Audit Materiality and Thresholds - Example

Contents Part 3 1(a) Explanatory s For Audit Rules and Regulations 3 1(b) Explanatory s In Relation to External Audit 4 2 (a) Audit Fee Threshold 6 1.2 (b) Audit Fee Base 6 Part 2: Ethical Considerations 7 2.1(a) Family Links 7 2.1 (b) Internal Control Issues 7 2.1 (c) Expectation Gap and Engagement Letter 8 2.2 Audit Engagement letter 9 Part 3: Financial Analysis and Work of Others 11 3.1 (a) Analysis of Financial Information 12 Turnover 12 Gross Profit Margin 12 Debit Terms 12 Share Price 13 Working cycle 13 Administrative Expenses 13 Interest Expense 13 Going Concern 14 Distribution Costs 14 3.1 (b) Audit Materiality and Thresholds 14 3.2 (a) Risk Elements 15 Audit risk 15 Inherent risk 15 Control risk 16 Detection risk 16 3.2 (b) Internal Control Systems Audit Evidence 16 3.3 (a) Using the work of others 17 3.3 (b) Using Sean’s Work 18 References 18 Part 1: 1.1(a) Explanatory Notes For Audit Rules and Regulations Explanatory notes for the management of Golbourne’s made under the Legal Rules and Corporate Governance Requirements Note: Statutory audit is required by law for the registered or incorporated entities with exemptions granted to small companies. External audit aims at boosting the confidence and trust of users of financial statements on the provided financial information related to an organization. External audit pertains to the independent opinion formed by the auditor(s) on the truth and fairness of the financial information along with an independent opinion on the presentation of financial statements as per the standards and framework applicable. Since the directors play a role of stewards of the assets of shareholders, the national legislatures, usually, require external audit of all companies with exemption given to small companies. (Kim, 2005) Small companies may be exempted if they meet the following criteria: The Revenue is less than or equal to £ 6.5m and Gross assets are less than or equal to £3.26m And/or average employees of the company are less than or equal to 50. The companies that work under certain industries like banking and insurance cannot be exempted from the statutory audits. Moreover, even if the above criteria are met, if 10% or more equity holders call for an external audit, it may be undertaken. It will be a non-statutory external audit as it is called by the members. Corporate Governance refers to the system through which the companies are directed and controlled. The code of corporate governance, like combined code of UK, provides guidelines on governing activities and maintain the confidence of shareholders and users of financial statements. These guidelines, in relation to auditing, suggest that: Every organization must conduct an annual independent audit of its financial statements Financial statements should be audited in accordance with the applicable frameworks and standards to ensure reliability and comparability of statements Organizations should establish an audit committee to ensure the reliability of internal controls External auditor must carry out procedures to ensure the reliability of internal control system External auditor provides information on maintaining independence if non-audit services are also provided by the firm to the client The major aim of corporate governance codes relating to audit of companies is to increase users’ confidence and standardization of the accounts to aid investors’ decisions. In our case, it is important to understand that Sean was once associated with our firm. Although a considerable time (5 years) has been elapsed since he left, it is still advisable to keep the audit negotiations between the audit firm and an audit committee as required by the code of corporate governance. In case audit committee has not been established, the negotiations should be set out between non-executive directors and audit firm partner to maintain independence and escape the self-interest threat. 1.1(b) Explanatory Notes In Relation to External Audit Explanatory notes for the management of Golbourne’s made under the Legal Rules and Corporate Governance Requirements Note: Statutory audit is limited in nature, scope and purpose and the differences between types of assurance engagements prevail and must be understood. There are a number of assurance services offered by the audit firms. The statutory (external) audit, however, is often mistaken and confused with the internal audit services. The nature of external audit, for instance, is to form an opinion on the reliability and fairness of the information presented in the financial statements. On the other hand, the nature of internal audit is more inclined towards forming an opinion on the management’s abilities to follow the plans and procedures as designed and secure the shareholders’ investments. The scope of external audit of financial statements is not limited to any extent. The auditor needs to be skeptical regarding the issues and perform procedures until a reasonable assurance is formed. The scope of statutory audit cannot be bound by limitations placed by management or any third party. Internal audit, on the other hand, is bound by the limits established by the management and is less reliable for the involvement of management is high. The purpose of external audit is to protect the interests