LECTURE 5 – AUDIT MATERIALITY…………………………..

LECTURE 5 – AUDIT MATERIALITY

Good morning friends once again…………..

In the last lecture we had discussed about the audit evidences………..

In today’s lecture we will discuss about Audit materiality………….

Now there would be very big question in your mind that WHAT IS AUDIT MATERIALITY????

Pay attention that our institute has asked this concept many times in its exams by way of theory as well as case study.

I am coming on that point but before that read this issue and just think about it……….

One day Mr. Vijay Rajput won Rs. 50 Lakhs from lottery. He went to his wise and intelligent friend CA Aryan and asked him to invest that money.

CA Aryan was known to all market flows.  He was aware about the recent boom of stock market. He advised his friend Mr. Vijay Rajput that he should invest his money in to share market. CA Aryan also advised to his friend that before investing this much money he should verify the financial statements of companies means profit and loss account, balance sheet and other important statements. He should assess the results and position of the company.

Now students pay your attention that what happened exactly…………

There was company named KBC Ltd. Vijay Rajput verified his financial statements and found following details…………………

–         Profit and loss account of previous year end was showing receipt  of Rs. 1050 Crores.

–         Expenses of that particular company were Rs. 750 Crores and profit was showing Rs. 300 crores.

–         Balance sheet was showing total assets of company which was amounting  Rs. 1000 crore out of which sundry debtor was Rs. 300 crores  and liability was Rs. 500 crore.

Now I like to ask that as being an investor should Mr. Vijay Rajput invest in such company…………….. and I am damn sure that your answer will be YES………………

You can see here that company has good income and good assets and liability position……….. from the first view it looks that there is no risk by investing in it.

Now just turn the picture by this way……………..

Now assume that…………

–         In profit and loss account out of Rs. 1050 crores receipts, Rs. 300 crores is received from government as subsidy……….

–         From the total receipt, Rs. 200 crores has been received from Insurance Company for passing claim of property damage.

–         In Balance sheet out of total of assets of Rs. 1000 crores, Rs. 300 crores is Preliminary Expenses (fictitious assets).

–         Out of total Rs. 300 crores of sundry debtors, Rs. 75 crores is of internal debtors. (Related party debtors by making internal transactions)

–         Out of liabilities of Rs. 500 Crores, Rs. 400 crores is secured by the fixed assets………….

Now think that should Mr. Vijay Rajput invest in such company???

Now your answer will be big NO……….

Now friends this is the impact…………

I am not here to advice you that in which company we should invest BUT I want to make emphasis on the point that what is the importance of disclosure………..

If disclosure is not made then we can say that decision would be different than disclosure made…………. after disclosure we can say that picture became more clear………….. and this is the concept of MATERIALITY……………….

So now you have lots of questions……………. like

• Ø What is materiality?
• Ø Which points are important to decide materiality in the process of audit?
• Ø Why materiality co ncept is important?
• Ø Which points auditor should consider for deciding materiality?

So, remember that…..

Transaction or item is material if it influences the decision of reader. Means after reading transaction or item of financial statement, if reader changes his mind or decision then, it is said that transaction is material.

And when the transaction or item is material then it is must to disclose them separately means……….. separate disclosure is required………….

So from the above issue we have verified that how important the disclosure is??????

Here we can see that concept of materiality is mainly related with the disclosure of data. In other words it is related with the presentation of data.

We all know that main objective of auditor is to express opinion about truth and fairness of financial statements.

So auditor has to verify that, all important data, which may influence the decision of reader has been disclosed separately in the financial statements.

• Ø Which points auditor should keep in mind while deciding materiality of item??????

–         It is true that each and every item of transaction cannot be said material.

–         As per PART V of schedule VI of The Companies Act, 1956 if xpenses amount is Rs. 5000 or 1% of the total revenue whichever is higher, then separate disclosure for such expenses is required.

–         For deciding materiality of transactions and items shown in the financial statements auditor should verify the data of previous year. He should make comparison and decide the disclosure item. (In the previous year there was sales of only one commodity when in current year there is sales of two commodities, so sales of both the commodities should be shown separately.)

