Materiality, Tolerable Error and Sampling on Receivables
You are planning the audit of Fenwick Trading Ltd for the year ended 30 September. Draft profit before tax is £1.2m and total assets are £9m. You set overall materiality at 5% of profit before tax. The receivables ledger contains 1,850 customer balances totalling £4.6m. One customer, a national retailer, accounts for £1.1m of that total. The remaining balances average £1,900 each. Management has a history of small errors in cut-off around the year end, and last year's audit found a £60,000 overstatement of receivables caused by invoices recorded before goods were despatched. The client's credit controller is on long-term sick leave and a temporary clerk is covering.
1. Calculate overall materiality and performance materiality, justify the basis chosen, and explain how the single large customer affects your sampling approach.
Read the worked answer
Overall materiality. 5% × £1.2m = £60,000. Profit before tax is the appropriate benchmark because Fenwick is a profit-making trading company and users focus on earnings. Total assets (£9m) would give a much higher figure and is less relevant for a trading company.
Performance materiality. Given the history of cut-off errors, the control weakness (inexperienced temporary clerk), and last year's £60,000 misstatement, set performance materiality at, say, 60% of overall materiality = £36,000. This leaves headroom for undetected and uncorrected misstatements.
Effect of the large customer. The £1.1m balance is 24% of receivables and far above materiality. It should be tested individually (100% testing of the balance, confirmation, subsequent receipts, cut-off) and excluded from the sampling population. Sampling is then applied only to the remaining population of £3.5m across 1,849 balances. Because the remaining balances are small and homogeneous, monetary unit sampling or stratified sampling is appropriate. The large balance must not be left to chance selection.
2. Explain how you would design the sample for the remaining receivables, and how you would treat the £60,000 prior-year error in your evaluation.
Read the worked answer
Sample design.
- Population: 1,849 balances totalling £3.5m, after removing the individually significant customer.
- Tolerable misstatement: use performance materiality of £36,000 (or a portion allocated to receivables).
- Expected misstatement: based on last year's error, assume some misstatement; this increases sample size.
- Sampling method: monetary unit sampling gives each pound an equal chance and automatically over-weights larger balances; alternatively stratify by value and use random selection within strata.
- Test: positive confirmation for a sample, plus subsequent receipts testing and cut-off testing around 30 September.
Prior-year error. The £60,000 error was in the prior period and, if uncorrected, affects the opening balance and comparative figures. It is not automatically a current-year misstatement, but it is strong evidence that the cut-off control is ineffective. I would:
- Assess whether the error was corrected in the prior year or carried forward; if carried forward, treat it as a known misstatement in the current year.
- Increase the sample size and extend cut-off testing because the expected error rate is non-zero.
- Evaluate the aggregate of uncorrected misstatements against materiality at completion; even individually immaterial errors can aggregate to a material amount.
- Consider whether the control deficiency requires a report to those charged with governance.