Auditing & Ethics: Materiality, Analytical Review, Cash Flow Analysis

This article covers the topics of materiality, analytical review, and cash flow analysis in auditing and ethics. It includes a case study of Beach Energy Limited and its financial statements. The article discusses the determination of materiality level, performance materiality, and related party transactions. It also includes an analytical review of the company's ratios and a cash flow analysis. The subject is Auditing & Ethics, and the course code is not mentioned. The college/university is not mentioned.

Auditing & Ethics
Auditing & Ethics
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Table of Contents
Brief:......................................................................................................................................................3
Materiality:............................................................................................................................................3
Analytical Review:..................................................................................................................................4
Cash Flow Analysis:................................................................................................................................6
Opinion:.................................................................................................................................................7
References:............................................................................................................................................8
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Brief:
Beach Energy Limited is engaged in the business of exploration and production of oil and
gases in country Australia. It is the main supplier of the oil and gases in Australian gas
market. Its main objective is to ensure the sustainable growth in the shareholders value. It has
extracted the oil and gases from five producing basins located not only in Australia but also
in New Zealand.
Materiality:
International Standard on Auditing 320 (ISA 320) deals with the ‘Materiality in Planning and
Performing an Audit’. It refers to the application of the concept of materiality by the auditor
in the planning and performing an audit of financial statements. In conducting an audit of
financial statementresponsibility of an auditor is to express an opinion on the true and fair
view of the financial statement of an organization and get a reasonable assurance that
financial statements are free from material misstatements.
Audit materiality is totally depend on the auditor’s professional judgment and also depends
on the facts and circumstances of the case. Materiality is the concept in which auditor decides
the material level for performing the audit and to decides the nature, timing and extend of the
audit procedure to be carried out. (Anon, n.d.)
According to ISA 320, the materiality level may vary from case to case because .user
expectation from industry to another industry may differ. There are some benchmarks for the
determination of materiality in an audit of the financial statements of an entity. Some of such
benchmarks may be as under:
a) Profit after tax
b) Income and expenses incurred
c) Gross profit earned
d) Equity
e) Net Assets of the organization
In the present case, the company operates in the oil and gas industry. Users of the financial
statement of the company would be most concerned with profit of the company. As such, as
an auditor we would select the benchmark ‘profit after tax’ to determine the materiality.
Quantitative detail of the materiality level is decided as under:
Particulars 2017 ($ Million) 2016 ($ Million)
Revenue 649.3 558.0
Net profit after tax 387.5 (588.8)
Other Expenses 70.1 (692.1)
Materiality level: (as under)
1% of revenue 6.50 5.58
30% of other expenses 21.03 -
As we noticed from the annual report that there was major changes in the net profit after tax
from the year 2016 to year 2017. Reason for such changes in profit was due to changes in
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other expenses. The revenue was also increased but percentage of increased in profit since
last year was more than the percentage of increase in the other expenses since last year.
As such, sound increase in the net profit after tax in comparison to the previous financial
year, lead us to conclude that a more appropriate basis of materiality for this year would be 1
percent of total revenue.
Other expense has majorly impacted the both year’s profit. It also gives a led to decide the
materiality level for checking the variation in such expenses.We would cover the 30 percent
of other expenses during the performance of an audit.
In the present case, the quantitative estimate of materiality will be as under:
i) 1% of total sales revenue i.e. $ 6.50m
ii) 30% of other expenses i.e. $ 21.03m
iii) 3% of gross profit i.e. $ 5.57m
In addition to determination of overall materiality, ISA 320 also dealt with the determination
of performance materiality. Performance materiality refers to the level of amount below the
overall materiality to ensure that the cumulative effect of undetected misstatements would not
exceed the overall materiality.
In the present case, there is major variation in other expenses. If we have decided the material
level 30 percent but there may be a chance of some misstatements, cumulative effect thereof
can exceeds the decided materiality level.
Reason for the variation in other expenses is reversal of impairment on property, plant and
equipment, petroleum assets etc. Reversal of impairment has a greatest proportion in the
variation of other expenses. As such, we have decided the performance materiality of 55
percent of the overall materiality i.e. 30 percent of total other expenses.
Related Party transaction: This is the risk prone area as transaction between the related parties
may not be at arm length price. In the audit of financial statement of the company we would
determine the materiality level at high as these transactions are more sensitive to minor
changes, which may lead to serious fraud or misstatements in an organization(Anon, n.d.).
We will decide the material level as well as performance level in this regards, which are as
follows:
Materiality level and performance level:
Related Parties Amount paid ($) Material Level ($) Performance Level
($)
DMAW Lawyer 64,742 45,319 30,000
Director fees directly
paid to DMAW
Lawyer
2,50,000 1,25,000 1,25,000
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Analytical Review:
As an auditor, in this section, we proceeds to comparison between the account’s balances and
ensure their reasonableness. We conduct the systematic analysis of the trends and ratios of
the company and ensure its reasonableness as compared to related industry.(Anon, 2017)
We have calculated the ratios of the company which are as follows:
i) Current Ratio: This ratio represents the liquidity of an organization. It represents
the ability of the company to pay off its current liabilities. The ideal ratio is
considered as 2:1. In the present case, current ratio of the company in year 2017 is
4.14, which represents the company’s strength to manage its liabilities.
