Audit materiality – a precision cast in stone or a subjective variable measure….continued

Evaluating qualitative factors
Evaluating
qualitative factors often requires subjective judgment. While
establishing the overall strategy for the audit, the auditor should
consider whether there are particular significant accounts or
disclosures in the financial statements for which misstatements of
lesser amounts than materiality for the financial statements as a whole
could reasonably be expected to influence the economic decisions of
users taken on the basis of the financial statements. Any such amounts
determined represent lower materiality levels to be considered in
relation to the particular items in the financial statements. For
instance, the magnitude of a misstatement that the auditor considers
material when caused by an illegal act or irregularity may be far lower
than the magnitude of a misstatement caused by an error.

Some of the factors to be considered are:

Whether
accounting standards, laws, or regulations affect users’ expectations
regarding the measurement or disclosure of certain items (for example,
related party transactions and the remuneration of management and those
charged with governance)?

The key disclosures in relation to the
industry or the environment in which the entity operates (for example,
research and development costs for a pharmaceutical company).

Whether
attention is focused on the financial performance of a particular
subsidiary or division that is separately disclosed in the consolidated
financial statements (for example, for a newly acquired business)?

Normalisation
There
may be particular circumstances that cause the materiality benchmark
amount to be at an unusual level for the current period — either
unusually high or unusually low. If so, it may be appropriate and
necessary to normalise the benchmark amount for the current period.
However, if the entity has recurring charges or credits, then
normalising for those items is inappropriate.

Examples of charges that may result in an exceptional decrease in profit before tax from continuing operations may include:
Unusual restructuring charges

Impairment of fixed assets or long-term investments not in the ordinary course of business

Changes in accounting methods/estimates

Examples of credits that may result in an exceptional increase in profit before tax from continuing operations may include:

One-time gains arising from the settlement of legal matters

One-time
gains arising from the sale of a component of a business (where the
ongoing business model of the entity is not focused on acquisitions and
disposals of components).

Use of another benchmark or
normalising the benchmark may also be appropriate if profit before tax
from continuing operations is nominal (i.e., small and close to zero) in
the current period. However, if an entity has a past history of low
earnings from continuing operations in relation to large revenues and
expects to continue generating income at such levels, this may represent
the normal operating results for the entity, and consequently,
normalisation of profit before tax from continuing operations in such
cases may not be appropriate.

Audit documentation needs to
explicitly substantiate as to why the identified benchmark is required
to be normalised and the corroborative factors that caused the
normalisation. It may not be sufficient if the documentation merely
states that the factor causing the normalisation is considered unusual
or exceptional without stating the basis on which such a conclusion was
reached.

Revision in materiality
At times,
particularly where an interim audit is performed before the year-end,
the auditor may need to set materiality for planning purposes based on
the entity’s annualised interim financial statements or financial
statements of one or more prior annual periods. While setting
materiality in such cases, the auditor needs to be cognisant of:

observations
emanating from the audit of the previous period i.e., control
deficiencies previously communicated to those charged with governance,

the effects of major changes in the entity’s circumstances (for example, a significant merger),

the effectiveness of the entity’s internal control,

any
public information about the entity relevant to the evaluation of the
likelihood of material financial statement misstatements,

relevant changes in the economy as a whole or the industry in which the entity operates.

Because
it is not feasible for the auditor to anticipate all situations that
may ultimately influence judgments about materiality in evaluating the
audit findings at the completion of the audit, the auditor’s judgment
about materiality for planning purposes may differ from the judgment
about materiality used while evaluating the audit findings at audit
completion. For example, while performing the audit, the auditor may
become aware of additional quantitative or qualitative factors that were
not initially considered but that could be important to users of the
financial statements and that should be considered in making judgments
about materiality when evaluating audit findings.

If the auditor
concludes that a lower materiality level than that initially determined
is appropriate, the auditor should reconsider the related levels of
tolerable misstatement and appropriateness of the nature, timing, and
extent of further audit procedures. The auditor should consider whether
the overall audit strategy and audit plan needs to be revised if the
nature of identified misstatements and the circumstances of their
occurrence are indicative that other misstatements may exist that, when
aggregated with identified misstatements, could be material. The auditor
should not assume that a misstatement is an isolated occurrence.

If
the aggregate of the misstatements (known and likely) that the auditor
has identified during the course of his audit approaches the set
materiality, it would be prudent for the auditor to evaluate the risk
that the possibly unidentified misstatements together with the
identified misstatements may exceed the materiality level. If in the
auditor’s judgment, such a risk is perceptible, then the nature and
extent of further audit procedures would need to be reconsidered.

Let us consider some case studies to understand the practical application of the above concepts.

Case Study I – Materiality at account balance and qualitative factors

Background

CAB Private Limited (‘CAB’ or ‘the Company’) is a trader of fans and has three streams of revenue. Revenue from sale of high speed ceiling fans comprises 60% of the total revenue, revenue from sale of automatic fans comprises 30% of the total revenue and the balance 10% represents revenue from table fans. High speed ceiling fans are sold entirely to XYZ Private Limited, a company in which one of the directors of CAB has a majority stake. M/s. ABC & Associates are the auditors of the Company and Mr. A is the audit in-charge on the job. The Company is profit making and accordingly Mr. A selected profit before tax as the benchmark for the purpose of materiality. The materiality for the purpose of audit of the financial statements for the year ending 31st March 20X1 as ascertained in the planning stage was set at Rs. 80 million.

The table below sets out the position of sales and debtor balances as on 31 March 20X1:

As per Company policy, debtors outstanding for more than 90 days are fully provided for. However, for the year ended 31st March 20X0, management has not made any provision for debtors. In light of the concept of materiality evaluate the following:

I)    Considering the fact that there are no other unadjusted misstatements in the financial statements, as an auditor, is the above misstatement material for reporting purposes?

