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Assertions at Risk for Advanced Computer Solution Limited

ACC 707 Auditing and Assurance Services Individual Assignment

Question 1

While assessing the risk of material misstatement and determining the appropriate response with regard to the inventory of Advanced Computer Solutions Limited (Advanced Computer Solutions) for the 30 June 2018 audit, you become aware of the following information:

  1. The best-selling computer presentation package has been experiencing a high level of returns owing to suspected software problems
  2. Based on closing inventory, inventory turned over an average of 5.4 times in 2017 and 3.8 times in 2018
  3. Advanced Computer Solutions moved its inventory from a central warehouse to six new regional warehouses in March 2018
  4. Inventory on hand at end of year represented 26 per cent of sales in 2018 and 18 per cent of sales in 2017
  5. Advanced Computer Solutions has recently won a tender to supply a large government department with various products. In order to win the tender and prevent competitors from gaining a foothold in the public sector market, Computing Solutions agreed to supply the items at 10 per cent below their cost price. The first shipment is due to be delivered to the government department in the middle of July 2018.

REQUIRED

  1. Identify and explain the two key assertions at risk in relation to inventory
  2. Identify and describe two substantive audit procedures that you could perform in response to each risk identified above
  3. Explain the requirement of ASA 701 Communicating Key Audit Matters in the Auditor’s Report and the rationale for this auditing standard. Determine if the above matters are key audit matters, providing full rationale for the determination. If it is determined that they are Key Audit Matters, provide the disclosures which are required in Key Audit Matters Section of the Auditor’s report as required under ASA 701.

Question 2

You are the auditor of Green Machine Ltd, a manufacturer. You have obtained a summary of the property, plant and equipment for the year ended 30 June 2018, which identifies cost and accumulated depreciation brought forward, additions and disposals in the year and depreciation charges.

A review of the management letter from the previous year’s audit shows that there were some problems in relation to making a distinction between capital and revenue expenditure; some items were capitalized when they should have been expensed and other capital items were included in repairs and maintenance in the income statement.

Another risk identified from prior years relates to depreciation calculations: there is a range of depreciation rates within categories and there has been concern that the rates applied to some assets have been too low. The depreciation policy disclosed in the financial report shows:

  • Building: 2  4% straight line
  • Plant and machinery: 5  10% straight line
  • Fixtures fittings and equipment: 5  20% straight line

REQUIRED

  1. Identify and explain the two key assertions at risk in relation to property, plant and equipment
  2. Identify and describe two substantive audit procedures that you could perform in response to each risk identified above
  3. Explain the requirement of ASA 701 Communicating Key Audit Matters in the Auditor’s Report and the rationale for this auditing standard. Determine if the above matters are key audit matters, providing full rationale for the determination. If it is determined that they are Key Audit Matters, provide the disclosures which are required in Key Audit Matters Section of the Auditor’s report as required under ASA 701.

Answer

Auditing and Assurance Services 

Two key assertions at risk

Existence  

One of the most important problems that are currently being faced by the Advanced Computer Solution Limited is that the sales return in the last financial year has been very high. The main reason behind this increased sales return is a problem with the software manufactured by the organization. The primary business of this organization is to make software for other business organization and currently, software made by the company are not up to the standards demanded by the clients. This type of problem can have a very significant impact on the overall sales of the company as the primary business of the company would be affected by the Complaints made by clients (Wild, 2017). From an auditors perspective it is important to make sure that all the sales returns are properly recorded by the management in the balance sheet. In addition to that any decrease in value of stock that is returned by the customer should also be evaluated. It is important to value the closing stock at cost or net realisable value. Therefore management auditor should check that if management has identified its resale value as these software were made especially according to needs and requirement of client.   

Valuation risk

This is the risk associated with the incorrect valuation of inventory at the end of financial year. According to AASB 102, inventory should be valued at cost or net realisable value whichever is lower. Companies also considering to undertake the government contract under consideration. This government contract will have a significant negative impact on the financial position of the company and it is important for management to understand the long term impact of this government contract. According to the terms and condition of this contract, all the product and services in relation to this contract will be provided at price lower than 10% of production cost in order to undercut the competition (Johnson, 2014). The strategy to undercut the competition is very effective in a competitive market and it is one of the most essential strategies but it is not financially viable for the company to provide the product and services at a cost lower the cost price. Auditor of the company should make sure that inventory is valued by the management according to the AASB 102. Therefore all the inventories should be valaued at 90% of the purchase price because net realisable value of such inventory in this government contract is 10% lower than its cost price.    

