BUSN3002 : Auditing and Ethics : Nature of Materiality and Considerati
Section 1.
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.
• Review the various draft notes and disclosures accompanying the draft annual report. Highlight those that may have significance to the audit, eg. Contingencies, and outline the audit procedures that you will need to perform.
Section 2
The partner has requested you to prepare a preliminary analytical review on the information provided by your company. The partner suggests that as a minimum you address key balance sheet and profit and loss ratios over the period 2014 to 2017.
Based on these results and the nature of your company’s business and its markets, outline the apparent trends and changes in these ratios, the key risk areas for the audit and the matters that will have to be addressed in the audit plan. Give examples of relevant assertions and at least one audit procedure for each assertion.
Section 3
Review the statement of cash flows. Which category of cash flows provided the majority of cash inflows? Which category had the greatest outflows?
Identify the primary cash receipts and cash payments during the year.
What were the main non-cash financial and investing activities?
Using the results of questions 2 and 4, evaluate the going concern risk of this company. What audit procedures would you recommend to address this risk.
Answer:
Introduction:
Auditing in materiality is amongst the significant concepts for auditors. The concept of materiality in the audit consists of both qualitative and quantitative aspects.
ASA 320 deals with the accountabilities of the auditor to implement the concept of materiality in planning and conducting the audit of the financial statements. ASA 450 is also implemented to explain the way materiality is applied in analyzing the impact of identified misstatements on the audit and the financial statements (Auditing and Assurance Standards Board, 2015).
So, in this report, different aspects of materiality would be discussed in the context of the annual report of Orora Limited, a company listed on the ASX under the code ORA.
The key ratios of the company would also be discussed in the light of major risks confronted by the company along with stating the relevant assertions and audit procedures to address the issues. Furthermore, the going concern risks would also be analyzed on the basis of these and audit procedures shall be recommended.Lastly, the opinions given by the auditors shall also be discussed.
Section 1
Analysis of the nature of materiality and considerations employed in arriving at materiality
As per ASA 320, the framework of financial reporting discusses materiality which comprises of misstatements containing omissions are often considered to be material if they impact the choices made by the users in the context of the financial report.
ASA 450 deals with the accountabilities of the auditors to assess the effect of the recognized misstatements on their auditing and of erroneous misstatements on the financial statements (Auditing and Assurance Standards Board, 2015).
As per the Auditing and Assurance Standards Board (2010), ASAB 1031 introduces to the concept of materiality. The information is material if its misstatement, omission and non-disclosure has the probability to impact the economic decisions taken by the stakeholders on the basis of financial statements.
The three steps of determining and apply materiality are Determination of the base and calculation of numbers. The guidelines for calculating materiality are:
- 5% of profit derived from continuous operations
- 5% of the net income after tax.
- ½ to 2% of the sales revenues.
After this, the qualitative items can be assessed such as misstatements due to fraud or illegal acts and amounts which may violate the contractual agreements (Keune & Johnstone, 2012).
Secondly, auditors track the misstatements on the basis of a summary of unadjusted errors. Thirdly, the likely misstatement is estimated and it is contrasted with the preliminary materiality.
As in the income statement of Orora Limited, the profit derived from continuing operations in the year 2017 is $280.7 Million, so the level of materiality would be considered up to 5% i.e. $266.67 and the profit of the previous financial year is $280.5, so it would be considered to be normal
The net income after tax for the year 2017 is $171.1 Million and materiality up to 5% can be $162.55 Million and the income as the show is $ 168.6, it would also be considered to be appropriate. The sales revenue is $4039.1Million and the level of materiality can be up to 2% i.e. $3958.32 Million and the revenue for the previous year is $3849.8 Million. In this case, the level of materiality should be contrasted with the preliminary materiality. The company acquired the business of The Register Print Group and The Garvey Group Tech in 2017. The purchase consideration paid amounted to $136 Million (Orora, 2017).
Regarding contingencies, the audit procedure should be to evaluate each of the legal proceedings on the basis of available information. When it is considered probable that a future obligation will result in the discharge of resources then it should be verified that a provision has been created to identify the present value of the cash outflow (Mock et al., 2012).
Section 2
Review of the performance of the company and its business and the assertions and procedures of audit
Orora Limited is an ASX listed company which derives its revenue from the manufacturing and supply of the packing products. It has employed about 6700 people and conducts its business in New Zealand, Australia, Canada, Mexico and the United States.
As per Orora (2017) to judge its performance, its key ratios are to be analyzed:
Financial Leverage of the company (Orora, 2016):
|
Year |
Particulars |
|
2014 |
1.99 |
|
2015 |
2.04 |
|
2016 |
2.09 |
|
2017 |
2.17 |
As the Financial leverage of the company is increasing from 1.99 to 2.17 it means that it has high-interest payments which would adversely affect the earnings per share of the company.