of shareholders and other stakeholders by providing an independent opinion on the truth and fairness of financial statements. External audit establishes opinions regarding the reliability of information presented in terms of presence or absence of any material misstatement (Basu 2009; p 2.5). Assurance engagements are services provided by professional accountants and qualified auditors to provide assurance on a specific area of the company’s statements or operations. External audit and annual reviews are two types of assurance engagements with marked differences. The external audit, for instance, provides a reasonable assurance due to the existence of inherent limitations of time, large number of transactions and accounting records, professional judgment and assumption based professional decisions in accounting and so on. On the other hand, annual reviews provide a negative assurance report on existence of misstatements or inconsistencies. An annual review is less reliable as the scope of such engagements is limited by the management. The auditor or accountant provides annual reviews against a specified criterion. 1.2 (a) Audit Fee Threshold Audit opinion must be independent and unbiased. Heavy reliance on income from one client may raise self-interest threat and the fairness of audit report will be impaired. The audit firm may not want to lose the client and hence, a considerable amount of recurring income. To overcome or lessen this threat, regulatory bodies like ACCA have placed a threshold of up to 15% on recurring income from a client. The purpose of thresholds on audit fee, hence, is to ensure that independence of auditors are not impaired. Moreover, the over reliance on a company’s income give an automatic power to the management to influence auditors’ opinions. They may force auditors to provide an opinion as per their wish for future business relationships. 1.2 (b) Audit Fee Base Audit fee must be agreed upon between the audit firm and the client before commencing the audit. The basis of audit fee should take into account: The expected number of hours required to conduct the audit work efficiently by each member of the audit team The required travelling expense Hourly rate (as per the market or level of expertise or reputation) Possible expenses during the audit work Nature of Audit (complex audit assignments must be charged higher to maintain quality) The competitive tendering is an idea that is of great attraction to the management offering lower audit fee. In order to win a tender, audit firms are more inclined towards lowering their fee, especially for the new clients. This lowering is not illegal; however, it may affect the quality of work, amount of testing, size of samples and so on. The overall audit quality might be affected in an attempt to reduce the tender price (Deloitte 2013). Part 2: Ethical Considerations 2.1(a) Family Links Family and close personal relationships that exist between the staff of the auditing firm and client may pose a threat to independence. There is a need to identify the responsibilities of the related members in the assurance engagement, their influence and ability to influence the audit opinion and the extent of relationship. If there is a threat to objectivity, the person must be removed from the engagement team immediately. In the scenario, David Chizande is carrying out most of the delegated tasks of sales related transactions. David’s brother, being in the audit firm employed with the external auditing task, must ensure that he is not included in the audit team working for this assignment. Moreover, it must be ensured that none of the team members are influenced by remarks, suggestions or requests from David’s brother. A quality control review may aid in identifying any discrepancies that still existed due to this relationship (Nasba 2013). 2.1 (b) Internal Control Issues The internal Control system seems to be weak as the sales director, Chris, is given more responsibilities than he can handle. His absence and informal delegation of work is another internal control weakness. There seems to be no monitoring of the processes. The sales invoices seem to be dispatched and banked without authorization from the Sales director. There is a high risk of fraud, firstly due to heavy reliance on Chris for whole of the sales procedures till banking the amount from clients. Moreover, lack of monitoring provides ample space to David for misappropriation of sales and records. Similar is the case of Amanda who is dealing with production and supplier issues. She is solely responsible for the entire process till authorizing the cheques. This bestows excessively high power to an individual without any mechanism of monitoring or control working around. Moreover, the purchasing requirement and production schedule is not matched against any records. The sole reliance on meetings regarding sales order requirements may not reflect the actual or calculated amounts. There is a high possibility that David or Chris place a higher sales demand and steal the finished products as the sales records may easily be manipulated by them. The internal control risks, hence, seem to be high. The risks of weaknesses in internal controls call for more substantive and analytical procedures to be performed, by the external auditor. The risk of fraud and human error for lack of delegation and monitoring is also high. The external auditor, as a result, needs to extend the extent of audit procedures. 