Question

Claytonhill Beverages Ltd. is 100-percent owned by Buzz Bottling. While the company has in the past been profitable, it incurred a loss for the year ended December 31, 2020. The parent company, Buzz Bottling, has indicated that if Claytonhill incurs another loss, it will put the subsidiary up for sale. In response, Claytonhill is looking to expand its market share and therefore its profitability by performing private labelling for a nationwide supermarket chain, ValueFoods Inc. Private labelling involves producing and packaging pop and other non-alcoholic beverages under the ValueFoods label. However, in order to proceed with this endeavour, Claytonhill needs a packaging facility dedicated exclusively to co-packing. To finance this expansion, the company has applied to the Better Business Bank for financing.

The bank has indicated that, before it will approve the loan application, it would like to see audited financial statements for 2020. It also wants to ensure the entity has a current ratio of 2:1.

Claytonhill Beverages has provided you, its new auditor, with the draft (unaudited) financial statements in figure 4.10:

Figure 4.10 Unaudited financial statements for Claytonhill Beverages

Income Statement for the Year Ended December 31, 2020 (partial)
Revenue
Sales	$2,057,505
Cost of goods sold	1,445,450
Gross margin	612,055
Less:
General and administration costs (including bonuses of $100,000)	775,899
Net loss before tax	$(163,844)
Balance Sheet as at December 31, 2020
Assets
Current assets
Cash	$  179,825
Accounts receivable, net	64,475
Prepaid expenses	3,004
Inventory	1,507,413
Total current assets	1,754,717
Property, plant and equipment
Land	2,004,933
Building, net	964,224
Office furniture and equipment, net	85,106
Total property, plant and equipment	3,054,263
Total assets	$ 4,808,980
Liabilities
Current liabilities
Accounts payable	$  799,255
Other accrued expenses	44,875
Warranty provision	9,456
Current portion long-term debt	25,000
Total current liabilities	878,586
Long-term liabilities
Bank loans	2,200,000
Total long-term liabilities	2,200,000
Total liabilities	3,078,586
Equity
Common shares	248,000
Retained earnings	1,482,394
Total equity	1,730,394
Liabilities and equity	$ 4,808,980

Calculate the three levels of materiality.

Planning Materiality		$
Performance Materiality		$
Specific Materiality		$

Answer 1

Concept of materilaity - This is needed to rule out all small/trivial mistatements which when accumulated may not impact the decision making of the readers of the financial statements from audit procedures. Further the auditor will design appropriate audit procedures in order to assess the true and fair view of financial statements based on the materiality ranking.

Now there are different types of materiality-

1) Overall materiality (also known as planning materiality) - this is assessed at overall company financials level. The standard bechmark for overall/planning materiliaty is often arrived using "averaging" method. The average refers to

1% of turnover, 2% gross assets and 10% profit before tax

Note - Here in this case since the company is in losses let us avoid taking profit before tax as benchmark.

Now let us compute the Planning materiality - {1%(2,057,505) + 2% (4,808,980 }/2 = $ 58,377

Planning materiality = $ 58,377

2) Performance materiality - Performance materiality further narrows down the scope of audit procedures and analytical procedures and is dependent overall materiality. Hence performance materiality can only be determined post determining the planning materiality. Below is an example for simple understanding -

Let us say the auditor thinks that 75% of the planning materiality shall be the performance materiality -

Peformance materiality = 58,377*0.75 = 43,783

Example - Now the auditor came across 3 invoices worth 30k, 45k, 60k

For the invoice of 30k - this is below both performance and overalll materilaity hence no risk of misstatement - no audit procedure

For the invoice of 45k - this is above performance and below overalll materilaity hence the auditor cannot ignore this and minimum amount of analytical procedures shall be performed.

For the invoice of 60k - this is above performance and above overalll materilaity hence the auditor shall perform full and complete set of audit procedures on this invoice due to its materiality level.

3) Specific Materiality (only applicable for specific classes of account balances or disclosures) -

This materiality is applicable for more "sensitive areas which may look small compared to performance materiality but are significant for readers due to thier nature".

For example say the compaany has related party transactions worth 30K -

If we compare this 30k with benchmarks - this is clearly below performance and overall materiality. However due to the sensitive nature the auditor may set 50% of performance materiliaty as specific materiality.

Specific materiality = 0.50*43,783 = $ 21,892

Since the transactions exceeded the specific materiliaty the auditor may perform the audit procedures accordingly.