Return on Equity of the company (Orora , 2016):
|
Year |
Particulars (in %) |
|
2014 |
-5.38 |
|
2015 |
9.31 |
|
2016 |
11.47 |
|
2017 |
11.24 |
Return on Equity analyzes the profitability of the company in relation to book value of shareholder’s equity, so it evaluates the extent to which the company uses its investments to enhance its earnings. 15 -20% is considered to be best for a company, so accordingly, Orora Limited is not able to generate income from the available equity as its maximum return to equity is 11.47% in 2016.
Net Profit Margin of the company (Orora, 2016):
|
Year |
Particulars (in %) |
|
2014 |
-2.73 |
|
2015 |
3.85 |
|
2016 |
4.37 |
|
2017 |
4.23 |
This ratio is an indication of the number of profits generated by sales for each Dollar. So, it has been assessed that the net profit margins are 4.23% in the year 2017, so it suggests that Orora Limited has made more money as compared to its expenditures (Orora, 2017).
The current ratio of the company (Orora, 2016):
|
Year |
Particulars |
|
2014 |
1.28 |
|
2015 |
1.33 |
|
2016 |
1.30 |
|
2017 |
1.19 |
The current ratio of the company is an indication of the capability of the company to pay its off short-term debts. A ratio of more than 1 suggests that good liquidity of the Orora Limited so that it can liquidate its current assets to pay its short-term liabilities.
A quick ratio of the company (Orora, 2015):
|
Year |
Particulars |
|
2014 |
0.62 |
|
2015 |
0.66 |
|
2016 |
0.70 |
|
2017 |
0.64 |
The quick ratio measures the liquidity of the company by assessing the extent to which the current assets are able to meet the current liabilities. The quick ratio is also known as the acid test ratio and utilizes the liquid assets which can be converted into cash in a period of fewer than 90 days.
A ratio below 1 indicates that Aurora Limited is unable to meet its current liabilities.
The key risk areas and matters addressed in the audit plan are low quick ratio which means the inability of the companies to meet its current liabilities, its low return on equity and financial leverage ratios. The audit risk plan will consider the inspection of whether adequate liquidity risk management system is developed by the company which is aligned with the strategic objectives, risk profile and nature of the business of Orora Limited(Christensen, Glover & Wood, 2012) .
With regards to low return on equity, the audit risk management plan should comprise of analyzing the structure of the organization and it risk analysis approach. The auditors shall differentiate the assumptions for calculation of risk-weighted assets and requirements of liquidity at the level of product variants along with validating the assumptions as compared to the regulatory guidelines (Deloitte, 2017).
For mitigating the risk of high financial leverage, the auditors understand the risks of foreign exchange, credit and commodity. The auditors shall also verify the management of cash and bank within the commercial transactions of the company so that the net interest costs and financial charges are decreased (PWC , 2012).
In this context, the audit assertions allow the auditors to execute the testing activities on the internal control of the company and its financial reporting procedures. The first audit assertion is Presentation and Disclosure. It makes sure that the financial statements of the entity are in accordance with the accounting principles and industrial standards. The audit procedure in this regard is verification of employee benefit expenses in the notes to the financial statements as per a separate heading viz. wages and salaries, pension costs and social security taxes and contributions.
The second assertion is Occurrence.It means that the transactions are disclosed as and when they happen in relation to the entity. The auditors should evaluate the sample of entries from the sale account in the nominal ledger and tracking the appropriate sales invoice (Padia & van Vuuren,2012).
The third assertion being Completeness pertains to the records of transactions and the non-omissions of disclosures. The relevant tests are that the auditors should select the sample of the orders of consumers and verify the dispatch notes and sales invoices and their posting to the sales accounts in the nominal ledger.
The fourth assertion being Classification is related to the recording of transactions in the appropriate accounts. The relevant audit procedure is checking the posting of purchase invoices to the nominal ledger accounts.
The fifth audit assertion is associated with Accuracy. It means that there have been no omissions in the preparation of documents or their posting of transactions into the ledgers. In this regard, the audit procedures pertain to checks related to the calculation of invoices and payroll etc. The accounting reconciliations should be designed to provide the assurance about accuracy (Borthick, 2012).
Section 3
Reviewing the statement of cash flows and evaluation of the going concern risk of the company
The major cash inflows of Orora Limited are from its operating activities amounting to $351.2 Million with the major contribution of profit amounting to $171.1 Million. The major cash outflows are arising from Investing activities amounting to $271.5 Million with major expense arising due to payments made for property, plant and intangible assets amounting to $157.1 Million (Orora, 2017).
The non –cash financial activities are goodwill and other intangible assets amounting to $446.5 Million. The expenses on intangible assets pertaining to purchase of computer software amounting to $50 Million with others amounting to $6.3 Million and goodwill amounting to $390.2 Million.The depreciation and amortization expenses amounted to $116.1 Million. The company has also paid the amount for acquiring controlled entities and business amounting to $157.1 Million.
The company had acquired business which would enhance its services related to concept development, digital printing and design (Orora, 2017).
The going concern risk pertains to risk related to creditability, liquidity and market risks of the company. The company is exposed to foreign exchange risk because of its dealing in international transactions. The risk is related to its transactions to be conducted in future, financial assets and obligations which are not denominated in A$.
