Appropriateness of Preliminary Assessment of Materiality

Entities operating in Australia must comply with the requirements of AASB 1031 to include all material information in the financial reports of the entity. According to AASB 1031, omission or commission of any financial information that affects the decision making process of users of financial statements are material information and must be reported in the financial statements. Though there has been no specific definition of materiality however, the standard (AASB 1031) provides that materiality shall be determined on the basis of specific circumstances of each scenario (Lakis and Masiulevi?ius, 2017).  

Generally percentages are used to determine materiality of different items of revenue, expenditures, assets and liabilities. 5% to 10% bracket is generally used to calculate materiality of elements of financial statements. Using a 5% bracket on sales and cost of sales in case of Chestnut Enterprise has been used to determine materiality level.  

Jul 1, 2016 – Dec 31, 2016	Jul 1, 2015 – June 30, 2016
Materiality level   Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
For revenue:  Sales @5%	4,948.75	9,372.50
For expenditures: 5% of Cost of sales	1,526.25	3,179.75

Thus, for items of revenue an amount of $4,948.75 and $1,526.25 for expenditures can be used as material amount to conduct the audit of Chestnut. The materiality level of $15,000 suggested by the audit partner after preliminary assessment of materiality for the financial report of Chestnut is not appropriate considering the scale of operation of the enterprise (Moroney and Trotman, 2016).

As a result of change in materiality level, the auditor will have to include number of items of revenue and expenditures in auditing procedures which earlier were not subjected to substantive testing due to increased amount of materiality level. Thus, substantive audit procedures will have to be conducted on number small items of revenue and expenditures which earlier was not a part of audit plan. As a result the audit budget will increase significantly as the substantive testing would be at much larger scale compared to preliminary audit planning (Choudhary, Merkley and Schipper, 2018).

Analytical review:

Analytical review is a process that require an auditor to calculate different ratios on the basis of financial information of an entity to identify significant fluctuations in profitability, liquidity and solvency position of such entity. The analytical review of Chestnut reveals the following picture:

Profitability position of Chestnut:

	Jul 1, 2016 – Dec 31, 2016	Jul 1, 2015 – June 30, 2016
Gross profit ratio
Gross profit (Sales – Cost of sales)	68,450.00	123,855.00
Sales	98,975.00	187,450.00
Gross profit ratio (Gross profit x 100/ Sales)	69.16	66.07
Net profit margin
Net profit	25,056.43	33,071.67
Sales	98,975.00	187,450.00
Net profit margin (Net profit x 100/Sales)	25.32	17.64

Liquidity position of Chestnut:

Liquidity ratio:
Current ratio
Total current assets:
Cash at Bank	70,000	73,000
Accounts receivable	120,750	122,750
Inventory	185,000	174,000
	375,750	369,750
Total Current liabilities:
Current liabilities (Assumption equivalent to cost of sales and inventories)	215,525	237,595
Current ratio	1.743417237	1.55622

Trend analysis help an auditor to identify abnormal fluctuations in different items of revenue and expenditures. In case there is no appropriate justification behind such fluctuations then, the auditor will have to use all necessary substantive testing on the items related to such fluctuations to ensure that the financial statements are not materially misstated. On the basis of the analytical procedures and the significant differences between items of revenue and expenditures as provided in the table below, a detailed discussion on 4 accounts from income statement of Chestnut that appear to be at risk of being materially misstated are discussed here (Eilifsen, Hamilton and Messier Jr, 2017).

	6 months ending on December 31, 2016	Annual equivalent expenses for June 30, 2017	12 months ending of June 30, 2016	Difference
Bank charges	174.00	348.00	350.00	(2.00)
Depreciation	8,282.50	16,565.00	15,738.33	826.67
Interest expense	5,750.00	11,500.00	11,500.00	–
Printing	185.00	370.00	375.00	(5.00)
Repairs and Maintenance	720.00	1,440.00	5,050.00	(3,610.00)
Wages	26,285.00	52,570.00	53,000.00	(430.00)
Superannuation	1,997.08	3,994.15	4,770.00	(775.85)

Analytical Review of Income Statement

Sales and cost of sales: Increase in gross profit margin from 66.07% to 69.16% indicates that there have been significant reduction in cost of sales. The items included in cost of sales must be verified properly to ensure there is no error in recording the cost of sales in the books of accounts of Chestnut (Bumgarner and Vasarhelyi, 2018).

Expenditures: The net profit margin of the organization has increased significantly since last year. Within a period of 6 months the net profit margin has increased by almost 8% to 25.32% for the 6 months period ending on December 31, 2016. It is important to conduct thorough investigation of all expenditures as to whether these have been correctly recorded in the books of accounts or there has been any omission or commission in recording items of expenditures in the Income statement of the organization (van Buuren et. al. 2017).

Repair and maintenance: Repair and maintenance expenditure for the six month period has reduced by an annual equivalent amount of $3,610 in the 6 months period ending on December 31, 2016. Considering the significant drop the auditor will have to verify the amount of repair and maintenance for the 12 months period ending on June 30, 2016 and for the 6 months period ending on December 31, 2016.

