The concept of materiality and its significance in the audit process
The objectives of this assignment is to conduct audit procedures for the purpose of ascertaining the materiality level of the financial statements of a company in order to review whether the financial statements are free from misstatements. The materiality concept is fundamental to the scope of audit as the auditors determine whether the financial statements are showing true and fair view on the basis of judgement of the auditor. The company which is considered for this assessment is Met Cash Limited (Mars-metcdn-com., 2018).
The concept of materiality states that the auditor needs to considers items which forms a major part of the financial statements and also affects the decision-making capabilities of the investors. In order to estimate materiality of an item of a financial statement, the auditor needs to apply his expertise skills and judgements. Materiality is determined on the basis of qualitative and quantitative aspects of financial statements (Legoria, Melendrez & Reynolds, 2013). The auditor considers qualitative aspects such as net profits, changes in accounting principles, assets of the business. As per quantitative aspect of materiality, the auditor considers a percentage which is used for the purpose of computing the materiality of the business. Normally this is done at the planning stage for the audit process and planning materiality is computed (Vîls?noiu & Buzenche, 2014). Generally qualitative materiality for an item is considered for items which has a significance in the business or the items which are complex in nature.
During the planning stage of audit, planning materiality and performance materiality is to be computed. In the calculation of planning materiality, a particular base is considered which is an item present in the financial statements of the company (Elder et al., 2013). It is normally the policy of most of the auditing firms to take the item which has the highest value for the computation of planning materiality of a business (Eilifsen & Messier Jr, 2014). On the basis of planning materiality, performance materiality of a business is computed.
The annual report of Metcash ltd shows the financial performance of the business for the year 2018. The figure of total assets which is shown in the balance sheet of the company is shown to be $ 3,719 million which is considered for the purpose of calculating the planning materiality of a business. In addition to this, the calculations of planning materiality require the auditor to assume a percentage on the basis of which the planning materiality figure is to be derived. The computation of planning materiality is shown below:
Key disclosures and draft notes in the annual report of Met Cash Limited
The planning materiality comes to about $ 185.95 million which will be used by the auditor to identify performance materiality which is ultimately used for ascertaining if there are any material misstatements in the financial statements of the company (Jacoby & Levy, 2016).
The key disclosures which are shown in the annual reports of Met Cash ltd which can affect the audit process are listed below in details:
- Commitment, Contingencies and other financial exposures: The operating lease commitments of the business which is related to warehouses and retail stores is shown to have decreased significantly from $ 1491.7 million to about $ 1373.1 million in 2018. This is a material disclosure and therefore the auditor needs to verify the same as the same can affect the financial statements of the business (Lewis, 2013).
- Tax:The items of tax which is shown in the financial statements of Met cash ltd shows current tax expenses of the business, deferred tax expenses. The disclosures which is shown in the annual reports of the business for tax shows that the company has complex tax treatments and has introduced a tax funding program. This needs to considered by the auditor as the complexity of the treatments makes the situation more material in nature from the perspective of audit.
- Interest Bearing Borrowings: The financial statements which is prepared by the company shows that the business has taken interest bearing borrowings during the year. The interest-bearing borrowings of the business shows that it comprises of Financial leases, US private placements, Bilateral loans and also bank loans. The borrowings of the business are shown in the balance sheet of the company and has the capability of affecting the entire financial statements of the business. The borrowings of the business represent a material amount and therefore has the capacity of affecting the financial statements of the company.
Analytical Review of the Financial statements
Analytical procedures are one of the practices which is used in auditing which considers significant financial ratios to get an overview of the financial performance of the business. Analytical procedures require the auditor to consider key financial ratios which are indicators of the health of the business (Sharma & Panigrahi, 2013). Some of the ratios which are considered are profitability ratios, liquidity ratios, solvency ratios and capital structure ratios.
In this case, in order to apply analytical procedures for the business of Met Cash Limited, financial statements are considered for a period of 4 years starting from 2014 to 2017. The table below shows the computation of key financial ratios of Met Cash Limited for the four years period.
