Determine the level of materiality to be used for the audit of the group accounts for the year ending in 2017. Your answer should include a discussion of the nature of materiality, and a description of what materiality represents in terms of the audit of a set of financial statements,and should discuss the different bases and considerations employed in arriving at materiality.Explain the rationale behind your choice of a certain level of materiality. Provide a
quantitative estimate of materiality for your company.
Factors to consider when determining materiality
The company Magellan is engaged in the business of global investment. It invests the client’s capital in the global market and generates the higher returns to its clients as compared to its competitors. It has a team of professionals which analyze the best possible companies for the purpose of investment and provide the better return to its clients for their invested capital in the company.
The responsibility of an auditor in the audit of the financial statements of an organization is to express an opinion on the financial statements that whether the financial statements have been prepared according to financial reporting framework and also give the opinion on the true and fair view of the financial statements. To complete the task of an audit, the auditor should review the entire records of the company which leads to more time taken in the audit. The new concept of materiality has been introduced for the completion of the audit in the reasonable time (PWC, n.d.).
ISA 320 describes the ‘Materiality in planning and performance of Audit’. In the performance of audit, the concept of materiality is used. Materiality is decided by the auditor by its own professional judgment and professional experience. Auditor uses such materiality during the audit and to give the report on the financial statements as a whole. As such, materiality is decided not for a particular operation but it is decided for the company as a whole.
An auditor decided the materiality level, to get an understanding of the nature, timing, and extent of the audit procedure and to amend the audit plan accordingly if required. This level may vary from case to case. There are quantitative factors for the determination of materiality level in an organization, which may be useful for the auditor to decide the materiality during the audit. Some of these factors are as under:
- Profit after tax
- Gross profit reported
- Equity
- Income of the organization
- Expenses incurred in an organization
- Net assets of an organization
In the present case, the company engaged in investment business and purpose thereof is to generate the more revenue to their customers. Users of the financial statement of that company will be most concerned with the investment made by the company in the global market as this is the source of revenue to the company. The auditor will decide the materiality on the basis of the quantitative factors of materiality. The quantitative estimate of the materiality of the company is as under:
|
Particulars
|
Year 2017 ($ ‘000)
|
Year 2016 ($ ‘000)
|
|
Revenue
|
3,38,268
|
3,33,805
|
|
Net profit after tax
|
1,96,225
|
1,98,357
|
|
Total Expenditure
|
82,141
|
74,104
|
|
Materiality percentage:
|
|
|
|
2% of Total Revenue
|
6,725
|
6,676
|
|
4% of total Expenses
|
3,285
|
2,964
|
According to the annual report of the company, we have noticed that overall revenue of the company has been increased as compared to the year 2016 but net profit after tax has decreased due to increase in some expenses. Such a reduction in the net profit as compared to the previous year gives a lead to us to select the ‘net profit after tax’ as quantitative measures for the determination of materiality.
Financial Assets of the company
Analysis from audit perspective:
Decrease in performance fees and dividend income: In addition to that, we have noticed that performance fees in the year 2017 fall down by 50% in comparison to the year 2016. As an auditor is should be analyzed and extensive audit procedure should be applied thereon. Apart from that, there is a major fall in the dividend and distribution income to $ 5,501 in the year 2017 from $ 11,88,1000 in the year 2016. It should be properly analyzed as the company is investing company and it is expected that the company will devote its financial assets in the market to earn more revenue either in term of dividend or in another term.
There are two terms in materiality, one is overall materiality and another is performance materiality. ISA 320 also describes the performance materiality, which means the quantum of the amount lower than the overall maturity which will not be exceeded by the cumulative effect of the misstatement remains undetected (Anon, 2009).
In the present case, expenses were increased due to which the net profit of the company get reduced even the total revenue has increased. The auditor should identify such expenses which has impacted the profitability of the organization. In this case, the auditor has taken the materiality level of 4% of total expenses.
The quantitative figures of performance materiality will be as follows:
|
Expenses
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Amount ($ ‘000)
|
Materiality Level ($ ‘000)
|
Performance Level ($ ‘000)
|
|
Employee Expenses
|
47,370
|
1,895
|
1,137
|
|
Occupancy Expenses
|
3,155
|
126
|
75
|
Any abnormal increase in expenses may lead to the existence of material misstatement in the financial statement. As such, an auditor should extend the audit procedure to such type of abnormal events. In the present case, the auditor has decided the performance materiality for such events of 60%. So that, it can be assured that the transactions are genuine or not.
Financial Assets of the company: According to the nature of the company, financial assets as appearing as non-current assets are critical to the organization. These assets represent the amount of the customers invested in the global equity funds. These are very sensitive as minor changes in these assets may lead to serious fraud or misstatements. The auditor should decide the materiality at the high level and also review the valuation of these assets to ensure that the valuation is in accordance with the financial reporting frameworks.
This is the procedure, which is used to analyze the data of the company in different terms. In this analysis, an auditor reviews the financial data, the balance of accounts, various ratios and their trend as compared to industry. Based on that, he can decide the nature, timing, and extent of the audit procedure (Anon, 2018).
Key Financial Ratios
The key ratios have been calculated and discussed as follows (Glenn, 2016):
- Current Ratios: This ratio is calculated to ensure the liquidity of the company. It represents the portion of current assets to meet its current liabilities. If the ratio is 2:1 then it is considered that the company’s ability to pay off its short-term obligations is good.
In the present case, the current ratio of the company in the year 2017 is 7.91. While in the year 2014, it was 4.94. The current ratio of the company is increasing regularly. Reason for the same is the increase in the current assets of the company due to in ncrease in cash and cash equivalent portion. Another reason is the decrease in the current liabilities since 2015 regularly. This shows the company’s strength about its short-term provisions.
