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Audit Risk and Key Audit Matters During Assessment of Financial Statement

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

Executive summary

This report reveals the key audit matters and substantial test which could be taken into consideration by the auditors while auditing the financial statement of company. Inventory is the one of the most key audit matter which needs to be assessed to evaluate the true value of the stock turnover in the books of account of company. The plants and machinery is accompanied with the high value therefore, it is considered as the most lucrative assets to investors. Auditors should use valuation assertion test to evaluate whether these assets are shown at their right value or not. 

Introduction 

This report reflects the key details on the audit risk and key audit matters which are identified by the auditors while assessing the financial statement of company. In the starting of this report section, we have undertaken the two key assertion at risk which are focusing on assessing the inventory value recorded in the advanced computer solution company. After that, assessment of the substantive audit test have been taken into consideration. In the end of this report, key audit matter and valuation of the plants and machinery is being done. 

Answer to question no- 1(a) 

The two key assertions at risk relating to the inventory of Advanced Computer Solutions Limited for the financial statements audited for the year ending on 30th June 2018 are:

With the changes in time, there are several material misstatement risks that revolved around the inventory and other assets. By using the right method of the assertion test, these inventory risks are identified. Ideally, in multinational organization while auditing these risk, mostly two key assertion test are followed to identify the risk associated with the valuation of the risk named valuation of inventory assertions test and existence assertion test. 

  1. Completeness: this key assertion exerted by management states that while computing the value of inventory on the date reported by financial statements, every item that is compulsory to be included to arrive at the actual value has been included. 

This assertion seems to be at risk because of the trends that have been seen in the inventory movement in the current year. The inventory is seen moving to six regional warehouses in March 2018 that have been constructed newly. Also there were returns from the side of customers that have risen significantly. High risk revolves that these items have not been included in the inventory value for the audited financial year (Knechel, & Salterio, 2016). 

  1. Valuation:  this key assertion states that the management has valued the inventory items in correct manner and the same denotes the value of inventory as at balance sheet date. This assertion test is used to identify the right value of the inventory based on their existing internal and external factors. However, there are several risks which are associated with the wrong valuation of the inventory recorded in the books of account of company.

The valuation is at risk because of the observations made comparatively for the financial year 2017 and 2018. The inventory turnover has been less than the previous financial year as well as high customer return is also there in 2018. These two things signify that higher inventory should have been in stock. Further to satisfy the order related to a new government tender in mid July 2018, there is a need to stock more inventories. Even when these conditions are persistent, the rise in the inventory value for financial year 2018 seems less than what it should have in comparison to financial year 2017 (AICPA, 2018). 

The main reason behind this concept is that all the central warehouse is moved to new 6 warehouse and audited in the financial year. It is found that inventory while transferring to new warehouse got absconded and resulted to high loss to organization. In addition to this it also reflects the increased number of items which got returned from the clients. 

 It shows that these items and inventory perhaps not reached to the warehouse but got taken away in the process or absconded. 

Answer to question no- 1 (b)

Ideally substantive audit procedure is used to perform and implement the audit risk model to reduce the risk associated with the identified inventory risk model. 

The substantive audit procedures that can be designed in response to the risks identified above and which can help in obtaining a sufficient and appropriate audit evidence are mentioned as follows:

  1. Physical count: the inventory items that are present both in the central warehouse and the regional warehouses must be checked to get a physical count of them. Even when the physical count of stock is already done by the organisation, a sample count shall again be conducted. This shall help in identifying the methodology adopted by organisation for the physical count as well as the accuracy of the same. Further, the physical count of the inventory items that base high in value than the rest should be conducted with more care and diligence (Chan, & Vasarhelyi, 2018). This assertion test is accompanied with the audit procedure which is accompanied with the manual testing in which inventory assessment test is done. It not only check the inventory invoices but also assess the supply or movement of inventory from one place to another. 
  2. Document search: the invoices related to the inventory items sold, the bills related to the purchased inventory, warehouse sending and receiving receipts, consumer return receipts should all be checked for a sample time period. This shall help in reconciling the inventory items both for their completeness as well as value. The rate at which inventory items are purchased shall help in gathering evidence for whether the inventory items have been valued at lower of realisable value (net) or their actual cost of purchase (Brasel, Doxey, Grenier, & Reffett, 2016). 