Analytical Review: The current ratio of the company is continuously increasing
year by year. The current ratio of the company in the year 2014 was 1.59 which
comes to 4.14 in the year 2017. Reason thereof is increase in current assets and
corresponding decrease in the current liabilities. On the hand, the ratio goes
double in the year 2017 as compared to the year 2016 due to major increase in
cash and cash equivalent in the year 2017. It is the better sign for the company.
There is no risk in this ratio but the auditor should not rely on such ratio until he
checked it. The ratio has changed unusually in the year 2017 as compared to the
year 2016. As such, the auditor should proceed to extensive audit procedure.
ii) Quick Ratio: This ratio is also calculated to analyze the liquidity of the company.
In liquidity analysis, we analyze the short term liquidity of the company to ensure
that it will be able to pay off the short term debts. In calculating this ratio
inventories of the company are not taken into consideration because this ratio
ensures the quick assets availability with the company to discharge its short term
liabilities.
In this company, quick ratio of the company in the year 2017 is 3.74 which ensure
the sound position of the company towards its current debts maturing in next
twelve months. As ideal ratio is considered is 1:1. The quick ratio of the company
was greater than 1 since the year 2014. As such, company is sound enough from
the liquidity point of view.
The trend of ratio is good but in the year 2017 liquid assets ratio proportionately
increased as compared to previous years. Reason thereof is the amount of
inventory was no more in the year 2017 and current liability got reduced.
From the audit perspective, there is no such risk in the company as the ratio is
good. But the auditor should take into consideration the review of liquid assets in
its audit procedure because there may be a risk of change in the user decisions.
iii) Debt to Equity Ratio: This ratio refers to the analysis of financial stability of the
company. This ratio describes that how much financing is being done from
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external sources as compared to the investors financing. Each company should try
to keep this ratio as minimum level because if the ratio is high, outside financers
would have more stakes in the company’s assets.
In this company, the debt to equity ratio was slightly increased in the year 2016 to
0.14 from 0.11 in the year 2015. Reason thereof was the decrease in the equity as
compared to decrease in the debt in the financial year 2016. But overall, it can be
said that company has low risk because of less dependency on external financing.
There may be risk of non-recognition of debt according to prevailing accounting
policies. The auditor should review the compliance of policies in recognition of
debt as current and non-current.
iv) Debt to Assets Ratio: This ratio is calculated to analyze the fact that how much
portion of the assets has been financed by the external financiers. In other words,
this ratio ensures the percentage of the assets owned by the creditors etc. Higher
the ratio will be more risky to the company and investor would not be interested in
such company.
In the present case, in the year 2017 the ratio is 0.08 which is minor amount and it
is a good indicator to the company that it has low taken less financing from
creditors etc. The low ratio ensures the investors about the assets of the company
that they have a greatest proportion in the company’s assets. As such, company’s
position is sound enough.
The ratio is good for the company but there may be risk of overvaluation of assets.
As such, auditor should record the valuation of assets in his audit plan and will
should to the same following the compliance of applicable standards.
v) Gross Profit Ratio: This ratio is calculated to ensure the effectiveness of the
operating activities of the company i.e. how effectively it produces the goods and
sale thereof. If the ratio is high it means company’s operations are effective. In
other words, this ratio measures the company’s efficiency in using material and
labour.
In the present case, the company has gross profit ratio of 28.63 in the year 2017.
The ratio is good and shows the company’s operational activities are good. The
ratio was very less in the year 2016 because of reduction in the sales and
corresponding decrease in the gross profit. But in the year 2017, it has recovered
itself and maintained the gross profit margin as it maintained in 2015 and 2014.
There is an unusual trend in the gross profit ratio. There is risk of overstatement of
revenues by the company and understatement of expenses. The audit plan should
cover the review of both the revenue and expenses.
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vi) Net Profit Margin: This ratio is a measure of company’s profitability. It is the
proportion of sales after meeting all the expenses, which is available to
shareholders. It can be considered as basic tool of the company, which will be
useful in case of adverse situations.
In the present company, the ratio in the year 2015 and 2016 was adverse, which
show the companies worst position. In other words, it can be said that there was
nothing available to shareholders. Reason for the same was provision of
impairment on property, plant and equipment etc. But in the year 2017, it has
reported the good profit and ration come up at 59.68. The reason for such
increment in the net profit is the reversal of the impairment on property, plant and
equipment etc.
This ratio shows the increase in the ratio abnormally since previous year. It is a
risk prone area in term of showing the better position of the company. The auditor
needs to extend the audit procedure to verify the calculation of net profit.