Currently, sales of the company are very lower and the sales return is very high. It means that the revenue of the company is down and the company does not have sufficient operating cash for fulfilling the contract. Overall revenue generated from the government contract would be lower as compared to overall cost, therefore there will be lack of operating cash for a long period of time which can have a negative impact on the existence of the company in future. This can be managed by the company by increasing the contract price of other clients which will definitely reduce the number of clients with the company.

Substantive audit procedures

Existence 

Physical verification 

With the help of these vouchers, the management of the company would be able to identify whether the number of sales return has increased over the last financial year or not. Auditor of the company should also consult management on the reason provided by every client for returning the software manufactured for them. Auditor should ask management to conduct a physical verification of all the software that are returned by the customers in the financial year. 

Management declaration

Auditor of the company can also take a certificate from management of the company to make sure that all the inventories shown in the balance sheet are physically available with the company at the end of financial year. This declaration should be taken along with applying other substantive procedures for physical verification. Auditor should conduct physical verification on sample basis but such sample should include all the warehouses of the company.    

Accuracy 

Observation of company policy 

Auditor should make sure that management of the company is following the policy of valuing their inventory at lower of cost and net realisable value. Auditor of the company should examine the products that will be delivered to the government. This cost sheet can be extracted from the similar products manufactured by the company in past. The auditor will be able to understand whether the price offered by the company is actually 10% load to the overall cost of production or not. Auditor should make sure that all the products that are supplied during this government contract are valaued at 90% of their purchase price in the balance sheet (Knechel & Salterio, 2016).

Management decision 

The auditor should also consult management in relation to the reason for which this contract is being undertaken by the company. In addition to that, there should also be a financial and operational plan prepared by the management for this contract. This plan should include the strategies that will be adopted by the management in order to continue the business in the future after a huge loss on this government contract. 

Key audit matters

The function of auditing is very important for every stakeholder that is involved in the process of audit whether such stakeholder is internal or external. The main purpose of this function is to make sure that the financial position of the company is properly depicted with the help of yearly statements prepared by the management. All the financial transactions recorded by the company in a particular financial year are summarised and presented in a specific format in a financial statement so that stakeholders of the company can understand the financial position from this financial statements. Therefore it can be said that the main purpose of financial statements is to make sure that accurate and relevant information is provided in the financial statement so that decisions can be taken by stakeholders (Sirois, Bédard & Bera, 2018). It can also be said that the function of auditing helps in supporting the main purpose of financial statements as it helps in making sure that all the information is relevant and accurate. 

After the process of audit, it is concluded a report is prepared by the auditor in which auditor presents his or her opinion on the financial statements of a company. Before the amendment in relation to key audit matters, information provided by the auditor with respect to the audit conducted was very limited. Auditors were only required to write whether the financial statements are presenting the true and fair value of the financial position of the company or not. In addition to that, they were also required to mention whether the financial statements are in accordance with applicable rules and regulations. It can be said that the information provided to stakeholders with respect to the process of the audit was very limited and stakeholders are not aware of the different types of problems that might be faced by auditors during the process. This is the reason that ASA 701 Key audit matters was introduced by auditing and assurance standard board of Australia (Cordoş, & Fülöp, 2015). 

ASA 701 Key audit matters were introduced in late 2016 after it was introduced by international accounting standard board. Key audit matters can be defined as the problems or difficulties faced by auditors while conducting the process of audit. It is not possible for the auditor to mention each and every procedure adopted by them in the audit report and this is the reason that required the inclusion of the audit matters in the audit report and annual report. key audit matter can be defined as the matters on which auditor of the company is not able to provide reasonable assurance to two different kinds of reasons such as non-cooperation from management, the complexity of financial statements, unavailability of relevant information etc.

The main objective of these matters is to make sure that users of financial statements are able to understand the process of an audit undertaken by the auditor and consider the problems mentioned by auditor while taking the decisions in relation to their investment in the organization. The inclusion of key audit matters in the audit report will also help in improving the quality of audit undertaken by audit firms as they are now required to conduct an audit in a more detailed manner (Kachelmeier, Schmidt and Valentine, 2017). Inclusion or exclusion of a particular matter in the key audit matter statement is totally dependent on the opinion of the auditor. Key audit matters are totally subjective and it is dependent on skill and knowledge of the auditor. It is also important to communicate the importance of key audit matters to stakeholders of the company. Stakeholders of the company should understand that the financial items or particulars mentioned in the key audit matter paragraph are at probability of higher risk as compared to other matters from the perspective of the auditor.