2.1 (c) Expectation Gap and Engagement Letter The expectation gap is the gap between what the public believe that auditors do (or ought to do) and what they actually do. The expectation gap usually is based on the assumption that auditors are responsible to detect and prevent fraud and error. This misconception needs to be curbed since auditors have a duty to detect, up to a reasonable level, material frauds. Moreover, corporate collapses were often misunderstood to be the responsibility of auditors’ negligence or conduct, whereas, directors are responsible for the running and long-term success of the organizations. In order to address the limited responsibility of auditors and remove the expectation gaps to a certain extent, an audit engagement letter provides the scope of auditors’ responsibilities. An audit engagement letter is a document that sets out the basic terms of the audit engagement. The engagement letter sets out the objective and scope of engagement, the responsibilities of auditors, the responsibilities of management, the financial reporting framework to be followed and the form and content of the report (ACCA, 2008). 2.2 Audit Engagement letter Bonney, Kuteszko & Co. Members of Association of Chartered Certified Accountants Central Manchester Edward Golbourne Ltd. Central Manchester. 25th August 2012. Dear Sirs, This letter is presented to provide the basis of our role as auditors of Edward Golbourne Ltd. and the respective areas of responsibility of management and of ourselves. This letter is applicable for the external audit work for the year to 30th September 2012 and subsequent periods unless agreed otherwise. We affirm to be bound by ethical guidelines as set out with the accountancy body we are members of (i.e. ACCA). The statutory audit engagement period is from 1st October 2011 till 30th September 2012. Company’s management is solely responsible for the preparation and management of accounts. Detection of frauds and errors, and the rectification thereof, is also under the responsibilities of the management. Management is responsible to prepare the financial statements as per the presentation criteria set out in International Accounting Standards and the Framework. Auditor’s responsibility is to form an opinion, following the auditing standards and regulatory frameworks, on the financial statements of the company. The auditors are responsible to perform procedures in order to ensure that reasonable degree of assurance is attained to provide an opinion. Due to the inherent limitations of audit procedures, risks of undetected errors remain present. Auditor will be responsible to gather sufficient appropriate evidence to form an opinion. Fees will be charged on the basis of assessed risk that determines the time, scope and extent of audit procedures required. The fees will be charged at a standard market rate per hour of the audit time period for each member of the audit team. The audit work will be carried out keeping the UK GAAP and International Standards on Auditing under consideration. The terms of this engagement will be effective for the whole audit time period and any changes will be explicitly communicated. It is advised that you authorize (sign) and send the copy of this engagement letter back as an affirmation of the terms stated. Regards, Bonney, Kuteszko & Co Acknowledged on behalf of Edward Golbourne Ltd. ...................... Name and Title / Date Part 3: Financial Analysis and Work of Others Ratio 2011 2012 2012 (draft) Industry ROCE 1100/3930=28% 1560/5760=27% 1100/5790=19% 24% Interest Cover 1100/90=12.2 1560/220=7.09 1100/125=8.8 10 Average stock turnover 365/(4160/480)=42days 365/(4840/530)=41days 365/(5050/830)=61days 40 Debtors collection period (540/6120)*365=32days (730/7800)*365=34days (880/7650)*365=42 35 creditors collection period (455/4160)*365=40 (665/4840)*365=50 (775/5050)*365=56 50 EPS 737/1800=41p 940/2000=47p 760/4000=19p 20p GP Ratio 1960/6120=32% 2960/7800=38% 2600/7650=34% 35% Net Profit 1100/6120=18% 1560/7800=20% 1100/7650=14.4% 15% Dividend per Share 600/1800=33p 810/2000=41p 1850/4000=46p 30p 3.1 (a) Analysis of Financial Information Turnover Turnover has increased by £1530000 (almost 25%) over the last 12 months. There is a possibility and potential risk of revenue misstatement or erroneous sales recording. Gross Profit Margin The Gross profit Margin has been increased slightly (i.e. approximately 2%) as compared to the last year. In absolute terms, Gross profit has increased by 640,000 (i.e. 33%) compared to the last year. There is some discrepancy in the change in GP as a product of sales. There may be some unusual fluctuations in the company’s manufacturing costs. Debit Terms The company’s debt collection period has increased by 31% (i.e. it moved upward from 32 to 42 days). The debt collection process seems too sluggish as compared to the industry average. It might be a possibility that company has granted relaxation of extended credit to the clients to boost sales. However, such initiatives need to incorporate the risk of uncollectable debts by setting up a provision. As of now, the company does not seem to have a bad debt