Sources Of Information For The Auditor To Gain An Understanding Of The Client Company: Risks And Responses (essay).

Various sources are available to the auditors to obtain the required information to gain an understanding of the client company. The following discussion identifies and assesses two such sources which can be used by the auditor to obtain information for gaining an adequate understanding of Gift:

The audit file of the previous year is a major source of information. Accessing this file will provide the auditor with an understanding of the audit issues encountered by the previous auditor last year. It will also provide the auditor with the information on the audit procures designed and undertaken to resolve these issues. It will help the auditor in assessing whether Gift is a client with a high or low Risk Of Material Misstatement. Lastly, accessing this file will also provide the auditor with the information on any audit issue brought forward by the previous auditor so that those issues are duly considered during the current year’s audit (Czerney, Schmidt & Thompson, 2019).

Another key source is the previous year’s report to the management of Gift. By accessing this file, the auditor of Gift will be able in identifying any material weakness in Gift’s existing internal control that the previous auditor noted. It is important for the current auditor to obtain information about these internal control issues because of the possibility of their reoccurrence if the management failed to resolve them last year. It will help the auditor in assessing the level of reliance that can be put on the internal control of Gift (Chalmers, Hay & Khlif, 2018).

Assessment of the provided information on Gift demonstrates the presence of certain major audit risks which require a prompt response of the auditor at the audit planning stage. The following discussion identifies and assesses four of such risks and the auditor’s response to each risk in audit planning.

Risk 1 – The provided information shows that $2.1 million was spent by Gift for refurbishing all of its stores and extending its central warehouse. It is required to review this expenditure to evaluate whether this expenditure is a capital expenditure that requires capitalization or it is an expense that should be expensed. In accordance with the requirement of AASB 116 Property, Plant and Equipment (AASB 116), Gift needs to capitalize the expenditure if it is of a capital nature which will increase its asset position (aasb.gov.au, 2022). If the expenditure is associated with repaid, it will be regarded as a cost requiring expensing it in the profit or loss. Therefore, incorrect accounting treatment of this expenditure could overstate or understate Gift’s assets or profit.

The auditor should review the breakdown of this particular expenditure, and the auditor should agree to the relevant invoices associated with this expenditure to evaluate whether it is of a capital nature or it is associated with repairing. Then, the auditor should agree to include it within the asset register if it is a capital expenditure or to record it in the income statement if it is associated with repairing.

Major Audit Risks and Responses

Risk 2 – $2 million was borrowed by Gift from the bank for financing the refurbishment, and this loan is due to be repaid over five years. There is a requirement of correctly splitting this loan between the current and non-current liabilities. It represents the risk of understatement or overstatement of these liabilities if Gift fails to correctly split this loan. Furthermore, the bank may have received a charge over Gift’s assets as security for the loan. It increases the risk that the disclosure related to any security lacks completeness (Niemi et al., 2018).

During the audit engagement, the auditor is required to confirm that the loan of $2 million was received by Gift. After that, the auditor should review in detail the split of the loan between current and non-current liabilities and the associated disclosures to ensure that Gift accounted for this loan in accordance with the applicable accounting standards. The auditor is also needed to review the loan agreement to determine whether Gift has given any security to the bank against the loan taken, and the same should be confirmed from the bank through bank confirmation.

Risk 3 – Gift values its inventories at selling prices less an average profit margin because the financial director believes that it is a close approximation of cost. The entities are required to undertake inventory valuation at the lower of cost and net realizable value, and there is a risk of under or overvaluation of inventory if Gift does not follow this method. It is permitted by AASB 102 Inventories (AASB 102) as an inventory valuation method as long as it is a close approximation to cost (aasb.gov.au, 2022). There could be overvaluation or undervaluation of inventory if this provision is not followed by Gift.

The auditor should undertake tests to confirm the inventory’s cost and net realizable value, and the auditor should test whether Gift has valued its inventory correctly on a line-by-line basis. Furthermore, the auditor should undertake the testing of valuation by focusing on the comparison of the cost of inventory and selling price less margin to confirm whether the adopted method is actually a close estimation to cost.

Risk 4 – There has been some alteration in the finance department because of an increased workload at the head office, and the finance controller of Gift left in May 2021. The company will commence her replacement in late June 2021. As a result, the inherent risk is increased within Gift because the member of the finance team may have made some errors within the accounting records due to the increased workload. The possibility can also not be ignored that the new financial controller may lack adequate experience of producing the financial statements and resolving the accounting issues.

The auditor and other members of the audit team should stay alert throughout the audit engagement of Gift so that additional errors in the financial department can be identified. Furthermore, the auditor should discuss with the finance director whether he will be able in assisting the team with any issues in the audit which cannot be resolved by the new financial controller (Fakhfakh & Jarboui, 2022).

Risk 1: Capital Expenditure

As per AASB 101 Presentation of Financial Statements, an entity is required to consider an information material if omitting, misstating or obscuring it could rationally be anticipated to create influence on the decisions made by the primary users of the financial statements on the basis of those financial statements, which provide them with the required financial information about a specific company (aasb.gov.au, 2022). Therefore, materiality relies on the misstatements’ or omission’s size and nature judged in the adjacent conditions. Therefore, the determining factor in materiality is the item’s size and nature, or a combination of both.

