Materiality, Risk Assessment and Internal Control
15 theoretical questions from ICAI Study Material
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Use of Benchmarks in Determining Materiality for the Financial Statements as a Whole: As per SA 320, determining materiality involves the exercise of professional judgment. A percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial statements as a whole. Factors that may affect the identification of an appropriate benchmark include the following: • The elements of the financial statements (for example, assets, liabilities, equity, revenue, expenses); • Whether there are items on which the attention of the users of the particular entity’s financial statements tends to be focused (for example, for the purpose of evaluating financial performance users may tend to focus on profit, revenue or net assets); • The nature of the entity, where the entity is at in its life cycle, and the industry and economic environment in which the entity operates; • The entity’s ownership structure and the way it is financed (for example, if an entity is financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity’s earnings); and • The relative volatility of the benchmark. Determining a percentage to be applied to a chosen benchmark involves the exercise of professional judgment. There is a relationship between the percentage and the chosen benchmark, such that a percentage applied to profit before tax from continuing operations will normally be higher than a percentage applied to total revenue. In case if ABC Limited is engaged in manufacture and sale of air conditioner, and is having regular profits: CA B, the auditor may consider profit before tax /Earnings. In case ABC Limited is engaged in the construction of large infrastructure projects and incurred losses in the previous two financial years, due to pandemic: CA B, the auditor may consider Revenue or Gross Profit as benchmarking. Alternatively, CA B, the auditor may consider the criteria relevant for audit of the entities doing public utility programs/ projects, Total cost or net cost (expenses less revenues or expenditure less receipts) may be appropriate benchmarks for that particular program/project activity. Where an entity has custody of the assets, assets may be an appropriate benchmark.
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There are five components of an internal control framework. They are as follows: • Control Environment; • Risk Assessment; • Information & Communication; • Monitoring; • Control Activities.
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Important Points to be kept in Mind While Drafting Letter of Weakness: As per SA 265, “Communicating Deficiencies in Internal Control to Those Charged with Governance and Management”, the auditor shall include in the written communication of significant deficiencies in internal control: (i) A description of the deficiencies and an explanation of their potential effects; and (ii) Sufficient information to enable those charged with governance and management to understand the context of the communication. In other words, the auditor should communicate material weaknesses to the management or the audit committee, if any, on a timely basis. This communication should be, preferably, in writing through a letter of weakness or management letter. Important points with regard to such a letter are as follows- (1) The letter lists down the area of weaknesses in the system and offers suggestions for improvement. (2) It should clearly indicate that it discusses only weaknesses which have come to the attention of the auditor as a result of his audit and that his examination has not been designed to determine the adequacy of internal control for management. (3) This letter serves as a valuable reference document for management for the purpose of revising the system and insisting on its strict implementation. (4) The letter may also serve to minimize legal liability in the event of a major defalcation or other loss resulting from a weakness in internal control.
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Refer Para 6.1.3 MATERIALITY, RISK ASSESSMENT AND INTERNAL CONTROL 4.67
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Basic Accounting Control Objectives: The basic accounting control objectives which are sought to be achieved by any accounting control system are - (i) Whether all transactions are recorded; (ii) Whether recorded transactions are real; (iii) Whether all recorded transactions are properly valued; (iv) Whether all transactions are recorded timely; (v) Whether all transactions are properly posted; (vi) Whether all transactions are properly classified and disclosed; (vii) Whether all transactions are properly summarized.
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Basic system of Control: Internal Checks and Internal Audit are important constituents of Accounting Controls. Internal check system implies organization of the overall system of book-keeping and arrangement of Staff duties in such a way that no one person can carry through a transaction and record every aspect thereof. In the given case of New Life Hospital, the person-in-charge of inventory inflow and outflow from the store house is also responsible for purchases and maintaining inventory records. Thus, one of the basic system of control i.e. internal check which includes segregation of duties or maker and checker has been violated where transaction processing are allocated to different persons in such a manner that no one person can carry through the completion of a transaction from start to finish or the work of one person is made complimentary to the work of another person. The general condition pertaining to the internal check system may be summarized as under- (i) No single person should have complete control over any important aspect of the business operation. Every employee’s action should come under the review of another person. (ii) Staff duties should be rotated from time to time so that members do not perform the same function for a considerable length of time. (iii) Every member of the staff should be encouraged to go on leave at least once a year. (iv) Persons having physical custody of assets must not be permitted to have access to the books of accounts. (v) There should exist an accounting control in respect of each class of assets, in addition, there should be periodical inspection so as to establish their physical condition. (vi) Mechanical devices should be used, wherever practicable, to prevent loss or misappropriation of cash. (vii) Budgetary control should be exercised and wide deviations observed should be reconciled. (viii) For inventory taking, at the close of the year, trading activities should, if possible be suspended, and it should be done by staff belonging to several sections of the organization. (ix) The financial and administrative powers should be distributed very judiciously among different officers and the manner in which those are actually exercised should be reviewed periodically. (x) Procedures should be laid down for periodical verification and testing of different sections of accounting records to ensure that they are accurate.