Answer to question no- 1 (c)

With the ramified changes in the accounting standards, there have been several changes in the audit procedure and audit methods. It is analysed that ASA 701 is used to communicate the key audit matters which are found in the financial statement of the organization in the audit report of company. This requires each and every auditor of the company to audit the financial statement off company and communicate the audit disclaimers found by auditors with the stakeholders.  This is done to done with a view to strengthen the transparency in the financial statement and communicate true and fair view of the assets and liabilities recorded in the books of account to shareholders. It will not only give better insights in the financial statement but also strengthen the trust of the stakeholders towards the formatted financial statement of company. 

The key audit matters are mandatorily required to be mentioned by the auditor when the financial statements include such areas that do require special attention by the auditor while carrying out the audit function. This requirement is laid by ASA 701, communicating the Key Audit Matters in the Auditor’s Report.  These key matters are provided with a view to help the shareholders to understand the financials in a better and more transparent manner. However, for all these key matter, the auditor never gives a separate or distinct opinion.

The main key audit matter in this case study would be inventory. The reason behind choosing inventory as key audit matter is related to its valuation and existence inventory recorded in the books of account. Company may face issue related to over and under valuation of the inventory due to its increased level of movement from warehouse to another. 

The rationale behind anything becoming a key audit matter as per ASA 701 depends upon the professional judgement that the auditor uses while conducting the audit. If anything is so serious that makes it difficult for the auditor to gather appropriate and sufficient evidence in a proper manner, but that at the same time is resolved to a level for sparing it from turning it into a modification, is included in a key audit matter. It is that aspect which requires higher attention of the investors as the auditor himself has attached special attention to the same. However, the report of the auditor doesn’t get modified with the inclusion of the key audit matter paragraph. It is just a part of the audit report and there is no different opinion exist which the auditor wants to give upon the same (Sirois, Bédard, & Bera, 2018). 

IS THE MATTER STATED ABOVE FULFILL RATIONALE OF KEY AUDIT MATTER

The inventory is of significant value at any day in any financial statement. In the given case risks revolves around inventory’s valuation and completeness. Significant time and attention from the auditor’s side is disbursed while inspecting inventory items. Moreover, the trends represented in inventory have made it an area that needs special attention from the investors as well. Hence, the same proves to be a key audit matter.

DISCLOSURES REQUIRED

Key audit matter

The items that have been mentioned in this section are those that have demanded attention more than others. However no modified opinion is stretched upon the same, neither a distinct opinion is. 

Key audit matterThe steps taken to address the risk
Inventory valuation and completeness: Inventory seems to have been arrived at a value without the inclusion of all inventory items as well as without using proper rates. There has been irregular movement of inventory from central warehouse to new regional warehouses. Further, even when the inventory is facing lower turnover and high returns from customers, lower stocks of inventory are observed in the business at the end.
  • Physical count of inventory
  • Checking of bills, invoices, warehouse slips, return slips etc. relating to inventory items.
  • Visiting new warehouses and looking for the details regarding warehouse ownership and stock handling.
  • Re-computing values of sample inventory items to check whether inventory valuation has been made at lower of realisable value (net) or actual cost.


Answer to question no- 2(a)

The key assertions that are at risk for the Green Machine Ltd. for the property, plant and equipment are stated as follows:

  1. Rights and obligations: the assertion states that the assets that have been shown as assets belong to the organisation and the entity has the right to completely use these assets for its purpose (Arens, Elder, & Mark, 2012).

This key assertion seems as risk because the organisation’s financials have been made up including a mistake. The items that must have been counted into the revenue expenditure have been wrongly capitalised by the organisation and have been included in the property, plant and equipment section. Also, some of the items that must have been capitalised have been wrongly expensed and treated as revenue expenditure. Hence, for the items that have been wrongly capitalised are not an asset for the company, on which entity have a right to use. Like this other mistakes could also exist in the financials that penetrate way too deep for identification (Kuzniak,  Rabbani,  Heo,  Ruiz-Menjivar,  & Grable, 2015). 

  1. Valuation: there is a risk that relate to the valuation which is made for the property, plant and equipment asset.

The company has been depreciating assets on a rate lower than the rate which they are required to be depreciated for the type of asset that the entity owns. Moreover, the type of depreciation adopted is also straight line and not written down value method. As per methodology written down value method is more suited because higher depreciation is required to be charged in the initial years of asset installation, whereas lower depreciation is required to be charged in the later life (Warren Jr, Moffitt, & Byrnes, 2015). 

