Background and Purpose of Audit Report
Question:
Discuss about the Corporate Accounting and Finance System.
With the increased regulation by ACCA on the companies and the introduction of IFRS, the audit of companies financials have gained special importance and with the signed audit report, nothing can be taken on records and verified. There has been an increased regulation at the Stock exchange where the listing requirements also ask for the signed audit report. Besides this, audit report is also required in case of sanctioning of the loan or filing of the annual reports or paying corporate taxes. The purpose of audit is to give reasonable assurance to the users of the financial statements, both internal and external like employees, customers, banks, shareholders, financial institutions, government, taxation authorities, creditors, etc. Audit is an independent examination of the books of accounts of an entity, whether profit making or not, public or private with the view to express an opinion on the viability of the financial statements being prepared and to comment whether it has been prepared on an unbiased basis. While starting the audit, the auditor needs to know the ins and outs of the business in which the company deals in, the business environment and the industry, the external and internal macroeconomic and microeconomic factors to give a proper view on the financials. They also test the estimates and judgements being taken by the management to see whether the same is appropriate or not. They need to spot the risk areas where there is a chance of material misstatement and hence point out the same to the management. They also check the basic assumptions of accounting like materiality, consistency and whether the entity is a going concern (Sonu, Ahn & Choi 2017).
For giving effect to all this, they may take help of the substantive and analytical audit procedures. Substantive audit procedures is done via inspection of the books of accounts, ledger scrutiny, etc. and observation of the key activities being done in the company. They also take the external confirmation from the parties like banks and the financial institutions, creditors and debtors on the year-end balances, etc. and in some case make inquiry from the external parties like vendors and customers. Besides this, they also do re-performance and recalculation of certain critical numbers like earning per share, taxes, etc. to check the arithmetical accuracy. Further, besides this, reporting of the assets and liabilities is also seen whether they are recorded completely and without any errors. In addition, the related party disclosures and other crucial information, which needs to be disclosed, are checked.
Substantive and Analytical Audit Procedures
Once the auditor is done with substantive procedures, he applies the analytical procedures to determine the nature of the audit processes to be applied, the time to be taken for each activity and the extent to which the materiality level should be set and checked. He checks the level of internal control being maintained at the entity. If it is strong, the risks would be low and hence the checking required would be less. Similarly, if the internal control is weak, the risks would be more and it certainly calls for more audit corrective procedures and vigilant checking. Analytical audit procedures generally include analysis of key financial ratios, trend analysis over the period, comparison with the industry data and comparison of actual with budgeted figures to arrive at the variance analysis (Raiborn, Butler & Martin 2016).
Double Ink Printers Limited is the client and Stewart and Kathy would be conducting the audit in the given case study. The new auditors are taking over from the old ones, Jay and Associates because of which all the handover needs to be taken and opening balances needs to be verified. As per the case study, DIPL has undergone many changes in the last financial year including changes in the accounting policies, change in the top management, the new IT system being adopted, a huge loan being taken. In the light of above-mentioned financial and non-financialdata, it becomes inevitable for the new auditors to do a detailed checking of the books. Below is the ratio analysis of the entity for the last 3 years, which shows some of the trends (Knechel & Salterio 2016).
- Here the current ratio as well as the liquid ratio has just about reached near the industry standard of two&one respectively. However, it is still to achieve in the future. In addition, since as per the loan agreement with BDO Finance Ltd., current ratio was to be at least 1.5, which the company was just about reached in 2015.
- The Debt equity ratio here has increased from 0.4:1 to 1.13:1 over the period of 3 years, which is still below the industry standards of 2:1, but as per the loan agreement, the ratio was required to be within one, which has been crossed in 2015 financial year.
- Asset management ratios show a drastic fall in both the receivables cycle and the inventory turnover cycle as both of them increased by around 50%, which shows that the company has not been able to maintain effectivity over the business cycle and the control procedures have not been as was required.
- All the three ratios calculated here are evident of the fact that the ratios have been stagnant in the last 3 years near to 6% and has neither increased or decreased even after taking benefit of increased loan in the capital structure(Jones 2017).
Risk identification and mitigation is an important aspect of auditing. It is important that while conducting the audit, the auditor must apply proper judgement and professional scepticism to make sure that all kinds of risk is properly identified and the auditor must take care to inform the man agent for the same. The management must also ascertain that proper internal control measures are there, so that all kinds of risk elements are properly eliminated. There are three types of risk, inherent risks that occurs when things are not there in hands of the management, even if proper internal control is maintained. Control risks occur when the management has not maintained proper internal control measures that expose the entity to certain kind of risk. In addition, the detection risk, occurs when the auditor fails to detect certain risks and errors (Grenier 2017).