    What will be the situation in case where the outstanding debtors for more than 90 days is nil for Debtors – high speed ceiling fans, Rs. 35 million under Debtors – automatic fans and Rs. 50 million for Debtors under table fan category?

    The Company received share application money from its parent company located overseas in the month of May 20X0 aggregating to $ 1.66 million (Rs. 100 million) against which shares aggregating to $ 1.42 million (Rs. 85 million) were allotted. No allotment or refund has been done for the balance amount till date. For the shares allotted, the Company did not file

Form FC-GPR with the Reserve Bank of India within prescribed timelines. Non-compliance with the above provisions would be reckoned as a contravention under FEMA Act and could attract penal provisions. Let us evaluate what would be the implications of this situation.

    Analysis I

As per SA 320, one or more particular class of transactions, account balances or disclosures may exist for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users. In such a case, the auditor may consider the account balance or transaction or disclosure as material.

It is pertinent to note that more than 50% of the debtor balance is due from a related party. Further, 60% of the aggregate sales are to related party. Accordingly in the above case even though the aggregate misstatement of Rs. 70 million is below materiality, i.e., Rs. 80 million, Mr. A could consider having a lower threshold as far as debts due from related party are concerned rather than applying the benchmark selected for the financial statements as a whole.

    Analysis II

In the second situation though the account balances individually are below materiality but on aggregate level the total misstatement exceeds the materiality of Rs. 80 million and accordingly, Mr. A needs to consider the said misstatement as material and perform necessary procedures.

    Analysis III

As per the Circular No. RBI/2007-08/213 dated 14th December 2007 issued by the Central Government under Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, the Company is either required to allot shares within 180 days from the date of receipt of the application money or intimate Reserve Bank of India (‘RBI’) if 180 days have elapsed as on the date of notification.

In the above situation, the Company is in violation of FEMA regulations and accordingly although the un-allotted amount (Rs. 15 million) is below materiality (Rs. 80 million), the auditor will have to consider the same as material information for disclosing the same to the users of the financial statements and consider reporting the same in his report.

Case Study II – Normalisation

Background

FAT Private Limited (‘FAT’ or ‘the Company’) is a gem manufacturing company. The said Company has shut two of its plants in the current year. The financial position for FAT is given below:

This is a first year audit by MTS and Associates and the audit engagement partner has determined that the most appropriate benchmark to use in determining materiality is profit before tax from continuing operations. As shown above, the estimated profit before tax from continuing operations for the period is Rs. 400 million. This amount is net of Rs. 80 million restructuring charge for the closure of entity’s plant. In the light of the concept of materiality, evaluate the following:

I. Whether the auditor should consider profit before tax of Rs. 400 million for the purpose of materiality?

    Now consider a situation where FAT has two divisions where total revenue and profit before tax for Division
A is Rs. 800 million and Rs. 30 million and that for Division B is Rs. 1,200 million and Rs. 400 million respectively. The profit before tax from the Division A has historically been low as compared to Division B.

Since the profit from Division A is very low, the auditors have decided not to consider the same for the purpose of materiality. Evaluate if the approach is appropriate?

    Analysis

    As per SA 320, when the materiality for the financial statements as a whole is determined for a particular entity based on a percentage of profit before tax from continuing operations, circumstances that give rise to an exceptional decrease or increase in such profit may lead the auditor to conclude that the materiality for the financial statements as a whole is more appropriately determined using a normalised profit before tax from continuing operations figure based on past results.

In the current scenario, the current-period profit before tax from continuing operation includes a significant amount that is on account of an unusual transaction and is not a recurring expenditure. Accordingly the audit team needs to normalise the benchmark amount by excluding the restructuring charge from the current-period profit before tax from continuing operations.

    In situation II, although the profits from Division A are low as compared with the profits from Division B, it is not exceptional in nature. The profits have been historically low from Division A and accordingly if the Company expects that the same will be continued, the auditor should consider the profit of Division A for the purpose of calculating the benchmark for materiality.

    Case Study III – Revision in materiality

GFT and Associates are the auditors of Small Ltd. (‘the Company’). The following is the financial position of the Company:

Based on financial position given above, the auditor decided to use revenue as the benchmark for the purpose of calculating materiality for 20X1. During the course of audit while performing cut off procedures, the audit team realized that the Company had recognized excess revenue of Rs. 200 million. This amount was substantial comprising approximately 16.66% of the total revenue. Should the audit team revise the materiality?

What would be the answer had there been an under-recognition of revenue by Rs. 200 million, should the auditor revise the materiality?

    Analysis

As per SA 320, the auditor shall revise materiality for the financial statements as a whole in the event of becoming aware of information during the audit that would have caused the auditor to have determined a different amount (or amounts) initially. In the given scenario, as the revenue amount has been revised significantly the auditor would need to revise the materiality amount. As a higher materiality figure was earlier used to scope account balances/transactions for scrutiny, the likelihood of the risk of misstatements remaining undetected may not have been adequately addressed.

On the contrary, in a situation where the revenue recognised was lower by Rs. 200 million and accordingly the materiality calculated was also lower, the auditor may use his professional judgment to evaluate whether it is necessary to revise the materiality.

    Concluding remarks

In conclusion, auditors need to make materiality judgments on every audit which is a difficult process as it requires both qualitative and quantitative aspects to be evaluated. Additionally there is no formal or scientific method to compute materiality. Materiality judgments are crucial for conduct of a successful audit as poor judgments can result in an inappropriate audit opinion or may result in the audit being inefficient or ineffective.