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Background Information

You are a senior manager with Stewart and Kathy and you have been approached to undertake the audit of Double Ink Printers Ltd (DIPL). 2017DIPL print books, magazines and advertising materials for the publishing, educational and advertising industries on a print-on-demand basis. Printing on demand means that publishers can print the exact quantities ordered by retail outlets, rather than estimating in advance how many books are required and often printing too few or too many. The average printing turnaround time for DIPL is two business days for small orders and five to ten business days for large orders. In addition, five years ago, DIPL further expanded its earnings base by having publisher’s titles available as searchable ‘e-books’ that could be downloaded directly by readers from DIPL’s website.

Q1:

As part of your planning process, you are considering whether you will need to use the services of an expert in the audit of Double Ink Printers Ltd (DIPL).

Based on the background information contained in the case, explain whether it will be necessary to use the work of an expert in the audit of DIPL.

Q2:

You are at the planning stage of the audit of Double Ink Printers Ltd (DIPL) for the year ended 30 June 2017 and have been asked by the audit manager to assists determine the materiality levels.

  • Referring to the background information contained in the case, identify five factors that would influence your determination of the preliminary figure for overall materiality for the 2017 audit of DIPL.
  • Explain why the factors identified in (a) above are relevant to your calculation of the preliminary figure for overall materiality.
  • Describe how the factors identified in (a) above will influence your preliminary figure for overall materiality in the audit planning process.

Background Information

According to ISA 620, auditor’s expert is an individual having expertise in the field other than accounting and auditing, whose work is used by an auditor for acquiring audit evidence. The expert may be an auditor’s internal expert who is a partner or staff or an external expert like independent individual having expertise in valuation of intangibles (Accaglobal.com, 2011). The auditor may require services of an expert in the situations like valuation of shares, intangible or tangible assets, interpretations of laws and regulations, legal cases etc. Further, the management may also appoint expert at its own to seek assistance in preparation of the financial statements. At the time of preparing financial statements, if the management does not possess necessary expertise it may employ an expert to deal with those instances. Following are the few areas in which the auditor may seek assistance from the external expert (Accaglobal.com, 2011):

  • Valuation of certain type of assets like land and building, plant and machinery.
  • Determining the quantity and physical condition of assets such as remaining useful life of a plant and machinery.
  • Obtaining amounts by using specialized techniques like actuarial valuation.
  • Measuring the completed and to be completed work on contracts in progress.
  • Legal views related to interpretation of agreements, regulations (Ifac.org, 2017).

Further, as per standard on auditing 300, the auditor, among other things, has to consider the use of expert and decide the extent to which this use will be made (IAS 300, 2009). The auditor should give attention to the risk factors and complexity involved to decide the extent of use of expert’s work. The auditor should keep in mind that too much involvement of expert in the audit process could undermine the quality of audit so this use should be kept reserved only for exceptional circumstances which are beyond the auditor’s expertise area. Further, the auditing standard 620 specifies the procedures that the auditor should perform while using the work of an expert. The auditor should assess competencies of the expert to ensure that the work performed by him would be adequate for auditing purposes. Besides this, the auditor should also maintain proper co-ordination with the expert and give him directions from time to time (Accaglobal.com, 2011).    

In case of DIPL, it has been observed that the company engages in the business of printing books, magazines, and advertising material. There are several factors that may lead the auditor to consider the use of expert in auditing the financial statements of DIPL. For instance, the use of expert may be necessary in computation of the provision for inventory obsolescence. The provision for inventory obsolescence is made based on estimations which involve the use of several assumptions and study of past data. Further, the expert’s work may be handy to assess the physical condition of items of material. The assessment of physical condition of inventory is necessary in estimating the amount of provision for obsolescence. Apart from this, the company purchase material from foreign countries also which involves entering into agreements with the suppliers. Here, the involvement of expert in reading and interpreting the terms and conditions of the agreement would be crucial.        

Further, the company acquired Nuclear Publishing Ltd (NPL) in the year 2017 which resulted in goodwill recognition. At the end of year 2017, the company had intangibles of a sum of $975,000. The services of expert might be required to assist the auditor in valuation of these intangible assets. Further, there is property, plant and equipment of worth $15,572,062 in the balance sheet of the company, the assessment of physical condition of which is indispensible in the auditing process. In certain situations, it becomes necessary for the auditor to avail services of experts to assess the physical condition of the items of plant and equipment. Therefore, auditor of DIPL may require the use of services of expert in this area.    