Risk Identification and Mitigation
In the given case of DIPL, there are two types of inherent risk. The first risk is associated with the adoption of non-routine matter that is deviation from the general procedures that are followed by the company. The CEO of the company wants to adopt new methods of valuation of inventory and calculation of total depreciation. The life of the asset as per the rules of the industry must be taken as 30 years, but the company wants to adopt the total life as 20 years. Thus, we see that the management is deviating from the routine matters, which might leads to risk of material misstatement. It may lead to undervaluation or overvaluation of the assets in the financial statements. It is thus important that before undertaking such steps, proper research must be conducted by the company. It is important that the auditor must check all the records, and in case new measures are adopted, the auditor must give proper disclosure in the books of the account. The second case of inherent risk that is associated with the company is in the adoption of new IT system, and the company adopts the same without conducting any kind of research by the management. This is case where we see that the management has taken a decision without taking any expert advice and that might lead to overvaluation or undervaluation of the new system. It may lead to risk of material misstatement and that may affect the overall profit of the company. The management should make changes only when it is hindered percent sure about its validity and then implent the same. The results after implementation must also be monitored so that any case of misevaluation may be ascertained. This in these areas there are no proper control by the management and thus leads to inherent risk on part of the company (Fay & Negangard 2017).
Fraud occurs when the management of the company or the employees indulges in certain activity that might cause the profitability of the company to defalcate. There may be personal motives involved of the management that might cause such fraud activities. It is important for the auditor to apply all kind of substantive and analytical methods to make sure that the books of the company are able to portray the true state of affairs and there are no errors or fraud. Identification of fraud risk factor is the work of the management of the company and the auditor can help in mitigation of the same. While conducting the audit, the auditor must apply such methods that help in identification of major fraud risk factors. Often the management might be the culprit, the auditor should not rely on what the management portrays and should apply his own research techniques before reaching a conclusion
Fraud Risk Factors
In case of DIPL, there are two areas where there is probability of fraud. First in case of DIPL, there is no proper segregation of duties between the employees of the company. No proper authority is established and that may give the employees an opportunity to conduct fraud. Like in case of the accounts receivable department, a single clerk has been given the right to manage the accounts, verify the payment, decide the overall pricing and reconcile the accounts in the end. In addition, single clerk handles the cash department and there is no proper control that is maintained by the management. Thus, we see that in any case if the employees defalcate with the accounts it will become very difficult for the management. Thus, the auditor must see that while conducting his audit such errors must be identified. In the second case, we see that the management is installing a new system without proper verification in a lot of haste. There are high chances that there was certain personal motives involved of the management while taking such decision (DeZoort & Harrison 2016). It is also possible that this might lead to under or over valuation of the inventory and that might affect the profitability of the company. Before undertaking any new installation, it is important that proper reconciliation of the total cost and the probable result be done. Expert opinion of the outsiders must be taken in case of the same. Thus, it is important that the auditor must see that proper records must be checked in relation to the new system. It is important in case the management is not helping the auditor and not providing the proper records, then the auditor must check the records and can modify the audit report. The auditor must check that the management is providing proper disclosures in relation to the new system. In these few ways, the auditor can help I identification and mitigation of the overall fraud risk factors that might be associated with the company. It is the duty of the auditor and the management to make sure that suppose visits and timely checking of the accounts are done to keep a check on the sincerity of the employees. In addition, the management must establish proper controls. All these will help in mitigation of the major farud risk factors in the company and support the auditor in conducting hsi audit properly. (Bae 2017).
References
Bae, SH 2017, ‘The Association Between Corporate Tax Avoidance And Audit Efforts: Evidence From Korea’, Journal of Applied Business Research, vol 33, no. 1, pp. 153-172.
DeZoort, FT & Harrison, PD 2016, ‘Understanding Auditors sense of Responsibility for detecting fraud within organization’, Journal of Business Ethics, pp. 1-18.
Fay, R & Negangard, EM 2017, ‘Manual journal entry testing : Data analytics and the risk of fraud’, Journal of Accounting Education, vol 38, pp. 37-49.
Grenier, J 2017, ‘Encouraging Professional Skepticism in the Industry Specialization Era’, Journal of Business Ethics, vol 142, no. 2, pp. 241-256.
Jones, P 2017, Statistical Sampling and Risk Analysis in Auditing, Routledge, NY.
Knechel, WB & Salterio, SE 2016, Auditing:Assurance and Risk, 4th edn, Routledge, New York.
Raiborn, C, Butler, JB & Martin, K 2016, ‘The internal audit function: A prerequisite for Good Governance’, Journal of Corporate Accounting and Finance, vol 28, no. 2, pp. 10-21.
Sonu, CH, Ahn, H & Choi, A 2017, ‘Audit fee pressure and audit risk: evidence from the financial crisis of 2008’, Asia-Pacific Journal of Accounting & Economics , vol 24, no. 1-2, pp. 127-144.
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