Revenue cut-off, inventory count and a refused adjustment
Ravenswood Distribution Ltd has revenue CU 50,000,000, profit before tax CU 2,000,000 and total assets CU 20,000,000. The auditor sets overall materiality at CU 100,000 (5% of profit before tax) and performance materiality at CU 70,000. During the audit, the team identifies three items. First, sales of CU 90,000 with related cost of CU 70,000 were recorded on 30 December 20X5 with FOB destination terms; the customer received the goods on 3 January 20X6. Second, inventory count differences at two warehouses total CU 60,000, of which CU 25,000 relates to a warehouse where the count was observed and CU 35,000 to a warehouse counted by management without audit attendance because of a snowstorm. Third, a customer with a receivable of CU 80,000 is in administration; no allowance has been recorded, although the administrator has indicated a likely recovery of 20%. Management refuses all adjustments, stating that each item is individually below overall materiality.
1. Assess the materiality of the three items individually and in aggregate, including qualitative factors.
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The three items must be assessed individually and cumulatively. The cut-off error reverses revenue of CU 90,000 and cost of CU 70,000, so the profit effect is CU 20,000. The inventory differences reduce profit by CU 60,000. The receivable allowance is 80% × CU 80,000 = CU 64,000. Individually, CU 20,000, CU 60,000 and CU 64,000 are all below overall materiality of CU 100,000 and mostly below performance materiality of CU 70,000. In aggregate, however, the profit impact is CU 144,000, which exceeds overall materiality. Materiality is not a purely arithmetic test. The cut-off error affects revenue recognition and may indicate management bias or fraud risk; the unobserved warehouse creates a risk that the CU 35,000 difference is not representative; and the receivable in administration is a valuation issue with known evidence of impairment. Management's claim that each item is immaterial ignores the aggregate and the qualitative factors. The auditor should accumulate the misstatements and request adjustment.
2. What audit procedures should the auditor perform on the cut-off error, the unobserved inventory and the receivable?
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For cut-off, inspect the sales contract and shipping terms, bills of lading, goods received notes, sales invoices and subsequent credit notes; confirm with the customer whether control transferred in 20X5 or 20X6. If the terms are FOB destination, revenue should normally be reversed and inventory reinstated, with the related cost reversal. For the unobserved warehouse, perform alternative procedures: test roll-forward or roll-back of inventory, agree subsequent sales and purchases, inspect third-party warehouse confirmations, reperform counts at other locations, and use analytical procedures. If sufficient appropriate evidence cannot be obtained, this is a scope limitation. For the receivable, obtain the administrator's correspondence, assess the recovery estimate, calculate the required allowance and consider subsequent cash receipts. The auditor should also evaluate fraud risk, test journal entries around year-end, and consider whether management's refusal is evidence of bias.
3. If management refuses to correct the misstatements, what are the implications for the audit opinion and reporting?
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Under ISA 450, the auditor communicates uncorrected misstatements to those charged with governance and obtains written representations. If the aggregate uncorrected misstatement of CU 144,000 is material but not pervasive, the auditor should issue a qualified opinion because the financial statements are materially misstated. If the misstatement is pervasive, an adverse opinion is required. The unobserved inventory may also create a scope limitation if alternative procedures cannot provide sufficient appropriate evidence; a scope limitation that is material but not pervasive leads to a qualified opinion, while a pervasive limitation leads to a disclaimer. On the facts, the known misstatements are material in aggregate but not obviously pervasive, so a qualified opinion is the likely outcome unless management adjusts or further procedures reduce the misstatement. The auditor should also consider the effect on covenants, communicate the matter to those charged with governance, and ensure the basis for opinion is clearly described.