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Importance of Materiality Concept: Case Study of Dexus Real Estate Assessment 2 Answer

CQUniversity Australia School of Business & Law ACCT20075 – Auditing and Ethics Assessment Task 2 - Term 2, 2020

The object of this assignment is to assist students to develop critical analysis skills in relation to materiality used for the audit, analytical review, audit procedures and forming an opinion. This is a written assessment with a weighting of 30%. A marking rubric has been provided to assist you with the marking scheme for this assessment task. The written assessment is to be presented in report format, the report is due on Friday 2nd October 2020 at 5.00pm AEST (Week 11).

Assume you are part of the audit engagement team for your allocated listed company. The most recent annual report is the draft annual report for your company. Please check the list on Moodle and look up your Student ID to determine your company code. You are required to answer the following questions in this context. This must be your own work and if questioned you should be able to explain your answers without your assignment in front of you. Please read the plagiarism and academic misconduct section at the top of the Moodle page. You should also click on the link for Plagiarism Awareness and watch the video. If I consider any assignment is not the student’s work I will refer you for academic misconduct, therefore it is important that you read and listen to the plagiarism information provided to understand what is and is not acceptable behaviour. Please ensure you include citations and a reference list as appropriate.

Click on the company code you have been allocated. You should use the group annual report.

ailable. For example, in this screenshot of Westpac you can see on the right hand side, there is a pdf document available for 2019 Westpac Group Annual Report. (this is an example only, do not use WBC for your report).

Westpac Group Annual Report

There are three sections to this assignment. Each section is worth 10 marks. Each section includes a component for communication skills. Communication with clients is an imperative necessity for auditors and excellent writing skills are expected from professional accountants, therefore please write your answers carefully and clearly. You will lose marks for poor presentation, spelling mistakes or grammatical errors.

Section 1.

  • Determine the level of materiality to be used for the audit of the group accounts for the year ending in 2019. Your answer should include a discussion of the nature of materiality, and a description of what materiality represents in terms of the audit of a set of financial statements, and should discuss the different bases and considerations employed in arriving at materiality. Explain the rationale behind your choice of a certain level of materiality. Provide a quantitative estimate of materiality for your company.
  • Review the various draft notes and disclosures accompanying the draft annual report. Highlight those that may have significance to the audit, eg. Contingencies, and outline the audit procedures that you will need to perform.

Section 2.

  • The partner has requested you to prepare a preliminary analytical review on the information provided by your company. The partner suggests that as a minimum you address key balance sheet and profit and loss horizontal analysis, vertical analysis and ratios over the period 2016 to 2019. Based on these results and the nature of your company’s business and its markets, outline the apparent trends and changes in these ratios, the key risk areas for the audit and the matters that will have to be addressed in the audit plan. Give examples of relevant assertions and at least one audit procedure for each assertion

Section 3.

  • Review the statement of cash flows. Which category of cash flows provided the majority of cash inflows? Which category had the greatest outflows? Identify the primary cash receipts and cash payments during the year. What were the main non-cash financial and investing activities? Using the results of your review of the cash flows, analytical review and other public information, evaluate the going concern risk of this company. What audit procedures would you recommend to address this risk.
  • Review the audit report of the 2019 financial report. State what type of opinion was expressed?Are there any additional sections or paragraphs indicating any audit issues? What key audit matters have been addressed and how? Describe the nature of these issues in detail.

Answer

Introduction:

The primary responsibility of an auditor while conducting an audit of a company is to express an opinion that financial statements of a company do not carry any misstatements which are material in nature. The materiality concept plays a vital role while deciding the area of the audit. The materiality level is decided during the planning of the audit, depending on the size and business of the entity. Material misstatements take place in an organization because of error or fraud. It is the auditor’s responsibility to apply extensive audit procedures to identify the evidence and mitigate the risk of misstatements to its minimum. The auditor should determine the audit areas, where extensive procedures are to be carried to lower the risk of material misstatement. 

This assignment is based on a case study of Dexus Real Estate, which is a Real estate investment company, investing only in Australia and owns $16.5 billion of properties and office. This assignment will give an overview of the audit matter, audit procedures, and material risk that was involved while conducting the audit of the company.

Section: 1

Concept of materiality:

Materiality is a concept which has both quantitative and qualitative impact on the financial statements of a company. There is no specific definition for this concept. While conducting the review, the auditor is required to express an opinion, that financial statements as a whole do not carry any misstatements which are material in nature, i.e. before conducting an audit auditor must determine the level of materiality to be applied in performing the audit of financial statements.

