Background
All auditors have certain obligations, which could be observed in investigating and analysing the financial statements of the organisations so that it could be ensured that they do not contain material misstatements because of frauds and errors. The stakeholders associated with the organisations utilise the audit reports in order to check honesty and fairness in the financial statements of the organisations (Bepari and Mollik 2015). Various auditing assertions are used in relation to inventory, property, plant and equipment and others that include valuation, cut off, accuracy, occurrence, completeness and existence (Chambers and Odar 2015). The current report would emphasise on the assertions used for the provided organisations from the viewpoint of the auditor so that key audit matters could be ascertained.
Based on the provided scenario, some issues are evident in inventory valuation of Advanced Computer Solutions Limited, which could have unfavourable impact on the decision-making process of the stakeholders. Thus, it is necessary to conduct appropriate inventory valuation and for the concerned organisation, the key assertions at risk include the following:
(a) Two key assertions at risk in relation to inventory:
Valuation/Accuracy:
In order to test this specific assertion, the auditors have experienced two significant audit matters. They include the accuracy of the figures in relation to physical count of inventory and ensure that accurate inventory amount has been included as cost of sales in the income statement from the statement of financial position. Owing to all these reasons, it is necessary to conduct inventory valuation by the auditors. As per the case information, Advanced Computer Solutions Limited has transferred its inventories from the central warehouse to six regional warehouses. Such transfer has the possibility of wrong physical count of inventory and as a result, there could be a downfall in inventory turnover in 2018. Moreover, the organisation has been encountering software problems, which could lead to errors in inventory valuation procedure (Cohen and Simnett 2014). Due to these reasons, the assertion of valuation or accuracy is at risk.
Existence:
The management of an audit client has to assure that inventory values are recorded appropriately in the correct accounting period in order to ensure the existence of all account balances. Therefore, consideration needs to be provided to investigate receiving and shipping documents related to inventory, since it would assist in determining the existence of inventory. As a result, the actual inventory count might not be the same, which might put the assertion of existence at risk. In this case, the organisation has included the past year sales in the current year inventory, which places the existence assertion at risk. Thus, Advanced Computer Solutions Limited has not followed this aspect due to the inclusion of inventory record of 2018 in sales of both 2017 and 2018. This event validates the fact that there are errors in inventory recording in the correct accounting period. Another probable reason behind such inclusion might be the software issue or deliberate misconduct by any staff (Decaux and Sarens 2015). As a result, there is chance of deletion of some inventory-related transactions. Thus, the existence assertion is found to be at risk.
Inventory Valuation
(b) Two substantive audit procedures:
Substantive audit procedure 1:
In order to address the valuation or accuracy risk, the significant audit procedure is the methodical surveillance of all aspects of the physical count of inventory of Advanced Computer Solutions Limited. The initiatives to be undertaken by the auditor might include identifying the strengths and loopholes in internal control associated with inventory, checking the inventory count tags and being in person at the time of physical count of inventory. In addition, it is necessary to examine the inventory count in all the six warehouses. Finally, the management has used certain assumptions and judgements that the auditor needs to test and conformance to the needed standards of accounting (Griffiths 2016).
Substantive audit procedure 2:
In order to carry out existence examination, the substantive audit procedure might include verifying the notes for goods obtained and goods delivered that would aid in identifying the date of reporting. Besides, it is necessary to check whether there has been slow movement of inventory or the management has made some irrational adjustments in the same (Bepari and Mollik 2015). Finally, verification needs to be made by the auditor to identify any stop command while obtaining inventories in the warehouses. This is because all these factors in combination could place the existence assertion at risk.
(c) ASA 701 Communicating Key Audit Matters:
Requirement of ASA 701:
“Section 7 of ASA 701” states that the auditors are obliged to ascertain key audit matters, establishment of the same based on them and they are to be included and disclosed in the audit report (Auasb.gov.au 2019). On the other hand, “Section 8 of ASA 701” reveals the definition of key audit matters, which includes issues significant to the auditors while auditing the financial reports of the organisations and selection is to be made after conversing with the governance committees.
In accordance with “Section 9 of ASA 701”, three particular requirements are to be considered by the auditors so that the key audit matters could be ascertained. These constitute of the areas in the financial reports having the possibility of increased material misstatement risk in compliance with ASA 315, the uncertain judgements and accounting estimates made by the organisation and influence of significant events on audit that happened during the accounting year (Griffiths 2016).
According to “Section 10 of ASA 701”, the auditors have the responsibility of finding out the key audit matters after taking into account the significant issues and their influence on audit (Auasb.gov.au 2019).