–         For profit and loss account the materiality contents are its transactions when for balance sheet it is group and presentation of items. (for example Bonus paid to employees should be shown as Bonus under profit and loss account and not as the salary……. While loan given to any party cannot be shown as Deposit in the balance sheet…………. I hope you are aware that loans and advances is different concept than deposit…………

–         If transaction contains very attractive and abnormal amount, then it is material and known as quantitative in nature (For example scrap sales of property amounting Rs. 2500000…….. Now here you can say that transaction is ordinary but due to involving huge amount it becomes material and separate disclosure is required.

–         Sometimes transaction is not huge as per amount wise but it is special in nature.

–         Though the amount involved is very small, separate disclosure is required…….. because it is material in nature. (Every statutory transaction or item, though contain only 1 RUPEE, it is material and separate disclosure is required. [For example all type of TAXES (Income tax, VAT, Excise duty, Service tax etc.), government dues such as provident fund, Municipal tax, TDS, etc……]

–         Auditor should not only verify the individual effect of materiality but should check the cumulative effect also………… (For example bank ha charged Rs. 10 from the customer account. This is not that much important or material but think that there are 100000 customers are joined with the bank and from each and every customer’s account such amount has been deducted………….. So now this transaction becomes material in nature and for this separate disclosure is required.

–         All extra ordinary transactions, non recurring transactions, exceptional and abnormal transactions required separate disclosure because they all are material in nature………..

–         When transaction contains huge amount then it is called quantitative in nature, while all extra ordinary, non recurring and statutory transactions are known as qualitative in nature and separate disclosure is required for that.

–         Following are some transactions for which the separate disclosure is required……………………and which is material………….

• Insurance claim received from insurance company
• Profit on sale of any asset or property
• Profit on sales of investments
• Fraud committed by the management
• Any kind of losses (Fire, theft, accident………..)
• Dividend
• Interest paid
• Related party transactions
• Loan taken
• Any subsidy received from government authority.
• Asset revaluation transactions.

 

Here I will emphasis on one more point that ability to decide materiality from one individual to other may be different. It depends upon personal knowledge and experience.

• Ø Now think if such data has not been shown separately in the financial statements then what will be impact?

–         Then reader may be misguided with the data

–         Probability of Audit risk will be increased………………

Now you will have one more question in your mind that what is audit risk?????

To know about the audit risk you should be familiar with term detection risk…….

Now once again you will have one more question that what is detection risk???

To know about the detection risk fist you should know about control risk…….

And to know about the control risk you should be aware about the concept of inherent risk……………

AND

To know about the inherent risk you should be familiar with the concept of inherent limitations of internal control system……………

Now don’t ask me that what is internal control system??? We have already discussed it in the LECTURE – 2……….. So we will start our discussion with the inherent limitation of internal control system……………..

So first of all lets start with the concept………..INHERENT LIMITATION OF INTERNAL CONTROL…………

In the lecture no. 2 I had discussed about the concept of internal control system, I hope you are aware about it…….

Following are the limitation of internal control system………….. means though management have established good internal control system still there are some loopholes are always available. There is no any absolute authority that frauds and errors will be detected by such internal control system………….. because every system contains some limitations………. following are the reasons for such limitations

• Ø Management may not be able to create proper internal control system
• Ø Avoidance and carelessness of top level management
• Ø Humans are not machines. So human can make mistakes in the system.
• Ø Generally internal control is always set to control normal circumstances but when there are any kind of abnormal circumstances then it may possible that current internal control system may not able enough to control it. (in the organisation internal control system has been setup for normal weather but not for flood…………)
• Ø If management itself has been involved in making frauds then there is no any internal control system in the world which can prevent the frauds.

So students pay concentration here to understand the type of risk………….

• Ø There are always some risks are involved in any kind of system due to having inherent limitations of system. Risk involved at this stage is known as INHERENT RISK…………… such inherent risk is controlled by implementing internal control system. Means………………
• Ø To avoid such inherent risk and for finding frauds and errors internal control system is implemented.
• Ø CONTROL RISK means that frauds and errors due to having inherent risk in the system will not be controlled by the internal control also.
• Ø So such risk goes ahead and now there is only one filter available known as Audit. Such risk is detected by the audit process.
• Ø But if frauds and errors still not detected by audit process also then such involved risk is known as DETECTION RISK. Means frauds and errors not detected by the audit also.
• Ø Now pay concentration here what happened ultimately……………… such frauds and errors becomes part of the financial statement and there is one another risk that opinion given by the auditor is not correct. This risk is known as AUDIT RISK.

