How might materiality impinge on strategy?

This example is of financial statement materiality, that is, what might be material or not in annual accounts. Some figures may not have to be exact for an overall 'true and fair' view to be shown; however, if law requires a disclosure, for example of directors' remuneration, then the figures must be exact.

The balance sheet and income statement extracts below show only the pertinent figures.

The balance sheet (Table 5.1) has capital employed or net book worth of 200 (all figures are in millions). A significant asset class is inventory. The company is profitable with an operating profit of over 10 per cent of sales.

On finalization of the accounts and the audit, the physical stock records tested by stock counts indicate that existing stock may be only 36, that is, some 10 per cent less than the book amount, which comes from a sophisticated automated stock recording system (Table 5.2). The directors believe that the book value is correct. If the directors go ahead and publish the accounts, is the difference of 4 material?

What might auditors' views be? Auditors are not stock takers but do have to attend stock takes where inventory is material, which is the case here. Stock is 10 per cent or nearer 11 per cent overstated if the 36 is indeed the correct figure.

Auditors and the company would want to recount stock, maybe ensuring that testing covered a larger sample, if not all the stock. The sophisticated automated recording system should be reviewed.

If the reason for the discrepancy cannot be identified and the directors are adamant that 40 is correct, then from an overall perspective the 4 is not material - profits of 202 would fall to 198 and net book worth to 196.

TABLE 5.1 Balance sheet and P&L account

Balance sheet and P&L account

TABLE 5.2 Balance sheet and P&L account showing revised inventories amount

Balance sheet and P&L account showing revised inventories amount

However, this discrepancy should be tracked down and the directors reminded that if at the next quarterly or half-yearly reporting a 4 hit has to be made, this may not reflect well on their stewardship of the company and its assets.

The figures hovering around the 200 were deliberately chosen to make the point: there may be great pressure on the CEO and board to hit a target - the 200-plus target in both cases. What is material is very subjective, and auditors have to be very skeptical.

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