Assertions at Risk
Rationale for determination:
- If errors are detected in valuation process of inventory, it could be considered as an important part in the financial reports having increased possibility of material misstatements.
- As errors are evident in inventory valuation, few uncertainties might be inherent in the accounting estimates and judgements made by the management of Advanced Computer Solutions.
- As inventories are transferred from the central warehouse to six regional warehouses, it could be adjudged as a significant event having effect on the inventory count and valuation process.
Disclosures required in the section of key audit matters:
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Why significant? |
How audit addressed the key audit matters? |
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Shift of inventory in March 2018: There could be effect on the physical inventory count procedure due to the recent shift of inventory from a central location to six different locations. Moreover, for inventory valuation, adequate judgements and accounting estimates by the management are made that are deemed to be significant to audit. |
In order to deal with this matter, the audit procedures used include the following: 1. Methodical supervision of all aspects of the procedure related to physical count of inventory 2. Discussion of the strengths and drawbacks of internal control having association with inventory 3. Authentication of the tags used for counting inventory 4. Observation of the work-in-process inventory count 5. Assessment of the assumptions and judgements undertaken by the management and adherence to the necessary accounting guidelines 6. Verification of inventories in six locations |
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Sales of the last year included in the inventory of the current year: As the current year inventory contains a portion of the sales value of both current year and last year, error is bound to take place. Moreover, there could be material impact owing to the engagement of important accounting estimates and judgements of the management. |
In order to deal with this matter, the audit procedures used include the following: 1. Certification of each note for goods obtained and goods delivered in order to identify the reporting date 2. Exploration of whether there has been slow stock movement or presence of irrational adjustments in them 3. Verification of whether any stop command has been issued in obtaining stocks in the warehouses |
After evaluating the provided scenario, issues are inherent in the valuation method of property, plant and equipment of Green Machine Limited along with improper segregation of revenue and capital expenditure, which could lead to overstatement of profit. This leads to the creation of two assertions, which include classification and valuation. Therefore, the following assertions are at risk for the organisation:
(a) Two key assertions at risk in relation to property, plant and equipment:
Classification:
As per the demand of this assertion, the firms have to be committed towards correct classification of transactions in relation to their property, plant and equipment in its general ledger accounts. Thus, it requires the firms to assure that expenses are categorised and recorded appropriately in general ledger accounts, which are associated with property, plant and equipment (Pitt 2014). However, after going through the case information of Green Machine Limited, it has been observed that revenue and capital expenditures are not separated accurately by the organisation. Instead, there has been capitalisation of a portion of revenue expenditures, while a portion of capital expenditures is represented in the form of revenue expenditures in the profit and loss statement. This implies that the general ledger accounts of capital and revenue expenditures are not correct. This creates the chance of material misstatements in the financial reports of the entity and hence, this assertion contains risk.
Valuation:
According to the requirement of this particular assertion, the audit clients are expected to record all their assets, equity and liabilities at cost after subtraction of accumulated depreciation and hence, application of the accurate depreciation rate is made. This is one of the primary requirements for the business entities (Decaux and Sarens 2015). From the provided information of Green Machine Limited, the entity has charged depreciation rate much lower than the actual rate, which might result in wrong valuation of property, plant and equipment. Besides, the use of this rate could minimise the operating expenses of the entity significantly, which would inflate its net income and hence, misstatement could take place in profit. These are the main reasons that this assertion is found to be at risk.
(b) Two substantive audit procedures:
Substantive audit procedure 1:
As a part of the procedure, the auditor of Green Machine Limited is needed to analyse the guidelines and processes of the entity so that capital and revenue expenditures associated with property, plant and equipment could be ascertained. For ensuring the same, the auditor is required to check the general ledger accounts of revenue and capital expenditures for detecting the errors and necessary actions need to be undertaken (Griffiths 2016).
Substantive Audit Procedure 1
Substantive audit procedure 2:
As a part of the procedure, the depreciation policy of the concerned entity needs to be checked by the auditor as well as the accounting estimates and management judgements (Chambers and Odar 2015). After this, the depreciation rate is to be computed again by the auditor by taking into account the residual amounts along with losses or gains from selling a portion of property, plant and equipment. Thus, it is crucial to compare the depreciation rates at this stage (Bepari and Mollik 2015). This would aid the auditor in computing the revised depreciation rate again and accordingly, the correct depreciation expenses could be ascertained.
