Question

One of the audit clients Airtel has presented the income statement below to the audit firm Earnest and Young where you work as an assistant auditor.

Airtel Income Statement for the year ended December 31, 2018                                   ZMK

Revenue                                                                                                                          1,392,000

Cost of goods sold                                                                                                              680,480

Gross profit                                                                                                                         711,520

Distribution Administration expenses                                                                                367,200

Profit from Operation                                                                                                         344,320

Other income

Gain on sale of equipment                                                                                                   56,000

Income before taxes                                                                                                           400,320

Income taxes                                                                                                                      118,400

Net income                                                                                                                         281,920

The audit partner has decided that 5% income before taxes benchmark is appropriate for overall materiality and tolerable misstatement has been estimated to be 60% of overall materiality.

Required

a) Explain what overall materiality is and state some factors that the partner would have considered in deciding the 5 percent benchmark

b) Explain what tolerable misstatement is and state some factors that the partner would have considered in deciding the 60 percent benchmark.

c). Calculate the overall materiality, and tolerable misstatement.

d). During the course of the audit, the auditors discover that the revenue account has an invoice which was misstated by K8,200 explain the action that the auditors will take

e) Further, the auditors discover that in the distribution and Administration expenses account some invoices have been misstated by K17, 500.Explain the action that the auditors will take

f) Taking into account the two errors in (d) and (e) above, state the recommendations and explain the final decision that the auditor will make

Answer 1

(a)

Materiality is the level that is judged by the auditor to represent what is significant to the financial statements as a whole – the point at which it will effect the investment decision of the users of financial statement.

Factors to be considered in determining materiality include the following:

• The effect which misstatements on profitability may cause.

• Misstatements presenting a loss as an income or an income as a loss.
• The potential effect of the misstatement on the company's compliance with loan covenants, other contractual agreements, and regulatory provisions.
• The effect of misstatement on a particular business segment as it's pervasiveness may esffect the financial results of the whole segment.
• Any statutory requirement which may effect the determination of materiality.
• A misstatement that effects management compensation beyond an expected level.
• The sensitivity of the circumstances surrounding the misstatement, for example, the implications of misstatements involving fraud and possible illegal acts, violations of contractual provisions, and conflicts of interest.
• The effect which mis-classification of income or expenses may have.

(b)

A tolerable misstatement is the amount by which a financial statement line item can differ from its true amount and the true and fair view of financial mistatements remain intact.
In determining tolerable misstatement and planning and performing audit procedures, the auditor should take into account the nature, cause, and amount of misstatements accumulated in the audit of financial statements.

(c) Overall materiality = 5% of Income before Tax

= 5% of K 400320

= K 20016

Tolerable misstatement = 60% of overall materiality

= 60% of K 20016

= K 12009.6

(d) The auditor finds out a misstatement of K 8200 which is a tolerance misstatement as it is lesser than K 12009.6.

The auditor shall find out if this misstatement provides the hint that other such misstatements may exist which cumulatively will surpass this limit. If not, auditor is advised to ignore the misstatement of K 8200.

(e) The auditor discovers a misstatement of K 17500 which is more than K 12009.6. The auditor needs to consider this while forming an opinion as it surpasses the tolerance limit. The auditor shall find out other misstatements of such kind and modify his report accordingly.

(f) Considering the two misstatements auditor shall come to a conclusion that the statements does not represent true and fair view of financial statements and shall issue a modified opinion.