Depreciation: Increase in annual equivalent amount of depreciation is another account balance to be checked for risk of material misstatement. Audit testing shall be conducted to verify whether the amount of depreciation has been correctly provided or not. The method used to calculate the amount depreciation shall also be checked and verified (Beasley et. al. 2018).

The auditor needs to check the internal controls within the organization to correctly record sales and cost of sales transactions. Revenue from sales must be recorded in the books of accounts only when there is no uncertainty in receiving the revenue by the organization. Auditor must verify the process of recognizing revenue in the books of accounts. In case there is any uncertainty in receiving the revenue whether appropriate provision for such uncertainties have been made in the books of accounts is also to be checked (Wright, 2016).

For cost of sales, the method followed by the organization to ascertain the cost of goods sold and the inventory valuation method used by the organization also to be verified and checked. The accounting records shall also be verified with supporting documents such as purchase orders and sales order. In case of returns, sales as well as purchase returns, whether appropriate credit and debit notes have been issued and accordingly, adjustments have been made in the books of accounts of the organization to ensure that net revenue and cost of sales reflect actual revenue and cost of sales to the organization.   

Identification of Accounts at Risk of Material Misstatement

Expenditures:

The auditor must verify the accounting entries of different expenditures with vouchers to check whether the accounting entries made to record different expenditures are correctly reflecting the actual expenditures incurred in earning revenue for the business.

Repair and maintenance:

Repair and maintenance expenditures have reduced significantly in the six months period ending on December 31, 2016. Reduction of an annual equivalent amount of $3,610 in repairing and maintenance is significantly for Chestnut. The auditor must verify the supporting documents of repairing and maintenance expenditures to ensure that all repairing and maintenance expenditures have been correctly recorded in the books of accounts (Buckless, Krawczyk and Showalter, 2014).     

Depreciation:

The amount of depreciation has increased by an annual equivalent amount of $826.67. The auditor must evaluate the depreciation method used to calculate the amount of depreciation. Whether the same method was followed in earlier years and in case of change in method of depreciation then the reason for such change shall also be assessed by the auditor. AASB 116 must be followed by Chestnut in recording the amount of depreciation. The auditor needs to verify whether AASB 116 has been followed by Chestnut to record depreciation in the books of accounts (Krahel and Titera, 2015).

ASA 240 guides the practice of an auditor in relation to risk of fraud in an audit of financial statements. Irrespective of the situation, an auditor must follow the guidelines provided in ASA 240 to discharge his responsibilities in considering fraud in relation to the financial statements of an entity. The standard procedure must be followed in discharging the responsibilities of an auditor as per ASA 240 even if the employees and staffs of an organization are trustworthy (Badara and Saidin, 2014).

In this case, the suggestion of the audit partner to not consider fraud risk in relation to the audit of Chestnut as the staffs of the organization are trustworthy is not appropriate as the standard procedure mentioned in ASA 240 must be followed in the audit of Chestnut.

References:

Badara, M.A.S. and Saidin, S.Z., 2014. Empirical evidence of the moderating effect of effective audit committee on audit experience in the public sector: Perception of internal auditors. Mediterranean Journal of Social Sciences, 5(10), p.176.

Beasley, M.S., Blay, A.D., Lewellen, C. and McAllister, M., 2018. The Association Between Board Risk Oversight and the Risk of Material Misstatement.

Buckless, F.A., Krawczyk, K. and Showalter, D.S., 2014. Using virtual worlds to simulate real-world audit procedures. Issues in Accounting Education, 29(3), pp.389-417. Available at: https://www.aaajournals.org/doi/abs/10.2308/iace-50785?code=aaan-site [Accessed on 7 October 2018]

Bumgarner, N. and Vasarhelyi, M.A., 2018. Continuous auditing—a new view. In Continuous Auditing: Theory and Application (pp. 7-51). Emerald Publishing Limited.

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

Eilifsen, A., Hamilton, E.L. and Messier Jr, W.F., 2017. The Importance of Quantifying Uncertainty: Examining the Effect of Audit Materiality and Sensitivity Analysis Disclosures on Investors’ Judgments and Decisions.

Krahel, J.P. and Titera, W.R., 2015. Consequences of Big Data and formalization on accounting and auditing standards. Accounting Horizons, 29(2), pp.409-422.

Lakis, V. and Masiulevi?ius, A., 2017. ACCEPTABLE AUDIT MATERIALITY FOR USERS OF FINANCIAL STATEMENTS. Journal of Management, 2(31).

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.

van Buuren, J., Koch, C., van Nieuw Amerongen, N. and Wright, A.M., 2014. The use of business risk audit perspectives by non-Big 4 audit firms. Auditing: A Journal of Practice & Theory, 33(3), pp.105-128.

Wright, W.F., 2016. Client business models, process business risks and the risk of material misstatement of revenue. Accounting, Organizations and Society, 48, pp.43-55. Available at: https://www.sciencedirect.com/science/article/pii/S0361368215300040 [Accessed on 7 October 2018]