Materiality Concept In Auditing: Definition, Importance, And Application

Materiality Concept

The materiality concept means that the firm must disclose any item that is found to have noteworthy influence in the financial statements. The nature of the item must be significant enough to impact financial statements. Items that are important enough to matter are material items. For example if a customer owes $ 2 million dollars to a company which has a net asset worth $ 2 million the nature of the item is material in nature . not reporting it would have a significant impact on the financial statements. The materialtity concept is provided by the auditor while he performs and plans the auditing procedures. It is also applicable in assessing the consequence of  misstatements that have been identified on the audit and uncorrected misstatements, if any as well on the financial statements(Edgley,  Jones & Atkins, 2015). The concept of planning the level of materiality needs to be set  before the financial statements are prepared. The materiality needs to be reviewed. The audit can move forward if and only if the information makes an assessment  that  there is an opportunity  for the auditor to incorporate a lower level of materiality at the beginning of the audit. The materiality, in practice   is reassessed at least one time.. That can happen during the final audit and before the issue of the audit report. This is known as final materiality(Kugler,2016). The auditor can set performance materiality as well. The performance materiality includes  amounts that is less than the whole financial statements materiality. (Ngu  & Amran, 2018).

As per the annual report of the company , the cash flows, consolidated financial position may be materially affected by fluctuations in the Australian dollar and the local currencies with which the business deals . This is a performance materiality. The foreign exchange rates is very fluctuating in nature and hence if the value of the dollar depreciates in respect to any local currency, the earnings of the  company will take a significant hit(Engel, 2014).. Such fluctuations are not planned and can happen anytime. The quantitative estimate as per the last year is A$ 116.8 million.

After reviewing the notes and disclosures that is found in the financial statements the following issues have been observed:

• The consolidated financial statement have been prepared by eliminating all intercompany balances and transactions.
• the trade receivables have been primarily recognised at fair value and successively valued at amortised cost less provision for impairment.
• Intangible assets like customer relationships, trade names have been individually bought or valued at cost less accumulated depreciation(AnnualReports.com, 2018).
• The provisions have been recognised when the Group has a current legal or constructive obligation . This amount can be predicted reliably
• The Group uses derivative financial instruments. These financial statements have been prepared in accordance with policies approved by the board  to hedge risks of exposure(AnnualReports.com, 2018).

The ones that will have special significance include:

• Foreign exchange risk- the Group works internationally and is hence uncovers foreign exchange risk. This exchange risk  primarily deals with  transactions that is settled by  American dollars.The Group comes into  contact with forward foreign currency exchange contracts . This is done in order to hedge purchase or sales risks that may accrue later.
• Commitments and contingencies-The contingencies include a payment of operating lease of $ 3532.8 million. The company has guaranteed in respect of the contract performance  that is entered by the company  in the  ordinary course of business. These values have been provided by the Group . However  no amount has been documented in the financial statements(AnnualReports.com, 2018).

The audit procedures that need to be performed include :

• Verifying the existence of inventory by taking an independent physical count
• Valuing the correct amount of assets and liabilities of the company to see that he valuation has been done properly or not.
• Making a complete assessment by tracing how much a particular asset  is valued and how much should the actual worth of the asset be(Hillary,2017).

Key ratios and analysis

A key analysis of the key ratios can be as follows:

Return on equity-Return on equity is the amount of net income that is earned by the company in relation to the equity capital of the firm .thus is a measure that suggests how effective the company is in terms of turning the cash that is invested into the business into a greater gain and acquiring sound financial profits of the company(Utami,2017). The greater the return on equity, the more efficient the company is . An analysis of the return on equity for  four years  suggests that the company has made improvement in earning income  in relation to the sum of money invested from 2014 to 2015. It again  made a negative amount of income compared to the investment it made in 2016 and then finally made a positive improvement in the following year. This suggests that the company has achieved an inconsistent return on equity, in the four years. The auditor needs to assess whether the amount of return that is shown in the financial statements is accurate or not. He also needs to assess whether the capital invested by the firm is properly valued or not . He needs to  verify the accuracy of these two amounts(Nashihin & Harahap, 2014)..