Auditor should verify all the risks and should plan his compliance and substantive procedures accordingly.

 So now come to the original point means audit materiality…..

From the above discussion we knew that material item required separate disclosure in the financial statement if it is not disclosed properly then there is possibility of audit risk in the financial statement.

Now

During the process of audit if auditor found any material transaction and it is not shown separately in the financial statement then what auditor should do?

–         Auditor should ask management for adjustment in the financial statements. (here adjustments means improve financial statement by disclosing material items.)

–         Now if management deny to make adjustments then what auditor will do????

–         Auditor should QUALIFY his report by mentioning the same thing in to the his audit report.

Now you will have one question that what is meant by qualifying the report.

This concept is part of audit reporting.

There are mainly four types of audit reports are issued by the auditor

–         Unqualified or clean report

–         Qualified report

–         Disclaimer of opinion

–         Adverse report

Now let’s understand each report one by one………….

• Ø Unqualified or clean report

–         When auditor is fully, 100% satisfied with the presentation in financial statements he issues cleans and unqualified report.

–         In this situation auditor makes this statement……………….. “to the best of my knowledge and prudence, financial statement of ………………. ltd. Provides true and fair view………….”

• Ø Qualified report

–         During the audit process there are some transactions for which the opinion of auditor and management remains different. Not only that management doesn’t give his consent to adjust it. Here auditor remains dissatisfied to those transaction and presentation. In such particular situation auditor issues qualified report.

–         In this situation auditor makes following statement…………. “to the best of knowledge and prudence, financial statements of…………… ltd. Provides true and fair view EXCEPT………………………(mention issue on which auditor is not satisfied.)

–         For example Honda City purchased by Rs. 9 Lakhs shown as expenses in the profit and loss account. In this case auditor should issue qualified report because Motor car purchased should be shown as fixed assets and not as expenses.

• Ø Disclaimer of opinion

–         Sometimes auditor demands some details or records from management but due to having some reasons management does not provide that information or records. In such case auditor will not be able to verify those particular transactions and for that transaction auditor should issue disclaimer of opinion.

–         “to the best of our knowledge and prudence it is our opinion that financial statements of ……………. ltd. Provides true and fair view except…………….. (mention records or item which not provided by yhe management) as it is not provided by the management.

–         For example auditor demanded original investment certificate amounting rs. 50 crores from company but company does not provide it. So auditor should mention that except investments financial statement provides true and fair view because management has not provided investment records.

• Ø Adverse opinion

–         When auditor is dissatisfied with the entire presentation of financial statement he issues adverse opinion.

–         When there is huge fraud is involved and huge manipulation of accounts has been made, financial statements are not providing true and fair situation as per actual, auditor should issue adverse opinion.

–         For example in the audit process it is found that actual sales of the company is only Rs. 100 crores when in the profit and loss account it has been shown by Rs. 550 crores. In this case auditor should issue adverse opinion.

I hope now you are aware about the concept of qualified report.

Now sometimes institute asking the question that what is relationship between audit materiality and audit risk????

• Ø Auditor will consider the audit materiality to draft his audit planning and audit programme
• Ø Audit planning may be changed at any time by considering materiality level of the organisation.
• Ø If materiality level is high then there is more transparency in the financial statements.
• Ø More transparency means there is less chances of having frauds and errors and due to that there is lower audit risk in the financial statements. So auditor will complete his audit by using less time.
• Ø If there is lower material level then auditor has to perform more substantive procedures to avoid the audit risk. So audit risk is more if there is lower level of materiality.
• Ø So relationship between audit risk and audit materiality is inverse relationship.

 

So fiends in summary we have learned following points today…………..

• Ø Concept of materiality
• Ø Different types of risks concepts
• Ø Audit materiality and audit risk relationship
• Ø Factors affecting audit materiality.

Thank you very much students……………. we will meet once again in next lecture with some more concept……………

If you have any dought about this concept then please ask here……………

 

Take care………………….