provision in place. This may harm the company’s cash collection ability and the debtors shown in the financial statements may show an unreal and overly aggravated picture of company’s assets. There is a need to analyze the debtors’ collection period and possibility of bad debts in order to remove any excessive debt collection amounts shown as assets. Share Price The company’s Earning per share has been reduced to over 50% as compared to 2011. The EPS was 41p in 2011 and 19p as at 2012. Although a huge decrease has taken place, EPS at 19p is in line with the industry average which is noticed at 20p. The ordinary have doubled as compared to 2011. Audit evidence is to be gained with respect to the cash flow of the company. This huge increase direct towards a cash flow issue that is being covered up by the company by issuance of more issues. Working cycle An increase in both debtors and creditors period is not a good sign. Although an increase in creditors’ period may seem to be beneficial for the working cycle, there is a possibility to lose suppliers which may cause a big setback to Goulborne. The creditors’ collection period is higher than the industry average which may pave way to losing a few suppliers. A high debtor’s collection period may lead to more bad debts taking place causing a further blow to the cash flow of Goulborne. Average stock turnover has also been increased. Administrative Expenses Administration costs have been increased more than half of its value as on 2011. Although a huge increase was budgeted, revenue hasn’t climbed as much as expected. This area is to focused on during the planning phase and furthermore analytical procedures to be carried out to determine whether this is caused due to omission, misstatement or mismanagement. Administration costs being low than budgeted do not mean that the company has done well. An in depth analysis and assessment is to be carried out. Interest Expense An increase of more than one third of interest expense has been witnessed in the year 2012. There is a possibility that this increase has been cause to availing the facility of overdraft but this is not confirmed. Audit procedures such as enquiry and confirmation along with inspection of debt related documents should be carried out. It is also to be noted that long term has debt has also been increased by almost one fourth. Going Concern There is no such reason to believe that the company is going through any going concerns problems. But such high admin costs along with a significant decrease in earning phir share may seem a touch alarming, the revenue has not increased in line with admin expense, this may be a result of expansion. Well the cause of fluctuation are to be assessed more closely but at the moment as compared to industry averages, it seems like Goulborne has enough funds to meet its liability and carry on with it operations in near future. Distribution Costs Distribution costs have almost doubled; this may cause a cash flow problem for the company. There is a need to establish sufficient evidence to ensure that the company will be able to meet these expenses and its going concern assumption is secured. 3.1 (b) Audit Materiality and Thresholds Misstatements and omissions are said to be material if they could reasonably influence economic decisions of the users of financial statements, whether individually or in aggregate. To assess what is actually material depends on the professional judgement of the auditor and may be affected by the perception of the auditors about the needs of the users of the financial statements. The thresholds to determine material amounts to the financial statements are: Turnover ½%-1% Total Assets 1%-2% Profit 5%-10% Disaggregation is the procedure of analysing and breaking down data into more detailed sub categories. This may help in analysing data more closely as it shows up variances and difference that are not reflected properly in aggregated data. Disaggregation helps to minimise and reduce risk. 3.2 (a) Risk Elements The following risk elements are important to be understood and managed during an audit: Audit risk The risk that an auditor may give an inappropriate opinion on financial statements that are being audited is known as audit risk. The audit risk may arise due to 3 other risk elements, mathematically shown as: Audit risk= inherent risk x control risk x detection risk (ACCA, 2008) Inherent risk Inherent risk may be greater for some related classes of account balance disclosures and transaction as compared to others. Inherent risk can be defined as the risk that a financial assertion may be susceptible to a misstatement that is material in nature. Example includes double counting sales. Control risk Control risk is the risk that an error of material nature shall not be detected or be prevented on a timely manner by the internal controls of a company. Example may be taken as a wrong figure in revenue may not be noticed until the financial statements are actually published. Detection risk Detection risk is the possibility that the procedures being carried out by the auditor will not detect material misstatements that actually exist. The misstatements may be material individually or in aggregate. An example being that the revenue figures have been stated wrongly and the auditor consequently gives a favourable opinion that is actually inappropriate. 