Sampling, Materiality, and a Suspicious Journal Entry
During the audit of Meridian Supplies Ltd (revenue $48 million, materiality $720,000), the audit senior selects a sample of 60 journal entries from a population of 4,200 posted by the finance team. Testing finds two entries lacking supporting documentation: a $95,000 debit to 'consulting expense' and a $410,000 transfer between two bank accounts recorded three days after year-end. Neither is individually material. The client's financial controller explains the consulting entry as 'a verbal arrangement with a long-time adviser' and the bank transfer as 'just a timing thing, it nets to zero.' The engagement partner is under budget pressure with 40 hours remaining and suggests documenting the items as immaterial and closing the file. The audit manager disagrees and wants to expand testing.
1. Evaluate the manager's and partner's positions, and determine the appropriate audit response to the two unsupported entries.
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Both entries are individually below materiality but raise fraud-risk indicators that cannot be dismissed. The consulting payment lacks documentation for a verbal arrangement - a classic vehicle for fictitious expenses or related-party payments. The $410,000 post-year-end bank transfer that 'nets to zero' is a red flag for window dressing or a kiting-style scheme; its timing three days after year-end warrants scrutiny of cut-off and cash balances.
The partner's proposal to close the file on materiality grounds is unsafe. Materiality is a quantitative guide, not a shield: qualitative factors (possible fraud, related parties, management override) make small items significant, and ISA 240 requires follow-up on such indicators. The manager's instinct to expand testing is correct.
The response should: obtain the adviser's identity and any contract or invoices; confirm whether the adviser is a related party; trace the bank transfer through both accounts and bank statements to confirm it is genuine and correctly dated; extend journal-entry testing around year-end; and consider whether misstatements are indicative of a wider population issue. Findings must be documented and communicated to those charged with governance if fraud is suspected.
2. If the expanded testing projects a misstatement from the sample, explain how the auditor should evaluate it against materiality.
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The auditor projects the misstatement from the sample to the population, for example by extrapolating the average misstatement per sampled entry across the 4,200 entries, and compares the projected total to materiality of $720,000. Individually immaterial items can aggregate to a material misstatement, and the projection is the relevant figure, not the sum of the two known items.
If the projection approaches or exceeds materiality, the auditor should request correction, expand the sample, or perform alternative procedures. If management refuses to correct a material projected misstatement, the auditor considers a qualified or adverse opinion. Even where the projection is below materiality, the auditor documents the judgement and considers qualitative factors - fraud indicators, related-party involvement, and the effect on the financial report's reliability.
The auditor should also communicate the aggregate uncorrected misstatements to those charged with governance and obtain written representations from management on the completeness of identified misstatements. The 40-hour budget is not a valid reason to truncate procedures; if time is short, the engagement partner should escalate resources, not lower the evidence standard.