ASA-320, materiality in planning and performing an audit, sets out the ground rules, for the applicability of the material concept in the audit of financial statements. The level of materiality depends on the size and business of the entity and the industry in which it is carrying out operations. Millions of users put reliance on financial statements, hence, the factors that primarily affect the users should be considered as a base for setting materiality level (Iwanowicz, & Iwanowicz, 2019)

ASA-320 defines a series of benchmarks which can be used as a base of setting materiality level:

  • Adjusted Profit before tax
  • Net income
  • Gross profit
  • Equity
  • Total net assets

The materiality base which is to be considered is a matter of approach depending on the nature and business of the entity. A start-up company that has little revenue might use net assets as a base for setting materiality level. Other entities might use, profit before tax as a base for materiality. The entities, whose net assets are more than their net income, use net assets as a materiality level for the users of financial statements. (DexusReal Estate annual report,  2019).

In the company, Dexus Real Estate the base for materiality will be based on profit before tax from Funds from operations, as it is the key performance measure for the year ending in 2019. The materiality amount is $33.9 million, which is approximate 5% of the adjusted profit before tax from funds from operations. The materiality is also determined for qualitative factors like climate change, remuneration of employees, reiteration rate of employees.

Audit procedures to be carried out based on disclosures in the audit report:

It is the auditor’s responsibility to apply appropriate audit procedures while conducting the audit of financial statement. Audit procedures are dependent on the level of risk of misstatement which are material in nature. If in an entity the risk of misstatement is high, the auditor will have to apply extensive substantive audit procedures. While preparing the audit report, auditors mention the notes to accounts and disclosures that affect represent the material misstatement (Sun, 2019)

Some audit procedures that can be laid down for Dexus based on audit report are:

Investment properties: Investment properties are a key audit matter defined by auditors in the financial statements of Dexus. The following are the audit procedures that can be used for investment properties:

  • Capitalization of investment property which is under construction. Properties that are under construction are recognized at cost, and there is certain acquisition cost which become part of the initial cost of the property.
  • The cost of borrowing adopted for properties under construction are to be analyzed.  Borrowing costs are added to the cost of investment if it constitutes a substantial part of the investment. Analyzes of rate of borrowing cost are to be tested. 

Section: 2

Primarily analytical review of financial statements:

Horizontal review of the balance sheet from FY 2016 to FY 2019.

Particulars
2019 ($m)
2018 ($m)
Change ($m)
Change (%)
Investment properties
8,170
8242.6
72.6
0.88%


Particulars
2017 ($m)
2016 ($m)
Change ($m)
Change (%)
Investment properties
7,169.1
6419.5
749.6
11.68%

Horizontal review of profit and loss statement from FY 2016 to FY 2019

Particulars
2019($m)
2018 ($m)
Change ($m)
Change (%)
Property revenue
547.4
577.2
(29.8)
-5.16%
Development revenue
96.9
133.1
(36.2)
-27.20%


Particulars
2017($m)
2016($m)
Change ($m)
Change (%)
Property revenue
540.6
554.9
(14.3)
-2.58%
Development revenue
224.3
204.7
19.6
9.57%

Vertical review of the balance sheet for FY 2016 to 2019

Particulars
2019 ($m)
Change (%)
2018 ($m)
Change (%)
Non-current assets




Investment properties
8,170
54.49%
8,242.6
65.02%
Investment accounted for using the equity method
6,823.7
45.51%
4,432.9
34.98%
Total
14,993.7
100%
12,675.5
100%


Particulars
2017 ($m)
Change (%)
2016 ($m)
Change (%)
Non-current assets




Investment properties
7,169.1
65.22%
6,419.5
64.58%
Investment accounted for using the equity method
3,823.8
34.78%
3,520.2
35.5%
Total
10,992.9
100%
9,939.7
100%

Vertical review of profit and loss statement for FY 2016 to 2019

Particulars
2019 ($m)
Change (%)
2018 ($m)
Change (%)
Revenue from ordinary activities




Property revenue
547.4
84.96%
577.2
81.26%
Development revenue
96.9
15.04%
133.1
18.74%
Total
644.3
100%
710.3
100%


Particulars
2017 ($m)
Change (%)
2016 ($m)
Change (%)
Revenue from operating activities




Property revenue
540.6
70.68%
554.9
73.05%
Development revenue
224.3
29.32%
204.7
26.95%
Total
764.9
100%
759.6
100%

Analyzes of accounting ratios

Particulars
2019
2018
2017
2016
Current ratio
0.653
0.295
0.706
1.254
ROE
6.25%
5.85%


The overall analysis of financial statements of Dexus, on the basis of key balance sheet and profit and loss items, reflects that the Non-current assets i.e. investment properties show a decrease over the years. The company is earning major revenue from its operations of receipt of rent, and the same is showing a decreasing trend.