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According to SA-200, “Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Standards on Auditing”, the Audit Risk is a risk that Auditor will issue an inappropriate opinion while Financial Statements are materially misstated. Audit Risk has two components: Risk of material Misstatement and Detection Risk. The relationship can be defined as follows. Audit Risk = Risk of Material Misstatement X Detection Risk Risk of Material Misstatement: - Risk of Material Misstatement is anticipated risk that a material Misstatement may exist in Financial Statement before start of the Audit. It has two components Inherent risk and Control risk. The relationship can be defined as Risk of Material Misstatement = Inherent risk X control risk Inherent risk: It is a susceptibility of an assertion about account balance; class of transaction, disclosure towards misstatements which may be either individually or collectively with other Misstatement becomes material before considering any related internal control which is 40% in the given case. Control risk: It is a risk that there may be chances of material Misstatement even if there is a control applied by the management and it has prevented defalcation to 75%. MATERIALITY, RISK ASSESSMENT AND INTERNAL CONTROL Hence, control risk is 25% (100%-75%) Risk of Material Misstatement: Inherent risk X Control risk i.e., 40% X 25 % = 10% Chances of Material Misstatement are reduced to 10% by the internal control applied by management. Detection risk: It is a risk that a material misstatement remained undetected even if all audit procedures applied, Detection Risk is 100-60=40% In the given case, overall Audit Risk can be reduced up to 4% as follows: Audit Risk: Risk of Material Misstatement X Detection Risk = 10X 40% = 4%
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Control System over Selling and Collection of Tickets: In order to achieve proper internal control over the sale of tickets and its collection by the Y Co. Ltd., following system should be adopted - (i) Printing of tickets: Serially numbered pre-printed tickets should be used and designed in such a way that any type of ticket used cannot be duplicated by others in order to avoid forgery. Serial numbers should not be repeated during a reasonable period, say a month or year depending on the turnover. The separate series of the serial should be used for such denomination. (ii) Ticket sales: The sale of tickets should take place from the Central ticket office at each of the 5 centres, preferably through machines. There should be proper control over the keys of the machines. (iii) Daily cash reconciliation: Cash collection at each office and machine should be reconciled with the number of tickets sold. Serial number of tickets for each entertainment activity/denomination will facilitate the reconciliation. (iv) Daily banking: Each day’s collection should be deposited in the bank on the next working day of the bank. Till that time, the cash should be in the custody of properly authorized person preferably in joint custody for which the daily cash in hand report should be signed by the authorized persons. (v) Entrance ticket: Entrance tickets should be cancelled at the entrance gate when the public enters the centre. (vi) Advance booking: If advance booking of facility is made available, the system should ensure that all advance booked tickets are paid for. (vii) Discounts and free pass: The discount policy of the Y Co. Ltd. should be such that the concessional rates, say, for group booking should be properly authorized and signed forms for such authorization should be preserved. (viii) Surprise checks: Internal audit system should carry out periodic surprise checks for cash counts, daily banking, reconciliation and stock of unsold tickets etc.
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Communication and enforcement of integrity and ethical values: Refer Para 4.1.
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The general condition pertaining to the internal check system may be summarized as under: refer para 4.5. In the given scenario, Company has not done proper division of work as: (i) the receipts of cash should not be handled by the official handling sales ledger and (ii) delivery challans should be verified by an authorised official other than the officer handling despatch of goods.