As per ASA 320 Materiality in Planning and Performing an Audit, an entity needs to consider the misstatements, including omissions material, if it is rationally expected that they, in aggregate or individually, could influence the economic decisions made by the users of the financial reports based on those reports. The auditor is required to make materiality related judgments by taking into account the surrounding circumstance. The size or nature of a misstatement or a combination of both affects the judgements made to determine materiality (auasb.gov.au, 2022).

Quantitative Guidelines – These guidelines are used to ascertain the materiality of an item’s amount at arbitrary levels. The followings are the quantitative thresholds that the auditor may use to determine materiality:

1) The auditor should not presume an amount equal to or less than 5% of the appropriate base amount as material.

2) The auditor should presume an amount equal to or less than 10% of the appropriate base amount as material.

3) The ‘grey area’ is an amount greater than 5% but less than 10% (David & Abeysekera, 2021).

Qualitative Guidelines – Certain qualitative factors are there which should be considered in determining the materiality of an item’s amount. They are as follows:

1) Aspects like financial restrictions under debenture related agreements, debt agreements or fiduciary duties of the managers can make the financial items less material than qualitatively specified above.

2) Alterations in the regular activities can convert a profit into a loss or generate a margin of solvency in the balance sheet. These aspects affect the materiality assessment (David & Abeysekera, 2021).

Quantitative Guidelines – The auditor frequently ascertains the level of materiality by the application of a percentage to a selected benchmark. No conclusive figure is there for this percentage due to the number of variables that could relate. The examples of benchmarks are the categories of reported income like total income, profit before tax, total expenses, gross profit, total equity and/or net asset value. The frequent use of profit before tax is seen in profit-oriented entities. If this value is unstable, other more appropriate benchmarks are total revenue or gross profit (Canning, O’Dwyer & Georgakopoulos, 2019).

Qualitative Guidelines – Materiality is also related to the item’s nature regarding specific situations of its misstatement. Therefore, it will not be an adequate base to judge materiality by only considering the magnitude alone instead of the item’s nature and the situations in which the auditor has to make the decision. The auditor is also required to take into account the likelihood of misstatements of relatively small amounts that, cumulatively, could create a material impact. For instance, an error in a procedure conducted month-end basis could indicate a possible material misstatement if the error reoccurs each month. Likewise, if there is a weakness in the process of internal control, the auditor is needed to take into account whether that weakness might lead to a material misstatement that the internal control cannot prevent or detect (pwc.com.au, 2022).

Risk 2: Loan Agreement

Before the removal of AASB 1031 Materiality (AASB 1031), the auditors were required to apply the concept of materiality in preparing and auditing the financial statements. In order to judge the materiality of an item, the auditors were required to examine the item in aggregate and individually, and the judgment included observing both the nature and amount of the item. Nevertheless, in certain situations, either an item’s nature or amount individually or in aggregate used to be used to ascertain materiality. At the same time, the auditors were required to consider both the quantitative and qualitative guidelines provided by AASB 1031 to determine the materiality of an item. These quantitative guidelines used to be the main criteria for determining materiality. For example, the base amount of materiality is $100,000. Therefore, a misstated item with $4500 is not material as it is less than 5% of the base amount, and a misstated item of $11,000 is material as it is greater than 10% of the base amount. All these imply that the auditors were not able to determine materiality or make any materiality-related decision in the absence of the standards and guidelines of materiality (Houghton, Jubb & Kend, 2011). It implies that the auditors were fully dependent on these guidelines and standards to ascertain the materiality of an item.

AASB 1031 was removed to remove the quantitative guidelines of materiality determination. There were certain issues associated with the application of AASB 1031’s guidelines in ascertaining materiality. The guidelines were not equivalent to the international reporting standards, which contributed to the lack of uniformity or homogeneity in ascertaining materiality in different companies, sectors or countries. This lack of uniformity or homogeneity provided the auditors with the discretion to choose the thresholds. For example, the guidelines of AASB 1031 required the auditors to consider an item material if the item was greater than 10% of the base amount. However, there were many instances where the auditors reported the material items as material. All these aspects contributed to the development of inconsistencies in the whole materiality determination process (Cameron, 2014).

The removal of these quantitative guidelines was the main aim behind removing AASB 1031 so that disparity in materiality assessment can be eliminated. Through the removal of AASB 1031, the new quantitative guidelines to ascertain materiality were introduced which are in line with the international reporting standard. Now, all the auditors are needed to follow the same quantitative guidelines to determine materiality. First, the auditors are now needed to select an appropriate benchmark to determine materiality from the list of benchmarks provided, and the auditors cannot apply discretion because they are now required to justify the selection of a particular benchmark. After that, a particular percentage needs to be chosen based on the circumstances of the audit client, and the auditors need to justify the selection because the selection of this percentage is dependent on the auditor’s judgement. Unlike AASB 1031, the auditors are now required to follow a set rule to determine the materiality of an item while justifying their selection of the benchmark and percentage. There is no disparity and discretion in materiality assessment. On the basis of this discussion, it can be said that the removal of AASB 1031 would bring uniformity or harmonization in the auditors’ assessment of materiality misstatements.