All the matters that have a significant impact on the financial position of the company or if a particular matter is representing a potential risk, then such matters should be included in the key audit matters statement. After evaluating both of the above audit assertions it can be said that both of this matter should be included in the key audit matter paragraph of the audit report. Increasing sales return required immediate attention on part of management as if it continues for a long period of time then there are chances that there will be no client left with the organization. Quantum of loss on government contract will be very high because it is a large contract and expenditure on contract is done out of pocket by the management. Both of these matters will have a significant long term impact on the company, therefore, they should be included in the key audit matter paragraph. 

Question 2- Green Machine Ltd

Audit assertions

Risk in policy making 

It is important for a business organization to appropriately categorize between capital expenditure and revenue expenditure on fixed assets. This is due to the fact that treatment of this expenditure and profit and loss account and the balance sheet is totally different from each other. The main purpose of the financial statement is to make sure that the financial position and performance of the companies properly depicted. If there is no appropriate categorization between capital expenditure and revenue expenditure then you will definitely have a negative impact on profits recorded in a particular accounting period (Hoskin, Fizzell & Cherry, 2014). It is mentioned in the report that there are some revenue expenditures that were capitalized and some capital expenditure that was mentioned in repair and maintenance expenditure in the profit and loss account. It shows that the actual profitability of the company is not shown in the profit and loss account maintained by the company. This type of working classification is due to the lack of policies and procedures adopted by the company for classification of assets, liabilities, expenses and revenue items. Auditor of the company should check the policies developed by the management for classification of expenditure.   

Accuracy risk in depreciation

It was also identified in the previous years that the rate of depreciation charged on some of the assets was very lower as compared to rules and regulations and common practices of the business organizations working in the same industry. It is mentioned in the given information that the rate of depreciation on the building was 4%, on plant and machinery was 10% and on furniture fittings and equipment was 20%. On the basis of this information, it can be said that depreciation provided on plant and machinery and furniture and fittings is in accordance with the normal practices. On the other hand, depreciation charged on the building is very lower as compared to normal practices of the companies. Generally, the rate of depreciation charged on the building is around 10% that shows the life of the building will be around 10 years and it will require heavy capital investment after 10 years for efficient business operations. 

Substantive audit procedure

Risk in policy making 

Checking core policies and procedures 

First of all auditor of the company should check the procedures and policies that are being adopted by the organization for the classification of capital and revenue expenditure. The auditor should make sure that these policies and procedures are in accordance with the applicable rules and regulations. This substantive procedure will help in identifying the main cause of the error on part of management. This will also help auditor to get the understanding of basic knowledge and skill of management that is preparing the financial statements.  

Chekcing the nature of expenditure 

The auditor should also check the vouchers and bills of capital expenditure and revenue expenditure. Generally, for every purchase of a fixed asset, there is a bill provided by the vendor of the company. Examination of this bill will help in understanding the nature of expenditure undertaken by the organization (Chan & Vasarhelyi, 2018). In addition to that voucher or bill is also provided in case of revenue expenditure conducted as it is general practice for every business organization to record the nature of expenditure in the vouchers prepared by the management. Examination of these bills and vouchers will help in understanding the true nature of expenditure and relevant classification.

Accuracy risk in depreciation

Checking rate of depreciation 

First of all auditor of the company should identify the nature of the building and extract the relevant rate of depreciation from the list provided by the government of Australia on their official website. Link of this website is https://www.depreciationrates.net.au/. Identification of this rate will help in understanding whether the business organization is using an incorrect rate of depreciation to be charged on the building. Examination of this list it can be said that majority of the buildings are depreciated @ 10% and not at 4%.

Checking classification of asset

Auditor of the company should also examine the assumptions that are being taken by the management of the company in deciding the rate of depreciation at 4%. There are chances that the rate of 4% is correct in the opinion of management and it is important for the auditor to understand the reason for such an assumption by the management (Marques, Santos & Santos, 2016). If these assumptions are not reasonable in the opinion of auditors and auditor of the company should include this matter in the key audit matters treatment.

Inclusion in key audit matters

All the matters that have a significant impact on the financial position of the company or if a particular matter is representing a potential risk, then such matters should be included in the key audit matters statement. After evaluating both of the above audit assertions it can be said that both of this matter should be included in the key audit matter paragraph of the audit report. The main objective of a financial statement is to show accurate to the financial position and profitability of the committee and it cannot be achieved if above 2 errors are included in the financial statements. Incorrect classification of revenue and capital expenditure and under-recording of depreciation will result in the inaccurate recording of profits in the financial statements.  

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