Liquidity Ratios
The liquidity ratio of the business is shown in the chart which is shown above which comprise of current ratio and quick ratio. The current ratio of the business is shown to be favorable for the year 2017 as the estimate which is computed is shown to be 1.17. In 2014, the current ratio was not much significant and was shown to be 1.14 and the same has improved tremendously as per the chart which is shown above. An ideal current ratio should be greater than 1 and the same is shown for the business which also shows that the current assets of the business is more than current liabilities of the business. The quick ratio of the business for the year 2017 is shown to be 0.79 as per the estimate which is shown in the chart above. The quick ratio of the business has improved slightly from the estimate of previous year which suggest that the liquidity position of the business is favorable. The quick ratio considers assets which are more liquid in nature and does not include stock in the category of current assets (Khidmat & Rehman, 2014). The quick asset of the business has also increased during the period in comparison to previous year estimate which is computed. This shows that the business has an efficient liquidity structure which can meet the current obligations of the business effectively. The auditor needs to assess whether the current assets and current liabilities of the business are showing true and fair view or not. The net working capital of the business shows there is an increase in the same which is a positive sign for the business. The auditor needs to assess the liquidity position of the business considering the financial statements of the company.
Analyzing the financial statements through an analytical review
Profitability Ratios
The profitability ratios form an important part of the analysis which is conducted by the auditor as most of the manipulations are generally in this area. The ratios which are computed considering this area are gross profit margin, net profit margin, return on equity, return on assets. The gross margin shows that there has been an increase in the gross profits of the business from previous year estimates which shows operational efficiency of the business. The net profit margin of the business is shown to have declined which suggest that there has been an increase in the costs of the business. The estimate of net profit as calculated for the year 2017 is shown to be 1.23 which was 1.61 in 2016 as computed in the table above. This can be due to the increase amount of costs which are incurred by the business during the year (Al Nimer, Warrad & Al Omari, 2015). The return on assets and return on equity of the business are key financial indicators of the business and therefore should be considered by the auditor. The return on equity and return on assets of the business is showed to be on a declining verge which can be attributed to the fall in the profitability of the business. The auditor needs to apply audit procedures in order to check the viability of expenses which is incurred by the business during the period. This is to be done in order to ensure that the profits or losses which are shown in the financial statements are not vague in nature. In order to obtain a clear understanding of the expenses and sales figures which the management of the company has shown in the financial statements, the auditor needs to apply vouching procedures in order to justify the sales and different expenses figures which are shown in the annual reports of the company.
Asset Management Ratios
The asset management ratios of a business comprise of stock turnover ratio, asset turnover ratio which is related to the business. These ratios show how efficiently the management utilizes the assets of the business for the purpose of generating revenues of the business. The inventories of the business are always considered to be integral part of the financial statements and are most vulnerable to material misstatement.
The auditor of business needs to verify the balances which are shown for inventories and assets of the business in order to ensure that the same are fairly represented. The auditor can also check the balances of inventory by conducting a physical take of the stock in order to value the same. In case of valuation of assets of the business, the auditor can take the help of an expert in the field in order to confirm the valuation of the assets of the business.
Leverage Ratios
The leverage ratios of the business are generally associated with the capital structure which is used by businesses and the capital includes both equity capital and debt capital of a business. The ratios which are considered in case of such a business are related to debt ratio, debt to equity ratios and gearing ratio. The debt ratio shows that the level of borrowings of the company has decreased significantly which shows that the company is relying more on equity capital of the business. The debt to equity ratio also shows a similar figure during the year and the estimate for 2017 is shown to be 0.11.
The auditor needs to assess the capital structure of the business and identify any risks which can affect the business and overall audit process of the business. The figure of borrowings of the business has decreased and this is the reason due to which the for the fall in the debt ratio of the business. The auditor needs to check the repayment schedule for the company and also check whether the business has taken any additional loan for the business.
Valuation Ratios
The valuation ratio of the business comprises of price-earnings ratio, price to book value ratio which are considered important from the perspective of a business. The price earning ratio of the company is shown to have increased and the same is shown to be 0.11 for the year 2017. The price to book value ratio has also increased. The auditor needs to consider the earning per shares which is shown by the business and ensure that that figure is correct. EPS is considered by investors before taking investment decisions and therefore the auditor needs to check the same.