Application of Materiality Concept in Auditing Procedures

Return on assets- this suggests the income earned by the firm in relation to the total investments made by the firm . It is a measure suggesting how effective the company is  utilising its assets in earning income. The greater the return on assets is, the more effective the company is (Heikal, Khaddafi & Ummah, 2014). The above analysis suggests an inconsistent flow of return on equity over the four years. The company achieved an improvement in 2015 over 2014, while the ratio significantly came down in 2026. It rose again  in 2017 , which suggests a positive influence on the financial statements of a company in that year. The auditor must verify the existence of the assets. He must verify whether the individual assets are correctly valued or not( Zamboni,  & Litschig, 2018).

Current ratio- Current ratio implies the ratio of current assets to current liabilities. A higher current ratio suggests that the company has more current assets in relation to its current liabilities ,which suggests that the company has a sound liquidity position(Barman & Sengupta, 2017). In the analysis , the company has achieved an improvement year after year. The liquidity position of the company is achieving year after year. This suggests that the company is steadily improving its abilities to pay back its liabilities year after year. The auditor must verify the existence of the current assets and liabilities and see whether the corporation is actually in a sound position to pay off its liabilities in due time. He must assess the liquidity risk of the company and sees whether the current assets can be sold within a span of one year in order to pay off its current  liabilities.

Financial leverage- Financial leverage is the amount of debts that the company uses to buy more assets.it is employed to avoid using too much equity  and buy assets with debt capital( Ichsani & Suhardi, 2015) The financial leverage of the company over the four years  has found to have exceeded 1. It suggests that the company is highly dependent on borrowings to fund off its assets. The auditor needs to assess the liquidity risk of the company. He also needs to assess the level of borrowings and the amount of debt financing employed  by the company( Zamboni,  & Litschig, 2018).

Receivables turnover – The receivables turnover ratio measures how efficiently a firm utilises its assets and  makes timely collection of money from debtors. On analysing the four years , the turnover shows a decreasing trend in the first two years and it shows a rise in 2016 and 2017. This suggests that the company has made a significant improvement in collecting money from the debtors. The auditor needs to verify the balances of each debtor individually and follow up individually each debtor personally in order to know when they paid back the money due to the company(Zamboni,  & Litschig, 2018).

Cash Flow Statement

Analysis of Key Ratios

The cash flow statement displays where the entity’s cash is being generated and where it is applied. It is useful for analysing the liquidity and long term solvency of the company.In this company , the most significant inflow has been generated from operating activities. The investing activities and financial activities have yielded a  cash outflow(Ball et al .,2016) .

Answer 1

As per the cash flow statement of the company the cash flow from operating activities brought about the maximum  amount of cash inflow to the company(Lewellen & Lewellen, 2016). The amount brought in was $266.4 million.

Answer 2

The financing activities of the company bought the maximum amount of cash outflow to the company .The amount was $ 67.5 million(AnnualReports.com, 2018).

Answer 3

The primary cash receipts include that of the receipts from customers to the extent of $5274.6 million, the proceeds that the company received from sale of the assets that are held for use to the extent of $48 million. The primary cash payments  include that of the payments that the company made to suppliers and employees to the extent of $ 5000 million, the payments that the company made for property, plant and equipment to the extent of $ 126.5 million. It also includes the repayment of borrowings that the company made to the extent of $300.5 million and the dividends paid to its shareholders to the extent of $ 63.5 million.

Answer 4

The main cash financial  activities include the borrowings made by the company to the extent of $ 303 million and the repayment of borrowings to the extent of $ 300.5 million. The main cash investing activities include the acquisition of property, plant and equipment to the extent of $ 126.5 million (AnnualReports.com, 2018).

The going concern risk refers to the risk of liquidation for the conceivable future, usually regarded in the next one year. The auditor concluded that the company faces no such risk unless the management decides to cease operations themselves. There is no such material uncertainty that exists that can impact the going concern risk of the company. However future conditions or events may cause the Group to stop functioning as a going concern (Krishnan & Wang, 2014).