Questions:

Moreover, the company decide to invest in a new IT system that would fully computerised and integrate the accounting processes across the entire organization, including the integration into general ledger system. Although the IT department managed to install the new system but the testing and reconciliation of the system was not properly done because of the lack of staff. Results of preliminary test shows an inappropriate allocation of the transactions during the year, reason being the problem of the interface between the new and existing software systems. To allocate the transaction to the correct period, auditor needs to have knowledge about this new system and its working which needs an involvement of an expert.

According to standard on auditing 320 the auditor shall determine the materiality for financial statements as a whole at the time of establishing the overall audit strategy. A material item of financial statements is one that may influence the decision of user of such financial statements (ISA 320, 2009). There is not fixed benchmark, limit, or criteria to decide material; it is just the matter of auditor’s judgement. The auditor makes judgement about the materiality taking various factors into consideration. The reason for determining the overall materiality is to assist the auditor in planning and collecting the appropriate evidence. There are three major steps involved in setting overall materiality as given below:

  • Choosing an appropriate benchmark
  • Identification of adequate financial data for selected benchmark
  • Percentage determination to be applied to the benchmark (Bellandi, 2017).

Preliminary figure or the preliminary judgement about materiality means that the maximum amount set by the auditor beyond which, the auditor believes that the financial statements could be misstated influencing the decision of the users (Bellandi, 2017). The audit is conducted to provide reasonable assurance and not the absolute or hundred percentage surety about the accuracy of the financial figures. Since, the reasonable assurance is the objective of auditor, therefore, hundred percentage checking is not applied rather the items of financial statements are checked on test check basis. Test checking is the main reason that requires the auditor to set materiality so that the material items are covered for rigorous checking and immaterial items are skipped so as to make the audit effective. There are many factors or considerations that could affect the assessment of materiality, some of them are discussed as below (Bellandi, 2017):  

Fraud by Management: Amounts involving fraud are considered more important than unintentional errors because fraud on any part shows the honesty and reliability of the management. For example: misstatement of inventory will be of more concerned for the users rather than a simple error in the inventory of same amount (Bellandi, 2017).

Contractual obligations affected by misstatements: The minor misstatements turned out to be material if there are possible consequences from contractual obligations. Such as if the minimum account balance exceed the minimum due to misstatement, when the correct balance is less than minimum, this misstatement will be important for users.

Amounts affecting the trend in earnings: Amounts which are immaterial may considered as material if they affect the earnings tend. For example, if there is an increase from the past years in the reported income and a decrease in current year income, then that change will be material. In the same way misstatement due to which loss reported as profits may also be considered (Bellandi, 2017).

Answers:

Ownership structure: the figure is also affected by the structure of entity’s ownership and the way of financing used by it. Like, if the organization is solely financed by debt, then for users, assets are to be considered more than the earning.

The major five factors that would affect the preliminary figure of overall materiality in audit of DIPL are given below:

  • Changes in the accounting estimates and accounting policies
  • Implementation of the new IT system in the company
  • Changes in the top management
  • Implementation of internal auditing in the company
  • Severe fluctuations in cash balance, accounts receivables, inventory over the past three years.

All the five factors identified above are relevant to the computation of the overall materiality. The board of the company has gone through discussion and agreed changes in the valuation of inventory, estimation of provision for obsolescence, useful life of printing machine, cost method, and revenue recognition from E-book. The change in the accounting estimates and policies affect the amounts to be recognized in the financial statements (Dauber, 2009). The financial performance and position of the company would be affected by the changes in these accounting policies and estimates, therefore, these changes are relevant to determine the amount of overall materiality (Dauber, 2009).

The implementation of new IT system would cause changes in the accounting processes and financial reporting (Dauber, 2009). The determination of overall materiality is linked with the audit risk and the audit risk is linked with changes in the accounting systems and processes. Therefore, the change in accounting system caused by the new IT system is relevant to determination of the overall materiality. Further, another important factor is the change in management. Recently, the company has appointed new CEO and the previous CEO has been appointed on the board as non-executive director. The honesty, integrity, and attitude of management are linked with the risk assessment and the risk assessment is in turn linked with the materiality assessment. Hence, the change in management would affect the determination of the preliminary figures of materiality (Dauber, 2009).