During the audit of the current ratio, the auditor should not only rely on the accuracy of the ratio and trend thereof. He should also review the data used in calculating such ratios. There may be a risk of misstatement like overvaluation of assets. In the present case, the trend of the ratio is good but the auditor should include the review of current assets and liabilities data in his audit procedure.
- Quick Ratio: In this ratio, we analyze the relationship between the quick assets and quick liabilities of the company. In other words, it can be said that this ratio ensures the ability of the company to pay off its short-term debt by its readily available quick assets.
In the present case, the quick ratio of the company is 7.88 in the year 2017. The ratio is good from the industry perspective. The trend of the ratio also shows the company’s growth and stability.
During the audit, this ratio plays a vital role in determining the nature, timing, and extent of an audit procedure to be carried out by the auditor. In this ratio there may also be a risk of overvaluation of assets, as such, it should be properly considered in the audit process.
Equity Ratio: This ratio represents the relationship between the total assets and equity of the company. It is the determination of how much amount of assets have been procured from the fund of investors. In other words, it can be said that what is the percentage of shareholders in the assets owned by the company?
In the present case, the equity ratio is 0.91 in the year 2017 and 0.87 in the year 2014. It means the shareholders of the company have a 91 percent stake in the company’s assets. This is the good indicator to the company as it will increase the morale of the shareholder and ensure them their interest in the company is secured.
The risk in the ratio is that assets are not properly classified or booked. To ensure such correctness auditor should amend the plan and include the review of the all the assets of the organization.
- Return on Equity Ratio: It refers to the measurement of the profit earned from the investor’s funds. This ratio measures how investor’s funds are utilized effectively in generating the revenue for the organization.
Conclusion
In the present case, the ratio is 0.49 in the year 2017 which has been reduced from 0.60 in the year 2016. The reason thereof is an increase in equity in comparison to the increase in profit. This ratio is no good as around 50 percent efficiency are being reported i.e. shareholder’s fund is not being fully utilized in generating the revenue.
There may be a risk of misutilization of fund of the shareholders. As such, the auditor should review the fund’s utilizations and should also implement the extensive audit procedure in this regard.
- Cost to income ratio: This ratio deals with the proportion of cost to the total revenue earned. If this ratio is low it will be a good indicator for the company and it can get competitive advantages.
- In the present case, the cost to income ratio is 24.28 percent in the year 2017. This ratio is very high as compared to the year 2015 (19.16 percent). Reason for the same is the proportion of increment in expenses is higher than the proportion of the increase in sales.
There may be a risk of overstatement of expenses in the profit and loss account. The Auditor should include the review of the expenses in his audit procedure.
- Net Profit Ratio: This ratio refers to the determination of the profitability of the company. In other words, it represents the profit available to shareholders out of total revenue after deducting all the expenses.
In the present case, the ratio in the year 2017 is 58.01 it has been reduced from 59.42 (in the year 2016). Reason for the same is decreased in the profit after taxes due to an increase in occupancy expenses and employee expenses.
During the audit, it should be taken into consideration the accuracy of the data used for the calculation of the ratio. There may be a risk of unusual fluctuation in the expenses which had affected the net profit ratio of the company. As such, the auditor should extend the audit procedure to the area as relevant for the ratio.
From the audit perspective, it is considered that the trend of the ratios was good which shows the position of the company strong in term of the liquidity, profitability etc. But, the auditor should apply his own judgment and amend the nature, time and extent of the audit procedure, wherever required.
Cash flow is also the part of the financial statement of an organization. For the purpose of an audit, cash flow statement is used as a tool to get an understanding of the cash flow in the organization (James, n.d.).
In the present case, we have reviewed the cash flow statement of the company and noticed the operating activities are generating more cash flow. In the operating activities, management and services fees are generating more revenue for the organization as it is the basic source of income of the company. On the other hand, financing activities have more cash outflow as compared to the other activities because the company has paid more dividend.
Primary cash received was from the operating activities of the company. It has also received the cash from investing activities through the sale of financial assets. Cash outflow is from the financing activities as it has paid the dividend.
There may be a case of non-cash activities which does not affect the cash flow statement of the company. It may include the dividend declared but not paid, expenses booked but not actually been paid etc. This type of transaction does not affect the cash flow statement.
The annual report of the company for the financial year 2017 has been reviewed by us. We have also determined the materiality levels and performance materiality and prepared the audit procedure. We have also pointed out the areas where we need to amend the audit procedures. The opinion will depend on the results of the complete audit (Fraser, 2018).
References:
Megellan. (2017). Annual Report 2017.
Megellan. (2015). Annual Report 2015.
PWC. (n.d.). Materiality in audits.
Anon. (2018). Analytical Procedures.
Joe, L. (2012). 16 Financial Ratios for Analyzing a Company’s Strengths and Weaknesses.
Anon. (n.d.). Materiality in the Audit of Financial Statements.
Glenn, W. (2016). 6 Basic Financial Ratios and What They Reveal.
IFAC. (n.d.). Materiality in Planning and Performing an Audit.
James. (n.d.). Fundamental Analysis: The Cash Flow Statement.
Anon. (n.d.). Performance Materiality: What’s all that about
Anon. (n.d.). Non-cash Items.
Jimeet, M. (2017). How to interpret a cash flow statement for fundamental analysis in investing
Anon. (2016) Materiality & Performance Materiality (ISA 320).
Fraser, S. (2018). Types of Audit Opinions Rendered in Accounting.
Anon. (2009). Performance Materiality.
KJ, H. (2018). What are the 4 types of audit reports