The audit procedure to mitigate this risk is to verify the register of exposures and foreign exchange contracts and their related foreign exchange hedges (CPA Australia Ltd, 2009).
It is also exposed to risks related to interest rate, commodity price, employee share plan. For this, the auditors should assess the various arrangements made by the company to mitigate these risks like the fixed rate borrowing arrangements and contractually passing of adjustments related to rise and fall adjustments through consumers.
Other risks are credit risk and liquidity risk. The credit risk pertaining to risk arising from contracts arising from financial instruments. To mitigate this risk, the auditors should evaluate the system of counterparty approval and consistent monitoring of exposures (Fukukawa & Mock, 2012).
The liquidity risk pertains to risk arising from operations and external borrowings and to mitigate it, the auditors must evaluate that the firm has adopted the policy to adopt the flexibility within the funding structure to meet the working capital and objectives of investments.
Regarding the significant matter related to acquisitions, the opinion of the auditors is that the implementation of the acquisition method requires estimates and assumptions with regard to the determination of fair value of any deferred and contingent consideration and the acquired intangible assets and property (Knechel & Salterio, 2016).
Conclusion:
Hence to conclude it can be said that materiality in auditing pertains to considering misstatements and judgments about them according to the perception of auditors. It is crucial for the auditors to obtain reasonable assurance if the financial statements are free from material misstatements.
References:
Auditing and Assurance Standards Board (2010). Materiality. Retrieved August 31st, 2018 from https://www.aasb.gov.au/admin/file/content105/c9/AASB1031_07-04_COMPdec09_01-11.pdf
Auditing and Assurance Standards Board (2015). Auditing Standard ASA 320 Materiality in Planning and Performing an Audit .Retrieved August 31st , 2018 from https://www.auasb.gov.au/admin/file/content102/c3/ASA_320_Compiled_2015.pdf
Auditing and Assurance Standards Board (2015).Auditing Standard ASA 450 Evaluation of Misstatements Identified during the Audit. Retrieved August 31st, 2018 from https://www.auasb.gov.au/admin/file/content102/c3/ASA_450_Compiled_2015.pdf
Borthick, A. F. (2012). Designing continuous auditing for a highly automated procure-to-pay process. Journal of Information Systems, 26(2), 153-166.
Christensen, B. E., Glover, S. M. & Wood, D. A. (2012). Extreme estimation uncertainty in fair value estimates: Implications for audit assurance. Auditing: A Journal of Practice & Theory, 31(1), 127-146.
CPA Australia Ltd (2009). A guide to managing foreign exchange risk. Retrieved August 31st, 2018 from https://www.cpaaustralia.com.au/~/media/corporate/allfiles/document/professional-resources/business/managing-foreign-exchange-risk.pdf?la=en
Deloitte (2017). Capital efficiency and optimization Measured steps to achieve return on equity objectives: For private circulation only. Retrieved August 31st, 2018 from https://www2.deloitte.com/content/dam/Deloitte/in/Documents/audit/in-audit-capital-efficiency-and-optimization-noexp.pdf
Fukukawa, H.& Mock, T. J. (2012). Auditors’ evidence evaluation and aggregation using beliefs and probabilities. International Journal of Approximate Reasoning, 53(2), 190-199.
Keune, M. B. & Johnstone, K. M. (2012). Materiality judgments and the resolution of detected misstatements: The role of managers, auditors, and audit committees. The Accounting Review, 87(5), 1641-1677.
Knechel, W. R. & Salterio, S. E. (2016). Auditing: Assurance and risk. NY: Routledge. 1-20.
Mock, T. J., Bédard, J., Coram, P. J., Davis, S. M., Espahbodi, R. & Warne, R. C. (2012). The audit reporting model: Current research synthesis and implications. Auditing: A Journal of Practice & Theory, 32(sp1), 323-351.
Orora (2015) .Delivering On the Promise: Annual Report 2015. Retrieved August 31st, 2018 https://www.ororagroup.com/system/downloads/files/000/000/058/original/Orora_Annual_Report_2015.pdf?1480234847
Orora (2016) .Investing To Grow :Annual Report 2016. Retrieved August 31st, 2018 https://www.ororagroup.com/system/downloads/files/000/000/057/original/Orora_Annual_Report_2016.pdf?1480234713
Orora (2017) .Invest Innovate Grow: Annual Report 2017. Retrieved August 31st, 2018 from https://www.ororagroup.com/system/downloads/files/000/000/198/original/Orora_Annual_Report_2017_interactive.pdf?1505435145
Padia, N. & van Vuuren, M. J. (2012). Performance auditing: Development of an audit model to evaluate efficiency, effectiveness and economy of the performance of a business. African journal of business management, 6(39), 10417-10426.
PWC (2012). Finance Effectiveness Compliance & Control. Retrieved August 31st, 2018 from https://www.pwc.in/assets/pdfs/finance-effectiveness/fe_complainceandcontrol.pdf
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