Audit materiality, sampling and a disputed cut-off population
You are the engagement partner on the statutory audit of a Bulgarian wholesaler, Veliko Trade AD, for the year ended 31 December 2025. Total assets are BGN 42m, revenue BGN 96m, profit before tax BGN 3.2m. You set overall materiality at BGN 160,000 (5% of PBT) and performance materiality at 75%, i.e. BGN 120,000. The audit team tested 60 invoices out of a population of 4,200 sales invoices using monetary unit sampling and found three overstatements totalling BGN 41,000 in the sample. Separately, the client has recorded BGN 900,000 of revenue on 30 December 2025 for goods shipped on 4 January 2026, with a side letter allowing return until 31 March 2026. The client's controller says the side letter is 'commercially normal' and refuses to adjust. The audit manager proposes to sign off because the sampling exception rate is below 5% and the cut-off item is 'only one contract'.
1. Assess whether the sampling results and the cut-off item are material, showing the projection and the qualitative factors.
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Sampling projection. MUS projects the misstatement found in the sample to the population. With a sample of 60 from 4,200 invoices, the sampling interval is population value / sample size. If the tested value is proportionate, projected misstatement is roughly the sample misstatement scaled by the ratio of population to sample value. Using the invoice count ratio, 41,000 x (4,200 / 60) = BGN 2,870,000 projected, which is far above materiality. Even a conservative projection based on the value tested (if the 60 invoices represent, say, BGN 1.4m of the BGN 96m population) gives 41,000 x (96 / 1.4) = BGN 2.8m. Either way, the exception rate of 3 in 60 (5%) cannot be dismissed as 'below 5%': the monetary effect is what matters, and the upper misstatement limit must be computed. The manager's reasoning conflates exception frequency with monetary materiality.
Cut-off item. BGN 900,000 of revenue is 28% of PBT and 0.94% of revenue; it exceeds overall materiality by more than five times. Substantively, goods shipped 4 January 2026 with a right of return until 31 March 2026 fail the IFRS 15 criteria for transfer of control at 31 December 2025; revenue must be reversed and a refund liability recognised. The side letter is not 'commercially normal' boilerplate; it is evidence that control had not passed.
Qualitative factors reinforce materiality: the item affects the trend in revenue and profit, may affect covenant compliance, and indicates possible management bias or fraud risk in cut-off. The combined effect (2.87m projected + 0.9m) is pervasive.
Conclusion: the manager's sign-off is indefensible. The audit opinion cannot be unmodified without adjustment; a qualified or adverse opinion and communication with those charged with governance are required.
2. Design the additional procedures and describe the effect on the audit report if management refuses to adjust.
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Additional procedures:
- Extend cut-off testing around 31 December 2025: examine shipping documents, delivery notes, customer acceptance and incoterms for the last two weeks of December and first two weeks of January.
- Obtain and read all side letters, return agreements and credit notes issued after year-end; inquire of sales staff and legal counsel.
- Re-perform the MUS evaluation: compute the upper misstatement limit using the appropriate Poisson/binomial factors, and consider whether the three exceptions share a root cause (e.g. a single sales clerk or a system override).
- Investigate whether the 4,200-invoice population is complete, including credit notes and cancellations.
- Assess the reliability of the client's revenue system and whether journal entries around year-end were manually posted.
- Recalculate the refund liability and the related inventory reversal for the 900,000 contract.
Effect on the report. If management refuses to adjust a misstatement that is material but not pervasive, issue a qualified opinion ('except for'). If the combined effect, including the projected sampling misstatement, is pervasive to the financial statements as a whole, issue an adverse opinion. Either way, include a basis for opinion section describing the matter quantitatively. Because the matter concerns revenue recognition and possible management override, also report to those charged with governance under ISA 260 and consider the implications for fraud risk under ISA 240, including whether the matter should be communicated to the audit committee and whether the engagement should continue.