Hill.

Elder, R.J., Beasley, M.S. and Arens, A.A., 2011. Auditing and Assurance services. Pearson Higher Ed.

Hayes, R.S., Gortemaker, H. and Wallage, P., 2014. Principles of auditing: an introduction to international standards on auditing. Prentice Hall, Financial Times.

Hopwood, W.S., Leiner, J.J. and Young, G.R., 2011. Forensic accounting and fraud examination. McGraw-Hill.

Louwers, T.J., Ramsay, R.J., Sinason, D.H., Strawser, J.R. and Thibodeau, J.C., 2015. Auditing & assurance services. McGraw-Hill Education.

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

Nigrini, M., 2012. Benford’s Law: Applications for forensic accounting, auditing, and fraud detection (Vol. 586). John Wiley & Sons.

Porter, B., Simon, J. and Hatherly, D.J., 2008. Principles of external auditing (Vol. 3). Chichester: Wiley.

Singleton, T.W. and Singleton, A.J., 2010. Fraud auditing and forensic accounting (Vol. 11). John Wiley & Sons.

Zadek, S., Evans, R. and Pruzan, P., 2013. Building corporate accountability: Emerging practice in social and ethical accounting and auditing. Routledge.