Risk 3: Inventory Valuation

Under AASB 1031, a quantitative threshold was there that the auditors needed to consider to assess materiality and the management needed to consider during the preparation of the financial statements (aasb.gov.au, 2022). The preparers of the financial statements or the management were needed to follow and apply this quantitative threshold to prepare the financial statements. However, there was much evidence that showed that even in the presence of these quantitative guidelines, a lower materiality threshold was applied by the managers than those recommended in the accounting standard. It contributed to the major inconsistencies in the application of the concept of materiality. Because of the application of the lower materiality threshold to prepare the financial statements, the auditors failed to assess the materiality of an item correctly. It contributed to the wrong materiality related judgements. However, the removal of AASB 1031 would eliminate this issue. Since the quantitative threshold was removed, there is no opportunity for the preparers of the financial statements to apply a reduced level of materiality threshold. As a result, the financial statements would now be prepared by maintaining all the material aspects. Consequently, it would facilitate in the correct assessment of materiality by the auditors. It is because the judgments made by the auditors to assess materiality would be correct and appropriate.

Appropriate assessment of materiality implies that only information that is of key importance to the investors needs to be included in the financial statements, and the preparers can exclude the information about unimportant matters. It is a matter of judgment to ascertain whether the information is material. Therefore, the assessment of materiality works as a filter through which information is examined by the management. The purpose is to ensure that the financial information that could influence the decisions of the investors is incorporated into the financial statements. The concept of materiality is universal, and its application can be seen not only to present and to disclose information in the financial statement but in the decisions regarding recognizing and measuring the key financial elements. All of these imply that the assessment of materiality increases the usefulness of the financial statements by incorporating only the information which is of major importance to the users to make various financial decisions (Choudhary, Merkley & Schipper, 2019).

References

AASB 101. (2022). Presentation of Financial Statements. Retrieved 13 April 2022, from https://aasb.gov.au/admin/file/content105/c9/AASB101_07-15_COMPmar20_07-21.pdf

AASB 102. (2022). Inventories. Retrieved 13 April 2022, from https://aasb.gov.au/admin/file/content105/c9/AASB102_07-15_COMPmar20_07-21.pdf

AASB 1031. (2022). Materiality. Retrieved 13 April 2022, from https://www.aasb.gov.au/admin/file/content105/c9/AASB1031_07-04_COMPdec09_01-11.pdf

AASB 116. (2022). Property, Plant and Equipment. Retrieved 13 April 2022, from https://aasb.gov.au/admin/file/content105/c9/AASB116_08-15_COMPmar20_07-21.pdf

APESB. (2022). APES 110 Code of Ethics for Professional Accountants (including Independence Standards). Retrieved 13 April 2022, from https://apesb.org.au/uploads/home/02112018000152_APES_110_Restructured_Code_Nov_2018.pdf

ASA 320. (2022). Materiality in Planning and Performing an Audit. Retrieved 13 April 2022, from https://auasb.gov.au/media/er0j20xt/asa_320_12_21.pdf

Cameron, J. (2014). Applying the Materiality Concept: The Case of Abnormal Items. Corporate Ownership & Control, 12, 427-37.

Canning, M., O’Dwyer, B., & Georgakopoulos, G. (2019). Processes of auditability in sustainability assurance–the case of materiality construction. Accounting and Business Research, 49(1), 1-27.

Chalmers, K., Hay, D., & Khlif, H. (2018). Internal control in accounting research: A review. Journal of Accounting Literature.

Choudhary, P., Merkley, K., & Schipper, K. (2019). Auditors’ quantitative materiality judgments: Properties and implications for financial reporting reliability. Journal of Accounting Research, 57(5), 1303-1351.

Czerney, K., Schmidt, J. J., & Thompson, A. M. (2019). Do investors respond to explanatory language included in unqualified audit reports?. Contemporary Accounting Research, 36(1), 198-229.

David, R., & Abeysekera, I. (2021). Auditor Judgements after Withdrawal of the Materiality Accounting Standard in Australia. Journal of Risk and Financial Management, 14(6), 268.

Fakhfakh, I., & Jarboui, A. (2022). Research on the Relationship between Audit Risk Assessment and Risk Governance: Evidence from Tunisia. Journal of African Business, 1-16.

Houghton, K. A., Jubb, C., & Kend, M. (2011). Materiality in the context of audit: the real expectations gap. Managerial Auditing Journal.

Materiality in Audits. (2022). Retrieved 13 April 2022, from https://www.pwc.com.au/assurance/assets/audit-committee-guide/ac-guide-dec11-ch-11.pdf

Niemi, L., Knechel, W. R., Ojala, H., & Collis, J. (2018). Responsiveness of auditors to the audit risk standards: Unique evidence from Big 4 audit firms. Accounting in Europe, 15(1), 33-54.