1.(a) Define and explain materiality and performance materiality. (4 marks)
You are an audit supervisor of Daffodil & Co and are planning the audit of Peony Co for the year ending 31 May 20X9.
The company is a food retailer with a large network of stores across the country and four warehouses. The company has been a client of your firm for several years and the forecast profit before tax is $28·9m. The audit manager has attended a planning meeting with the finance director and has provided you with the following notes of the meeting.
Planning meeting notes
Peony Co has an internal audit (IA) department which undertakes controls testing across the network of stores. Each store is visited at least once every 18 months. The audit manager has discussed with the finance director that the
external audit team may rely on the controls testing which is undertaken by IA.
During the meeting, the finance director provided some forecast financial information. Revenue for the year is expected to increase by 3% as compared to 20X8; the gross margin is expected to increase from 56% to 60%; and the operating margin is predicted to decrease from 21% to 18%.
Peony Co values inventory in line with industry practice, which is to use selling price less average profit margin. The directors consider this to be a close approximation to cost.
The company does not undertake a full year-end inventory count and instead undertakes monthly perpetual inventory counts, each of which covers one-twelfth of all lines in stores and the warehouses. As part of the interim audit which was completed in January, an audit junior attended a perpetual inventory count at one of the warehouses and noted that there were a large number of exceptions where the inventory records showed a higher quantity than the physical inventory which was present in the warehouse. When discussing these exceptions with the financial controller, the audit junior was informed that this had been a recurring issue.
During the year, IA performed a review of the non-current assets physically present in around one-third of the company’s stores. A number of assets which had not been fully depreciated were identified as obsolete by this review.
The company launched a significant TV advertising campaign in January 20X9 in order to increase revenue. The directors have indicated that at the year end a current asset of $0·7m will be recognised, as they believe that the advertisements will help to boost future sales in the next 12 months. The last advertisement will be shown on TV in early May 20X9.
Peony Co decided to outsource its payroll function to an external service organisation. This service organisation handles all elements of the payroll cycle and sends monthly reports to Peony Co which detail wages and salaries and statutory obligations. Peony Co maintained its own payroll records until 31 December 20X8, at which point the records were transferred to the service organisation.
Peony Co is planning to expand the company by opening three new stores during July 20X9 and in order to finance this, in March 20X9 the company obtained a $3m bank loan. This is repayable in arrears over five years in quarterly instalments.
In preparation for the expansion, the company is looking to streamline operations in the warehouses and is planning to make approximately 60 employees redundant after the year end. No decision has been made as to when this will be announced, but it is likely to be in May 20X9.