explain the concept of materiality, Financial Accounting

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You have recently been promoted to assistant audit manager in SHAUNA & Co, a firm of Chartered Certified Accountants. Your first assignment in this new role is to supervise the audit of KROMATIC LTD for the year ended 30 September 2011 and now have been asked by the Engagement Partner to plan for the audit. 

The Partner does not foresee any problems with this year's audit as it is a client you are familiar with; having been involved on the two previous annual audits, as an audit senior.

Furthermore, KROMATIC LTD, a private company, has been an audit client of your firm for a period of seven years. During the last five years, Shauna & Co has also provided taxation and management consultancy services to this client.

The additional information below is available to aid the audit planning process:

  1. KROMATIC LTD is involved in the production of an assortment of chrome plated bathroom accessories and kitchenware. Two years ago, in the wake of the global economic downturn, the company started taking specialised orders for chrome plating of decorative items and clothing accessories as a means of staying financially afloat.
  2. During July 2011, the company landed a major new client in the Motor vehicle industry. This customer is projected to represent 20% of sales in the following year and a consistent 35% thereafter. In light of this, and on further market research, the company is seeking loan finance from its bank to fund an expansion into a new factory. The expansion should result in an increase in capacity of 30%. The company is confident that they will be able to sell the added output.
  3. The company has a sales ledger of approximately 120 customers, but in terms of value, 75% of the ledger is represented by just 5. Average annual sales revenue over the last three years has been in the region of £30.5 million.
  4. In 2008, KROMATIC LTD suffered substantial bad debt expense when a major customer went bankrupt and they are concerned that the reoccurrence of such an event would cause the company great financial distress. To avoid this happening again, the company outsourced the debt collection function. The trade receivables ageing as at 30 September 2011 is 5.4 months (2010: 2.3 months). Note: customers are allowed three months credit before their debt becomes overdue.
  5. Shortly before the year end, the company received a substantial claim from one of its top five customers for damages made to a priceless decorative piece during the chrome plating process. The claim is for the entire cost of the decorative piece, as the customer feels its beauty has been completely destroyed. IF the claim is successful, KROMATIC LTD may have to declare bankruptcy to meet the claim. The press around the claim is causing reputational problems for the company and this may affect future sales projections. The company has hired a renowned solicitor firm to handle the case, and the solicitors are convinced that the case will be settled at less than a quarter of the current claim.
  6. The Finance Director (FD) of KROMATIC LTD, recently telephoned you and mentioned that the bank are keen to obtain a reference from the audit firm, relating to the company's ability to repay the loan and whether the business plan is reasonable. He added that "they just need their forms filled, for their files. They know we can repay. We are one of their best clients".

Required:

Draft a report to the Engagement Partner, in which you:

1.  Identify the risks the company faces and how these risks increase the likelihood of material misstatement in the company's financial statements for the year ended 30 September 2010. 

2.  Explain the concept of "materiality" and its importance during the auditing process and discuss suggested sampling techniques that would provide a representative sample of sales invoices.

3.  Describe the work you will carry out to satisfy yourself about the debtors figure as well as the legal advice obtained from the solicitors.

4.  With reference to case law, discuss the matters you would consider in providing a reference to the bank as mentioned to you by the Finance Director.


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