From the year 2017, the company has implemented internal audit function, which is essential to ensure accurate and fair financial reporting. The internal audit function reduces the risk of failure of internal control system (Giove, 2015). Further, when determining the overall materiality, the auditor considers the possibility of failure of internal control system. Therefore, the implementation of internal audit function is relevant to the determination of the preliminary figure of materiality. Further, the study of trend in the financial figures such as cash, inventory, and accounts receivables is also relevant in determination of the overall materiality. The trend over the past three years depicts severe fluctuations in cash, accounts receivables, and inventories. When determining the materiality level, the auditor would be concerned about these fluctuations in the financial figures (Giove, 2015).

Similarly, the trend in other financial items such as revenues and operating profit is also essential which may affect the determination of the materiality level. It has been observed that revenue from operations over the past three years is increasing but despite that company is losing profits. The revenues increased from $34.21 million to $43.46 million accounting for 27% increase. However, the profit before tax reduced from $3.37 million to $3.06 million accounting for 9.20% (Appendix). Thus, these fluctuations and relations would affect the auditor’s determination of the level of materiality.                   

The first factor is change in accounting estimates and policies. There has been a change in the valuation of inventory, useful life of printing machine, and provision for inventory obsolesces (Rezaee and Riley, 2009). The change in accounting estimates and policies would require the auditor to check in more detail. Thus, the areas of accounting where change in accounting policies and estimates has taken place, the auditor would set the materiality level at low so that checking could be extended. Therefore, the closing inventory, deprecation on machinery, and provision for inventory obsolescence would cause the auditor to set preliminary materiality at low (Rezaee and Riley, 2009).         

The second factor is implementation of the new IT system. The new IT system in the company causes the audit risk go high and therefore, the amount of materiality would be set at low level (Rezaee and Riley, 2009). Here, the auditor should check all the major classes of accounting transactions and account balances to ensure that risk of material misstatement is reduced sufficiently. Next, there is change in the top management. The change in top management would also cause the auditor to set the materiality level low. For example, if the auditor believes that the management is honest, he may assess the risk as low and since the risk is assessed as low, the materiality level would be set at low level to increase the extent of checking (Rezaee and Riley, 2009).

Further, the implementation of internal audit function would reduce the risk of material misstatement and thereby the audit risk. Thus, this would cause the auditor to reduce the materiality level (Rezaee and Riley, 2009). The auditor could rely on the internal audit function and thus, he is allowed to reduce his extent of checking. The analytical procedures applied on the balances of cash, accounts receivables, and inventory shows severe fluctuations. The auditor would take these fluctuations into account when determining the amount of materiality. The fluctuations in the amounts of financial items depict possibilities of manipulations and signify the risk of material misstatement. Therefore, the auditor would strive to check in more detail to collect corroborative evidences and thus, the materiality level would be set at low level (Rezaee and Riley, 2009).     

References

Ifac.org. 2017. International Standard on Auditing 620 Using the Work of an Expert. [Online] Available at: https://www.ifac.org/system/files/downloads/2008_Auditing_Handbook_A190_ISA_620.pdf [Accessed 11 December. 2017].

Accaglobal.com. 2011. Using the work of an auditor’s expert. [Online] Available at: https://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_may11_cat8_fau_expert.pdf [Accessed 11 December. 2017].

Auasb.gov.au. 2009. Auditing Standard ASA 620 Using the Work of an Auditor's Expert. [Online]. Available at: https://www.auasb.gov.au/admin/file/content102/c3/ASA_620_27-10-09.pdf [Accessed 11 December. 2017].

IAS 300. 2009. International Standard on Auditing 300 Planning an Audit of Financial Statements. [Online]. Available at: https://www.ifac.org/system/files/downloads/a016-2010-iaasb-handbook-isa-300.pdf [Accessed 11 December. 2017].

ISA 320. 2009. International Standard on Auditing 320 Materiality in Planning and Performing an Audit. [Online] Available at: https://www.ifac.org/system/files/downloads/a018-2010-iaasb-handbook-isa-320.pdf [Accessed 11 December 2017].

Bellandi, F. 2017. Materiality in Financial Reporting: An Integrative Perspective. Emerald Group Publishing.

Dauber, N.A. 2009. Wiley The Complete Guide to Auditing Standards, and Other Professional Standards for Accountants. John Wiley & Sons.

Giove, F.C. 2015. Auditing Essentials. Research & Education Assoc.

Rezaee, Z. and Riley, R. 2009. Financial Statement Fraud: Prevention and Detection. John Wiley & Sons.

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