Projected misstatement in inventory when the client says it is only sampling
Falak Foods Limited manufactures packaged snacks and has a 30 June year end. Inventory is the largest balance: Rs 260 million against total assets of Rs 900 million. Profit before tax is Rs 180 million. The audit partner set overall materiality at Rs 9 million and performance materiality at Rs 6.3 million. The team tested all 25 items in the high-value stratum (book value Rs 140 million) and found a Rs 7 million overstatement caused by a standard cost not updated after a packaging redesign. The remaining population is 600 items with book value Rs 120 million. A sample of 60 items with book value Rs 24 million was tested; audit value was Rs 21 million. The finance director says the Rs 3 million difference is only sampling and refuses to adjust anything because the inventory will be sold anyway.
1. Compute the projected misstatement and evaluate it against materiality and performance materiality.
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Sample misstatement rate = 3,000,000 / 24,000,000 = 12.5%. Projected misstatement for the untested population = 12.5% x 120,000,000 = Rs 15,000,000. The Rs 7 million found in the 100%-tested stratum is factual; no projection is needed there. Total expected misstatement = 7 + 15 = Rs 22,000,000.
Materiality is Rs 9 million and performance materiality Rs 6.3 million. Rs 22 million is 244% of materiality. Even the factual Rs 7 million alone exceeds performance materiality and is 78% of overall materiality, so the balance cannot be accepted without further work.
One caveat on the projection: it assumes the 12.5% rate applies across the remaining population. That assumption is reasonable only if the stale standard cost affects products broadly. Because the cause is a packaging redesign, it probably does affect many items, so the projection is more likely to understate than overstate the problem. The auditor should state the sampling risk and the method used, and should not present Rs 22 million as a precise number but as the best estimate of misstatement.
2. Is the finance director right that the Rs 3 million is only sampling and need not be adjusted?
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No, and the argument conflates two different things. The Rs 3 million is an observed misstatement in items that were actually tested; it is not an estimate. The Rs 15 million is the projection. Management cannot refuse to correct errors that were actually found simply because the balance will be sold; inventory is carried at the lower of cost and net realisable value, so an overstatement is an overstatement whether or not a sale follows.
The auditor should ask management to correct the Rs 7 million factual error and to investigate whether the stale standard cost affects other products. Because the cause is systematic, the 12.5% rate is plausible and possibly conservative. The projection is used to evaluate whether the financial statements as a whole are materially misstated; it is not automatically a demand for a Rs 22 million adjustment. But management refusing any adjustment at all is not acceptable.
If management refuses, the auditor accumulates the uncorrected misstatements, considers qualitative factors such as covenants and bonus-linked profit targets, and evaluates whether the remaining misstatement is material. The refusal itself must be documented and communicated to those charged with governance.
3. What audit response follows, and what opinion would you consider if the misstatement remains uncorrected?
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Extend testing rather than closing the file. Stratify by product line and test all items using the redesigned packaging, or test the full remaining population if it is cost-effective. Recalculate net realisable value for slow-moving lines, because a cost error may be masking an NRV problem. Consider whether the stale standard cost indicates control override or a deliberate attempt to protect profit, and communicate with those charged with governance.
If, after adjustment of the known amounts, uncorrected misstatement still exceeds Rs 9 million, modify the opinion. A qualified 'except for' opinion is appropriate if inventory is material but not pervasive; an adverse opinion if the misstatement is pervasive to the financial statements. Document the projection method, sampling risk and the rationale for the conclusion.
Also consider the effect on key audit matters and on any covenants. A Rs 22 million overstatement against Rs 180 million profit before tax is 12%, enough to change a user's view of performance, so materiality should not be assessed on the balance sheet size alone.