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9706 · 3.2.3

Auditing and Stewardship of Limited Companies — practice questions

Practice and worked examples for 9706 Auditing and Stewardship of Limited Companies. Short previews only — attempt the full question in MarkScheme against the official scheme.

Worked example 1

An auditor for Delta Ltd is finalising the audit. The draft profit before tax is $5,000,000 and total assets are $80,000,000. The auditor's materiality threshold is 5% of profit before tax or 1% of total assets. An uncorrected error is found: a sales invoice of $40,000 was incorrectly omitted from the year's revenue.

Determine if this misstatement is material and explain the implication for the audit report.

Show solution outline

Step 1: Calculate materiality thresholds.

  • Profit-based threshold: 5% of $5,000,000 = $250,000
  • Asset-based threshold: 1% of $80,000,000 = $800,000

Step 2: Compare the misstatement to the thresholds. The misstatement is $40,000. This amount affects both profit (understated revenue) and assets (understated trade receivables).

  • $40,000 is less than the profit threshold of $250,000.
  • $40,000 is less than the asset threshold of $800,000.

Step 3: Conclude on materiality. Quantitatively, the misstatement of $40,000 is not material as it falls below both of the auditor's established thresholds.

Step 4: Explain the implication. Because the misstatement is not material, the auditor will communicate it to management but will not need to issue a qualified audit report if the directors refuse to correct it. The financial statements can still be considered to present a 'true and fair view'. The auditor would issue an unqualified audit report. However, the auditor would also consider if there are many similar small errors that could be material in aggregate.

Worked example 2

The auditor of Kappa plc finds that inventory has been valued at its cost of $900,000, although its net realisable value is only $600,000. The draft profit before tax is $4,000,000 and the auditor's materiality threshold is 5% of profit before tax. The directors refuse to change the valuation. Nothing else is wrong with the financial statements.

Determine whether the misstatement is material and explain the type of audit report the auditor should issue. [6 marks]

Show solution outline

Step 1: Find the misstatement. Inventory should be valued at the lower of cost and net realisable value, so it should be shown at $600,000.

  • Overstatement of inventory and of profit: $900,000 − $600,000 = $300,000

Step 2: Calculate the materiality threshold.

  • 5% of $4,000,000 = $200,000

Step 3: Compare. $300,000 is more than $200,000, so the misstatement is material: it could influence the decisions of someone who relies on the financial statements.

Step 4: Decide on the report. The directors will not correct a material misstatement, so the auditor cannot issue an unqualified (clean) report. The problem is confined to one item and everything else is fairly stated, so the auditor should issue a qualified report: except for the valuation of inventory, the financial statements give a true and fair view.

Step 5: Explain the effect. A qualified report is a warning to shareholders and lenders. It tells them that profit and assets are overstated by $300,000, and it may make it harder for the company to raise finance.

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