From the audit perspective, the trend of the ratios is good and also it is as per industry
averages except the net profit ratio. We have to analyze the reason thereof in detail and have
to pay the more attention in this area with the revised nature, timing and extent of audit
procedure.
Cash Flow Analysis:
For every organization cash flow statement is the integral part of the financial statements.
From the audit perspective it should be thoroughly reviewed to get an understanding about
the movement of the cash in the organization.(Anon, n.d.)
As we have reviewed the cash flow statement of the company and found the company have
more cash inflows from the operating activities. In the operating activities it has received the
cash and cash equivalent from the oil and gas operation, which is its main activity. As far as,
cash outflow is concerned, the operating activities have more cash outflow as the operating
and personal expenses are very high. Also there is an outflow in the investing activities but
which is lower as compared to operating activities.
Primary cash receipts are from the operating activities. And cash payments are major part
from operation and some of the cash payments made for the investing activities. Cash
Payments are also made for financing activities as dividend. A cash receipt is made from the
sale of subsidiary. The company has sold investment into the subsidiary company.
There are many times activities are done but the cash inflow and outflows are not affected. If
the assets is purchased or sale on credit basis then there is no cash flow but the activity is
made. In the same way if any dividend declared but not paid then the same will be out of the
cash flow. Further sometime interest over debt is due but there is no payment in the current
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financial year i.e. interest due but not paid is claimed as expenditure but not affected the cash
flow.
Opinion:
We have reviewed the annual report of the company for the year 2017. Based on which, we
have determined the materiality level for decided benchmarks and analyzed the ratios and
trend thereof. We have to follow the detailed audit procedure in respect of other expenses.
Our opinion will depend on the outcome of the audit procedure that wee we have selected.
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References:
Anon, n.d., Annual Report 2017, available at
http://www.beachenergy.com.au/irm/PDF/6793_0/2017annualreport?
IncludeUnapproved=83324855 [Online] [Assessed on 02/09/2018]
Anon. n.d., Annual Report 2015, available at
http://www.beachenergy.com.au/irm/PDF/4440_0/2015BeachEnergyLtdAnnualReport
[Online] [Assessed on 02/09/2018]
Anon, n.d., Materiality in the Audit of Financial Statements, available at
https://www.icaew.com/international-accounting-and-auditing/audit-planning/materiality-in-
the-audit-of-financial-statements [Online] [Assessed on 02/09/2018]
Anon, n.d., Materiality in Planning and Performing an Audit, available at
https://www.legislation.gov.au/Details/F2016C00029 [Online] [Assessed on 02/09/2018]
IFAC, n.d., Materiality in Planning and Performing an Audit, Available at
http://www.ifac.org/system/files/downloads/a018-2010-iaasb-handbook-isa-320.pdf [Online]
[Assessed on 02/09/2018]
Anon, 2017, Analytical Review, Available at
https://www.accountingtools.com/articles/2017/8/30/analytical-review [Online] [Assessed on
02/09/2018]
Anon, n.d., Net Profit Ratio, Available at
http://www.accountingexplanation.com/net_profit_ratio.htm [Online] [Assessed on
02/09/2018]
Anon, n.d., Key Ratios, Available at https://www.investopedia.com/terms/k/key-ratio.asp
[Online] [Assessed on 02/09/2018]
Anon, n.d., Performance Materiality: What’s all that about?, Available at
https://www.accountingweb.co.uk/practice/general-practice/performance-materiality-whats-
all-that-about[Online] [Assessed on 02/09/2018]
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Anon, n.d., Overall vs. Performance Materiality, Available at
https://www.icas.com/education-and-qualifications/back-to-basics-overall-vs-performance-
materiality-student-blog [Online] [Assessed on 02/09/2018]
James, n.d., Fundamental Analysis: The Cash Flow Statement, Available at
https://www.investopedia.com/university/fundamentalanalysis/fundanalysis8.asp [Online]
[Assessed on 02/09/2018]
KenFaulkenberry, n.d., Cash Flow Statement Analysis: Purpose, Components and Format,
Available at http://www.arborinvestmentplanner.com/cash-flow-statement-analysis-purpose-
components-and-format/ [Online] [Assessed on 02/09/2018]
Anon, n.d., Audit Procedure, Available at https://www.wikiaccounting.com/audit-
procedures-meaning-example-prepare/ [Online] [Assessed on 02/09/2018]
Nicole, 2018, Five Types of Testing Methods Used during Audit Procedures, Available at
https://linfordco.com/blog/audit-procedures-testing/ [Online] [Assessed on 02/09/2018]
Anon, 2016, Materiality & Performance Materiality (ISA 320), Available at
https://www.readyratios.com/news/audit/3198.html[Online] [Assessed on 02/09/2018]
Anon, 2018, Auditor’s or Accountant’s Opinion, Statement, Report, Available at
https://www.business-case-analysis.com/auditors-opinion.html[Online] [Assessed on
02/09/2018]
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