Answer to question no- 2 (b) 

The substantive audit procedures that are required to be performed in order to address and reduce the risk that is related to the above identified risks are (Christensen., Glover. & Wood, D. 2012).

  1. Written document inspection: there is a haphazard that has been created in the entity regarding capitalisation of revenue expenses. In order to analyse what expenses actually count to capital expenditure, the purchase documents that relate to several categories of property, plant and equipment must be checked. If any asset has been taken on finance lease, the documents pertaining to that should also be acquired and checked. Only this way the nature of expense shall be derived. This shall also help in understanding about the asset ownership, and the value at which the same has been acquired. Computations could be made upon the acquired value to gather the current value of the asset (AICPA, 2017). 


  1. Physical property verification: the valuation can only be verified when the physical condition of the property, plant or equipment is checked. The premises or the working areas of the organisation must be paid a surprise visit. This shall help in getting an idea about the assets that are actually available and the condition in which they are operated by the organisation. This overall analysis shall enable the auditor to analyse whether the valuation is done correctly or just to maintain good books hypothetical values are placed (Cannon, & Bedard, 2016). 

Answer to question no- 2(c)

The key audit matters are mandatorily required to be mentioned by the auditor when the financial statements include such areas that do require special attention by the auditor while carrying out the audit function. This requirement is laid by ASA 701, communicating the Key Audit Matters in the Auditor’s Report.  These key matters are provided with a view to help the shareholders to understand the financials in a better and more transparent manner. However, for all these key matter, the auditor never gives a separate or distinct opinion (Elder, Beasley, & Arens, 2011).

The rationale behind anything becoming a key audit matter as per ASA 701 depends upon the professional judgement that the auditor uses while conducting the audit. If anything is so serious that makes it difficult for the auditor to gather appropriate and sufficient evidence in a proper manner, but that at the same time is resolved to a level for sparing it from turning it into a modification, is included in a key audit matter. It is that aspect which requires higher attention of the investors as the auditor himself has attached special attention to the same. However, the report of the auditor doesn’t get modified with the inclusion of the key audit matter paragraph. It is just a part of the audit report and there is no different opinion exist which the auditor wants to give upon the same (Lennox, Schmidt, & Thompson, 2018). 

IS THE MATTER STATED ABOVE FULFILL RATIONALE OF KEY AUDIT MATTER

Property, plant and equipment formulate the solid foundation for any strong balance sheet. The chances of misstatements being penetrated are highest in this area. Especially in the given case several questions regarding capitalisation and depreciation rates are hovering. This has certainly a great requirement of special work and attention by the auditor. Hence the same is a key audit matter that deserves reflection in the audit report (Elliott, 2015).

DISCLOSURES REQUIRED

Key audit matter

There are several audit matters and undertaken disclaimers which states the misstatements and valuation methods needs to be implemented by the organization to strengthen the transparency of the recorded assets and liabilities in the books of account. The items that have been mentioned in this section are those that have demanded attention more than others. However no modified opinion is stretched upon the same, neither a distinct opinion is (Elliott, 2018).

Key audit matterThe steps taken to address the risk
Property, plant & equipment ownership and valuation: the assets have found to be wrongly expensed as well wrongly capitalised. Lower depreciation rates have been observed that questions the ability of the assets to be still in working condition..
Inspecting documents relating to asset purchase and ownership.
Checking the agreements entered to lease the assets.
Visiting the client to observe the physical working condition of the assets. 
Making computation regarding the current carrying value by using the acquired price, accumulated depreciation and other adjustments. 
Looking at the profit and loss account to verify the amount of depreciation charged and the capital expenses that have been treated as revenue expenditures.


Recommendation/ Conclusion

  • Company should consider inventory as its key audit matter as the value of the inventory consistently changes due to the internal and internal factors. 
  • The value of the inventory recorded in the financial statement shows the closing value. 
  • The plants and machinery value should be evaluated by using the valuation assertion test.
  • High risk of assets being overvalued needs to observe by auditors as it gives proper evaluation of the true and fair of the recorded assets in the books of account. There is a risk that the assets might have turned out-dated.

Now in the end, after assessing all the details and audit procedure, it could be inferred that auditors stands in the fiduciary position to the shareholders and he needs to work in the best interest of them. He needs to assess whether the shown financial data of company in its books of account are showing the transparent points or not. 

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