3.2 (b) Internal Control Systems Audit Evidence The following 5 methods may be used to generate internal control systems audit evidence for the audit of Goulborne (Open Tuition, 2013) . Inspection: refers to the physical review of the company records and its tangible assets. Inspection of documents such as purchase invoice of Goulborne shall help in obtaining audit evidence with respect to the amount being recorded in the accounting books. Observation: refers to the looking at a procedure or process that is being performed. This is carried out to make sure that the process being carried out actually is working as it has been documented. Enquiry and confirmation: refers to seeking information from people, who are knowledgeable, that may or may not be a part of the company. This may be done formally or informally both. The information being collected may be of financial or non-financial nature. With the help of this method accounts payable can be confirmed and purchases that have been taken place at Goulborne, can also be crosschecked. Recalculation: refers to the checking of arithmetical accuracy from and of the source documents along with the accounting records. Figures such as revenue and cost at Goulborne may be relcalculated to make sure that no material error has been performed by the management of Goulborne Analytical procedures: refers to the process of analysing significant ratios and investigating material fluctuations and variances. Analyse trends and relationships in financial and non-financial data by means of plausible relationships. With the help of this method material fluctuations of 2012 as compared to that of 2011 and the budgeted FS of Goulborne can be spotted out and then be analysed, hence helping planning out the audit. 3.3 (a) Using the work of others An auditor may use the work of other where professional judgement and expertise is required, for example valuation of property and where work of others is the only source of audit evidence. In case an auditor has to rely on the work of an expert he should make sure that the experience and reputation of the expert with respect to the audit evidence being seek is well known. It is preferable that the expert be a member of a relevant professional body and has a related license. The expert also should not be employed by the company, whose audit is being carried out. In case the work is someone who is an employee of the company and that is the only source of audit evidence available, the sample sizes of work should be increased and the work that has been performed should be scrutinised properly, leaving a minimum possibility of missing out a material error. Written representations may also be asked for. It is to be noted that it is sole responsibility of the auditor to obtain evidence and form an opinion on the financial statements. He cannot rely on others work and later on blame the related person for any misstatement. He should form an opinion once he is totally satisfied with the audit evidence that has been gathered. 3.3 (b) Using Sean’s Work While assessing Sean work a couple of things are to be kept in mind, firstly the nature of his work performed with respect to the audit. The work of Sean is highly material hence is to be analysed and assessed critically. He performs many tasks which should be performed by different individuals. Due to the nature of his work, until and unless his work is not assessed critically and enough audit evidence is not gained on the reliability and truthfulness of his work, it must not be relied upon. Another factor to keep in mind is Sean’s familiarity with the people at the audit firm. He had been working in the firm that is now auditing Goulborne, hence it should be made sure that people who are familiar with him are not assessing or reviewing the work carried out by Sean, even though 5 years is enough time to affect the independence of audit opinion or work; it is advisable that team members should consist of people who have not interacted with him recently and don’t know him personally. Sean’s work is not to be relied on unless the auditor is fully satisfied on the reliability and fairness of his work. The risk of fraud, intentional misstatement or omission thereof, requires the audit team to use professional scepticism when using Sean’s work. References Basu, S. K. (2009). Fundamentals of auditing. New Delhi: Pearson Education. Deloitte. 2013. Disclosure of auditor fees. [ONLINE] Available at:http://www.deloitte.com/view/en_BE/be/services/aers/audit/auditrequirementsinbelgium/independence-rules-for-auditors/disclosure-of-auditor-fees/index.htm. [Accessed 08 February 2013]. Open Tuition (2013). Audit Evidence. [ONLINE] Available at: http://opentuition.com/wp-content/blogs.dir/1/files/group-documents/15/1289456158-AUDITEVIDENCE.pdf. [Accessed 08 February 2013]. Nasba (2013). Ethics and Strategic Issues Discussion. [ONLINE] Available at:http://www.nasba.org/files/2011/03/Ethics_and_Strategic_Issues_Discussion-2010.pdf. [Accessed 08 February 2013]. KIM, J. (2005). Crisis and change South Korea in a post-1997 new era. Seoul, South Korea, Ewha Womans University Press. http://catalog.hathitrust.org/api/volumes/oclc/71353590.html. ACCA, 2008/09: Paper F8 UK. (2008). Wokingham: Kaplan Publishing. Read More