Chapter 4 Risks and Materiality

Answer 1

(a)        A matter is material if knowledge of the matter would reasonably influence the economic decisions of users on the basis of financial statements.
(b)        Refer to point 2.5.

Answer 2
(a)
Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit process.

An auditor cannot obtain absolute assurance because there are inherent limitations in an audit that affect the auditor’s ability to detect material misstatements. These limitations result from factors such as:

• The use of testing;
• The inherent limitations of internal control (for example, the possibility of management override or collusion); and
• The fact that most audit evidence is persuasive rather than conclusive.

(b)(i)
Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.

Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement.

The objective of an audit of financial statements is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. The assessment of what is material is a matter of professional judgment.

(b)(ii)
Materiality should be considered by the auditor when evaluating the effect of misstatements. Both the amount (quantity) and nature (quality) of misstatements need to be considered.

For the misstatement of inventory, we have to consider its effects on the misstatement of the balance sheet as well as the income statement because of the double entry system. Although the effect on the balance sheet is immaterial, the effect on the income statement is material. The income before tax of $600,000 is misstated as $1,000,000. The gross profit margin is misstated as well. Such misstatements could influence the economic decisions of users.

For the omission of disclosure of the related party transaction, it does not comply with accounting policy. The nature of this non-disclosure matter will have significant effects on the financial statement which in turn could influence the economic decisions of users.

(b)(iii)
Setting the acceptable materiality level at a lower level can help reduce the likelihood of undiscovered misstatements and to provide the auditor with a margin of safety when evaluating the effect of misstatements discovered during the audit.

Answer 3

The following factors would affect the assessment of the inherent risks associated with the audit of the financial statements of Wizzin:
(i)      The company is operating in a competitive market place, has suffered declining profits and has substantial bank borrowings. The directors appear not to be unduly concerned about the company’s trading position. However they may be predisposed to misstating the financial statements in order to present a more favourable trading and balance sheet position and to instil greater third party confidence in the company. The assessment of inherent risk would need to take into account these factors, together with the possibilities of potential going concern problems being encountered by the company.
(ii)     The geographical spread of the company’s activities over 14 sites would, in isolation, increase the possibility of material misstatement in the company’s financial statements. The nature of the company’s operation appears to be quite complex, with large volumes of purchases, sales and accounting transactions generally. There would therefore be concern as to the completeness and accuracy of recording of transactions in the company’s accounting records and the reflection of the same in the financial statements.
(iii)    The company has incurred substantial costs on repair and refurbishment programmes at all 14 sites around the country. These costs would have a material effect on the company’s financial statements and initial concerns would center around the completeness and accuracy of recording, including the correct categorisation of costs between revenue (repair) and capital (improvement) expenditure in the financial statements.
(iv)    The company has extensive retail operations selling a wide range of products. Sales are predominantly for cash, which is particularly susceptible to loss or misappropriation and this together with the ‘collect or delivery’ flexibility given to credit sale customers increases the likelihood of unrecorded sales. The nature and mix of sales at each site including the hiring of tools and equipment, would lead to audit concern as to the possibility of unrecorded sales and the incorrect categorisation of sales in the company’s accounting records.
(v)     Inventories would represent a significant proportion of the company’s assets and there would be initial concern over this area of the company’s financial statements. Concerns would centre around the basis of the quantification and valuation of inventories for inclusion in the company’s balance sheet. As regards quantification, there may be particular concern as to the measurement of stockpiles of sand and gravel and concerns about valuation may be founded primarily on the values ascribed to inventory lines and individual items of inventory held at each site. Owing to the portability of inventory lines and open access to them, there would also be concern as to the likelihood of loss or misappropration of inventories.
(vi)    The company’s tangible non-current assets include a large volume of high value mobile items. This would cause initial audit concern and would render this area of the company’s financial statements being allocated a high inherent risk factor. Any mobile or transportable assets owned by a company are susceptible to loss or misappropriation, but this characteristic is particularly applicable to the non-current assets stated as owned by the company, including the range of tools and equipment available for hire. As well as the issue of existence, the valuation of individual assets may cause concern given the possibility of damage and shortened assets’ lives brought about as a consequence of the relatively harsh operating environment of the company.
(vii)   The company employs 252 (14 x 18) full-time shop and yard staff supplemented with part-time and temporary employees, in addition to those employed at its head office. Given the likelihood of starters and leavers throughout the year and other payroll complexities including the possibility of overtime and bonus payments, the company will have a large volume of payroll transactions. This would lead to concerns over the completeness and accuracy of recording in this area and the potential of unauthorised payments of salaries and wages.

Answer 4

(a)        Audit risk – point 3.1
Inherent risk – point 3.3
Control risk – point 3.7
Detection risk – point 3.10
(b)        Point 3.13 and 3.14
(c)        Point 3.15
(d)        The aggregate of uncorrected misstatement comprises:
(i)         Specific misstatements identified by the auditors including the net effect of uncorrected misstatements identified during the audit of previous periods; and
(ii)        The auditors’ best estimate of other misstatements which cannot be specifically identified (i.e. projected errors).
(e)        If they conclude that the misstatements may be material, auditors would consider:
(i)         reducing audit risk by extending audit procedures; or
(ii)        requesting the directors to adjust the financial statements.

Answer 5

(a)
Bob’s Market Stalls
DR =
Detection risk here is calculated as 6.9%. The auditor can afford a 6.9% chance that the audit work will fail to detect material errors or misstatements.

Bill’s Bank
DR =
Detection risk here is calculated as 11.9%. The auditor can afford an 11.9% chance that the audit work will fail to detect material errors or misstatements.

(b)
As the level of acceptable DR is higher in the case of the bank, the auditor can apply his audit testing procedures to a smaller sample of transactions.

Answer 6

(a)        Point 3.3
(b)        Point 3.19
(c)        Point 3.20