(c) ASA 701 Communicating Key Audit Matters:
Requirement of ASA 701:
As per “Section 7 of ASA 701”, the objective of an auditor is ascertaining the key audit matters, providing accurate audit opinion and the same needs to published in the form of auditor’s report (Legislation.gov.au 2019). Moreover, the definition of key audit matters mentioned in “Section 8 of ASA 701” cites that these matters are issues deemed to be important for the auditors for auditing the financial statements and they are to be chosen after conversing with the governance group of the concerned entity.
At the same time, “Section 9 of ASA 701” states that there are three requirements for the auditors at the time of ascertaining key audit matters. These include those portions of the financial statements containing greater risk in accordance with ASA 315, accounting estimates and judgements that the audit clients have used doubtfully and the effect of the important issues or transactions on auditing that occurred during the accounting year. Moreover, “Section 10 of ASA 701” requires the auditors in ascertaining the key audit matters after taking into consideration the major events having the potential of impacting audit (Legislation.gov.au 2019).
Rationale for determination:
- The risks related to material misstatements are higher owing to the errors made in separation of revenue and capital expenditures and wrong depreciation calculation.
- The engagement of the significant judgements of the management as well as accounting estimates could be witnessed in the doubtful or uncertain areas.
- There is presence of two significant errors and transactions, which constitute of incorrect segregation of expenditures and use of low rate of depreciation and these events are bound to have effect on the audit of the entity.
Disclosure of key audit matters:
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Why significant? |
How audit addressed the key audit matters? |
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Wrong segregation of capital and revenue expenditures: Incorrect segregation has been made by the organisation for revenue expenditure and capital expenditure, which could have material impact on the financial reports and they include accounting projections and judgements made by the management and this is critical to audit. |
In order to deal with this matter, the audit procedures used include the following: 1. Checking the procedures and guidelines of the entity for ascertaining revenue and capital expenditures in relation to property, plant and equipment 2. Accumulating the list of the above-mentioned asset so that verification could be conducted 3. Assuring confirmation of the fact that adequate compliance has been maintained by the entity with the required accounting policies and guidelines |
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Use of depreciation rate below the actual rate for property, plant and equipment: The entity has used low depreciation rate for valuing its property, plant and equipment and this might lead to material effect on its financial statements. Along with this, the management judgements and accounting projections are deemed to be essential for audit operations. |
In order to deal with this matter, the audit procedures used include the following: 1. Checking the policy of depreciation used by the entity as well as its management reviews and accounting estimates 2. Computing the depreciation rate again after evaluating the residual amount of property, plant and equipment and any loss or gain from sale of such asset |
Conclusion:
After considering all the above-discussed aspects, Advanced Computer Solutions Limited has two key assertions at risk, which are valuation or accuracy and existence, while the major risk assertions for Green Machine Limited comprise of valuation and classification. It has been analysed that the auditors are needed to consider the risk assertions for planning the substantive audit procedures so that the overall risks could be minimised. ASA 701 assists the auditors by providing essential principles and guidelines so that they could ascertain the key audit matters. Adequate discussion has been made regarding the obligations of the auditors for undertaking effective communication with the organisations and accordingly, key audit matters are to be disclosed in the audit report section.
References:
Auasb.gov.au., 2019. [online] Available at: https://www.auasb.gov.au/admin/file/content102/c3/ASA_701_2015.pdf [Accessed 18 Jan. 2019].
Bepari, M.K. and Mollik, A.T., 2015. Effect of audit quality and accounting and finance backgrounds of audit committee members on firms’ compliance with IFRS for goodwill impairment testing. Journal of Applied Accounting Research, 16(2), pp.196-220.
Chambers, A.D. and Odar, M., 2015. A new vision for internal audit. Managerial Auditing Journal, 30(1), pp.34-55.
Cohen, J.R. and Simnett, R., 2014. CSR and assurance services: A research agenda. Auditing: A Journal of Practice & Theory, 34(1), pp.59-74.
Decaux, L. and Sarens, G., 2015. Implementing combined assurance: insights from multiple case studies. Managerial Auditing Journal, 30(1), pp.56-79.
Griffiths, P., 2016. Risk-based auditing. Routledge.
Legislation.gov.au., 2019. ASA 701 – Communicating Key Audit Matters in the Independent Auditor’s Report – December 2015 . [online] Available at: https://www.legislation.gov.au/Details/F2015L02016/Explanatory%20Statement/Text [Accessed 18 Jan. 2019].
Pitt, S.A., 2014. Internal audit quality: Developing a quality assurance and improvement program. John Wiley & Sons.
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