Cash flow statement is a part of the financial statements of a business and statement reveals the cash position of the business. The statements show the various sources from which cash comes in to the business and also the sources of cash outflows of the business. The cash flow statement of Metcash ltd is effectively shown in the annual reports for 2018 classifying the activities as operating, financing and investing activities.
The cash inflows from operating activities of the business shows the maximum cash inflows of the business which is receipts from the customers and the same is shown to be $ 15,765.9 million. The category of cash activities which has the greatest cash outflow is shown in cash from operating activities and the same is cash paid to employees and suppliers (Bhandari & Iyer, 2013). The primary cash receipts and cash payments which are shown in the annual reports of the business are cash received from customers and cash payments made to suppliers which are shown in the cash from operating activities of the business.
The main cash flows which are related to investing activities of the business are shown to be payments which are made by the business towards acquisition of assets and in case of financing activities the major cash flows which is shown in cash flow statement of the business is shown to be payments of dividends which are made to owners of parent companies.
The going concern principle is considered to a fundamental principle in accounting and therefore the auditor needs to ensure that this principle of the business is not affected. As per the significant ratios which are computed for Met Cash Ltd, the liquidity ratio of the business is shown to be favorable which shows that the company is not facing any liquidity problems. The business has incurred a loss in the current year but that is due to the increase in the expenses of the business. The management has made dividend payments during the year which suggest that the business has adequate reserves. Thus, only on the basis of the loss, it cannot be judged whether the going concern principle of the business is in jeopardy or not. However, the auditor needs to identify the negative financial indicators which are a sign that the going concern principle is affected.
The audit of Metcash Ltd is undertaken by one of the big four auditing firms which Ernest and Young (EY). As per the opinion of the auditor, the financial statement which is prepared by the business are showing true and fair view and also complies with all relevant Australian accounting standards and Corporation Regulations of 2001.
The auditor has recognized certain issues which were observed by the auditor during the course of audit which are portrayed in Key audit matters of the business. One of the issue which is recognized is impairment of intangible assets of the business which involves lot of assumption and judgements which are made by the company in computing the impairment amounts. Another identified issue is the accounting for rebates for suppliers for which the management doe not have fixed criteria as it is some time estimated on volume, weight of products and even on quantity basis as well.
Reference
Al Nimer, M., Warrad, L., & Al Omari, R. (2015). The impact of liquidity on Jordanian banks profitability through return on assets. European Journal of Business and Management, 7(7), 229-232.
Bhandari, S. B., & Iyer, R. (2013). Predicting business failure using cash flow statement based measures. Managerial Finance, 39(7), 667-676.
Eilifsen, A., & Messier Jr, W. F. (2014). Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), 3-26.
Elder, R. J., Akresh, A. D., Glover, S. M., Higgs, J. L., & Liljegren, J. (2013). Audit sampling research: A synthesis and implications for future research. Auditing: A Journal of Practice & Theory, 32(sp1), 99-129.
Jacoby, J., & Levy, H. B. (2016). The materiality mystery. The CPA Journal, 86(7), 14.
Khidmat, W., & Rehman, M. (2014). Impact of liquidity and solvency on profitability chemical sector of Pakistan. Economics management innovation, 6(3), 34-67.
Legoria, J., Melendrez, K. D., & Reynolds, J. K. (2013). Qualitative audit materiality and earnings management. Review of Accounting Studies, 18(2), 414-442.
Lewis, M. K. (2013). Off-balance sheet activities and financial innovation in banking. PSL Quarterly Review, 41(167).
Mars-metcdn-com. (2018). Retrieved from https://mars-metcdn-com.global.ssl.fastly.net/content/uploads/sites/101/2018/07/24145704/Metcash-Annual-Report-2018.pdf
Sharma, A., & Panigrahi, P. K. (2013). A review of financial accounting fraud detection based on data mining techniques. arXiv preprint arXiv:1309.3944.
Vîls?noiu, D., & Buzenche, S. (2014). Determining Audit Materiality in the Banking Industry–A Knowledge Based Approach. Procedia Economics and Finance, 15, 935-942.
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