The current ratio of the company in FY 2019 is better than FY 2018 and FY 2016, i.e. for every liability of $1, the company has assets of $0.653. There is an increase in return on equity also, and over the years the company is able to maintain a Return on equity of around 14% (Abel, & Panageas, 2020)

Kay audit matters to be taken into consideration regarding the above study are:

Investment properties: at the end of FY 2019 Company holds investment properties of $8,170 million. The key issue here is to determine the capitalization rate and discounting rate. This issue can be addressed by looking at market trends in which the company is investing.

Other audit issues that can be addressed are market volatility. The market in which the company works is highly volatile so proper provision and strategies are required to be formulated (Kitiwong, & Sarapaivanich, 2020)

Section: 3

Review of cash flow statement and audit procedure for Risk of going concern:

The cash flow statement is a statement that gives an overview of the inflow and outflow of cash in an organization. The Cash and cash equivalents of an Organization help to determine the financial viability of an entity. It consists of revenue from operating activities, investing activities, and financing activities (Paolone, 2020)

Analyzes of cash flow statement of Dexus in a table:

Particulars
Analyzes
Majority of cash inflows
The majority of cash inflows are from Financing activities, i.e. proceeds from borrowings.
Majority of cash outflows
Majority of outflow of cash is  from financing activities, i.e. repayment of borrowings.
Primary cash receipts
Primary cash receipts in Dexus consist of revenue from operating activities i.e. revenue from the property. However, there has been a decrease in revenue earned in FY 2019 when compared to FY 2018.
Primary cash payment
Primary cash payment is for the payment in the course of regular operations i.e. property expenses and salaries, and payment of finance cost, i.e. interest expenses incurred by the entity on its borrowings.
Non-cash investing activities
Non-cash investing activities are activities that are non-cash in nature, but they are indirectly affecting the cash flow statement of an entity. Major non-cash investing activity in Dexus is the Disinvestment of plant and machinery for the issuance of equity and debt instruments.
Non-cash financing activities
Non-cash financing activities are a part of the cash flow statement, though they don't affect the cash flow statement directly as they are non-cash in nature. Major non-cash financing activities in Dexus is the fair value hedge adjustments and foreign exchange rate.

Analyzes of going concern risk:

Going concern is one of the accounting principles, to be followed while preparing the financial statements of an entity. It is one of the most important and basic accounting principles, it assumes that the company will be carrying out its operations for this and next coming fiscal years. The company is mitigating the risk of going concern by following the concept of going concern for group entity while maximizing the profit for shareholders of the company by maintaining a balance between equity and debt of the company. Going concern concept is applied to entire financial statements, except investment properties, inventory as they are reported at fair value (Hsu, & Lee, 2020).

Review of audit report, audit issues, and key audit matters:

In the opinion of auditors (PWC), the financial statements of Dexus give a fair and true view of the financial position of the company and they have been prepared using the Australian Accounting Standards. 

The key audit matters that are highlighted by PWC in their audit report are:

  • Investment properties: Investment properties are recognized at fair value. The hardship is to decide the capitalization rate and discount rate. Auditor has identified investment properties as a key audit matter, because of its importance and volume to the group financials. The auditors addressed the key audit matter, by analyzing the market where the industry invests, by studying commonly applied valuation approaches.
  • Inventory: The valuation of inventory is carried out at lower of net-realizable value or cost. This is considered as a key audit issue because it requires judgment to determine the value of investment properties. Auditors have addressed the issue, by carrying out sample testing of inventory.

Conclusion:

This assignment gave an understanding of the material mistakes attached to the auditing of financial statements. Financial statements of an entity should give a fair and true view of the financial viability of the entity. It is important to draft an audit plan and decide the audit procedures before commencing the audit. A minimal percentage of material misstatement is decided, and as and when the audit continues, the required modification should be done to audit procedures and materiality concept. The auditor should be able to identify the key audit areas of a company and should prepare audit procedures to address those key audit matters. In addition, assurance should be taken from management that financial statements are prepared using Australian accounting standards and are free from material misstatement.

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