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As per SA 450, “Evaluation of Misstatements Identified during the Audit”, the auditor is required to reassess materiality, in accordance with SA 320, “Materiality in Planning and Performing an Audit”, before evaluating the impact of uncorrected misstatements. This reassessment is crucial to confirm the ongoing appropriateness of materiality in light of the entity's actual financial results. The determination of materiality under SA 320 often relies on estimates of the entity's financial results, given that the actual results may not be known during the early stages of the audit. Therefore, before the auditor proceeds to assess the effect of uncorrected misstatements, it becomes necessary to adjust the materiality calculated under SA 320 based on the now available actual financial results. SA 320 outlines that, as the audit progresses, materiality may be revised for the financial statements as a whole or for specific classes of transactions, account balances, or disclosures. This revision is prompted by the auditor's awareness of information that would have led to a different initial determination. Typically, significant revisions occur before the evaluation of uncorrected misstatements. However, if the reassessment of materiality under SA 320 results in a lower amount, the auditor must reconsider performance materiality and the appropriateness of the audit procedures' nature, timing, and extent. This is crucial for obtaining sufficient and appropriate audit evidence on which to base the audit opinion. MATERIALITY, RISK ASSESSMENT AND INTERNAL CONTROL In the present case involving MINI Builders Private Limited, it has been identified that the materiality calculated at the beginning of the audit for revenue was based on estimates provided by the management. The management extrapolated sales for the full year using the actual amount of 11 months, but since the company experiences significant monthly variations in sales, the actual sales for the last month were only 30% of the estimated figure. This discrepancy arose due to an unexpected slowdown in project completion. In this audit scenario, Mr. Gautam, the auditor, must review and reassess the materiality initially determined under SA 320 to ensure its continued validity in light of the actual financial results. If the re-assessed materiality is lower than the previously calculated amount, Mr. Gautam must reconsider performance materiality and the appropriateness of the nature, timing, and extent of further audit procedures. This meticulous approach is essential to gather sufficient and appropriate audit evidence, enabling Mr. Gautam to form an independent and objective opinion on the financial statements of MINI Builders Private Limited.
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As per SA 320, “Materiality in Planning and Performing an Audit”, when establishing the overall audit strategy, the auditor shall determine materiality for the financial statement as a whole. If, in the specific circumstances of the entity, there is one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than the 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, the auditor shall also determine the materiality level or levels to be applied to those particular classes of transactions, account balances or disclosures. The auditor shall revise materiality for the financial statements as a whole (and, if applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures) 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. If the auditor concludes a lower materiality for the same, he shall determine whether it is necessary to revise performance materiality and whether the nature, timing and extent of the further audit procedures remain appropriate. In the given case, Deepti & Co., as an auditor has applied the concept of materiality for the financial statements as a whole. But they want to re-evaluate the materiality concept on the basis of additional information of import of machinery for production of new product which draws attention to a particular aspect of the company’s business. Thus, Deepti & Co. can re-evaluate the materiality concepts after considering the necessity of such revision.
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(a) Internal Check System: The general condition pertaining to the internal check system may be summarized as under: (i) no single person should have complete control over any important aspect of the business operation. Every employee’s action should come under the review of another person. (ii) Staff duties should be rotated from time to time so that members do not perform the same function for a considerable length of time. (iii) Every member of the staff should be encouraged to go on leave at least once a year. (iv) Persons having physical custody of assets must not be permitted to have access to the books of accounts. (v) There should exist an accounting control in respect of each class of assets, in addition, there should be periodical inspection so as to establish their physical condition. (vi) Mechanical devices should be used, wherever practicable, to prevent loss or misappropriation of cash. (vii) Budgetary control should be exercised, and wide deviations observed should be reconciled. (viii) For inventory taking, at the close of the year, trading activities should, if possible be suspended, and it should be done by staff belonging to several sections of the organization. (ix) The financial and administrative powers should be distributed very judiciously among different officers and the manner in which those are actually exercised should be reviewed periodically. (x) Procedures should be laid down for periodical verification and testing of different sections of accounting records to ensure that they are accurate. MATERIALITY, RISK ASSESSMENT AND INTERNAL CONTROL (b) Yes, in the given situation general conditions pertaining to the internal check system are violated as follows: (1) The head of procurement, Mr. Amit, having complete control over the procurement process without oversight violates the principle that no single person should control any important aspect of the business operation. (2) The lack of staff rotation for over five years violates the principle that staff duties should be rotated periodically to prevent any single person from performing the same function for too long. (3) Allowing Mr. Gupta, the store manager, to maintain inventory records while also having custody of the inventory violates the principle that those with physical custody of assets should not have access to accounting records.