The audit procedures that can be implemented in this regard is making sure the net profit of the firm is correct or not, making sure that the assets and liabilities exist and have been correctly valued .The aim of audit procedure should be that the firm should not hide any evidence of material uncertainty that can impact its status as a going concern.

Cash Flow Statement Analysis

According to the auditor, the financial statements  of the corporation give a true and fair view of the financial position of the company. It also need to comply with the Australian Accounting Standards and Corporations Regulations 2001. The auditor has made a qualified opinion on the basis of having obtained adequate appropriate audit evidence of the financial statements(Tsipouridou & Spathis, 2014).

As  per the  report  of the auditor the carrying value and existence of inventories indicated audit issue. Inventories are measured at lower of cost or net realisable value .Cost  on the other hand is determined by either the first in or first out method or weighted average method. However while auditing, there was found to have no proper method of  valuation and evaluating the appropriateness of the allocation of costs while determining the weighted average costs of inventories.

References:

Ball, R., Gerakos, J., Linnainmaa, J. T., & Nikolaev, V. (2016). Accruals, cash flows, and operating profitability in the cross section of stock returns. Journal of Financial Economics, 121(1), 28-45.

Barman, A. N., & Sengupta, P. P. (2017). DETERMINANTS OF PROFITABILITY IN INDIAN TELECOM INDUSTRY USING FINANCIAL RATIO ANALYSIS. International Journal of Research in Management & Social Science, 25.

Edgley, C., Jones, M. J., & Atkins, J. (2015). The adoption of the materiality concept in social and environmental reporting assurance: A field study approach. The British Accounting Review, 47(1), 1-18.

Engel, C. (2014). Exchange rates and interest parity. In Handbook of international economics (Vol. 4, pp. 453-522). Elsevier.

Heikal, M., Khaddafi, M., & Ummah, A. (2014). Influence analysis of return on assets (ROA), return on equity (ROE), net profit margin (NPM), debt to equity ratio (DER), and current ratio (CR), against corporate profit growth in automotive in Indonesia Stock Exchange. International Journal of Academic Research in Business and Social Sciences, 4(12), 101.

Hillary, R. (2017). Introduction. In ISO 14001 (pp. 11-16). Routledge.

Ichsani, S., & Suhardi, A. R. (2015). The effect of return on equity (ROE) and return on investment (ROI) on trading volume. Procedia-Social and Behavioral Sciences, 211, 896-902.

Krishnan, G. V., & Wang, C. (2014). The relation between managerial ability and audit fees and going concern opinions. Auditing: A Journal of Practice & Theory, 34(3), 139-160.

Kugler, M. B. (2016). The Materiality of Sponsorship Confusion. UCDL Rev., 50, 1911.

Lewellen, J., & Lewellen, K. (2016). Investment and cash flow: New evidence. Journal of Financial and Quantitative Analysis, 51(4), 1135-1164.

Nashihin, M., & Harahap, L. (2014). The Analyis of the Efficiency of BPR-S: Production Function Approach Vs Financial Ratios Approach. Procedia-Social and Behavioral Sciences, 115, 188-197.

Ngu, S. B., & Amran, A. (2018). Board Diversity and Materiality Disclosure in Sustainability Reporting: A Proposed Conceptual Framework. Management, 5(4), 1-14.

Sims Metal Management Ltd – AnnualReports.com. (2018). Retrieved from https://www.annualreports.com/Company/Sims-Metal-Management-Ltd [Accessed 1 Sep. 2018].

Tsipouridou, M., & Spathis, C. (2014). Audit opinion and earnings management: Evidence from Greece. In Accounting Forum (Vol. 38, No. 1, pp. 38-54). Elsevier.

Utami, W. B. (2017). Analysis of Current Ratio Changes Effect, Asset Ratio Debt, Total Asset Turnover, Return On Asset, And Price Earning Ratio In Predictinggrowth Income By Considering Corporate Size In The Company Joined In LQ45 Index Year 2013-2016. International Journal of Economics, Business and Accounting Research (IJEBAR), 1(01).

Zamboni, Y., & Litschig, S. (2018). Audit risk and rent extraction: Evidence from a randomized evaluation in Brazil. Journal of Development Economics, 134, 133-149.

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