Assessing The Risk Of Material Misstatement In Inventory: A Case Study Essay.

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

• The best-selling computer presentation package has been experiencing a high level of returns owing to suspected software problems
• Based on closing inventory, inventory turned over an average of 5.2 times in 2017 and 3.8 times in 2018
• Computing Solutions moved its inventory from a central warehouse to six new regional warehouses in March 2017
• Inventory on hand at end of year represented 22 per cent of sales in 2018 and 18 per cent of sales in 2014
• Computing 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

• Identify and explain the two key assertions at risk in relation to inventory
• Identify and describe two substantive audit procedures that you could perform in response to each risk identified above
• Explain the requirement of ASA 701 Communicating Key Audit Matters in the Auditor’s Report and the rationale for this auditing 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.

2. You are the audit senior with Howard & Associates and have been assigned to the audit of Beautiful Hair Ltd (Beautiful Hair).

In early 2018, Beautiful Hair acquired a small manufacturer of high-quality organic hair-styling

products, Shimmer Pty Ltd (Shimmer). Beautiful Hair’s management had identified that Shimmer’s line of products would fit extremely well with the Beautiful Hair business, and organized funding for the acquisition from Regional Bank.

Shimmer uses special formulas to create its product. Only the owner of Shimmer knows the secret ingredients for the formulas. These secret ingredients are apparently documented and held by Shimmer’s solicitors.

Beautiful Hair’s management has been advised that the intellectual property related to the formulas has the potential to be both a material and valuable asset and has been recognized as an intangible asset arising from the acquisition in accordance with accounting standard AASB 3.

• Identify and explain the two key assertions most at risk in relation to the intellectual property intangible asset
• Identify and describe a substantive audit procedure that you could perform in response to each risk identified above
• Explain the requirement of ASA 701 Communicating Key Audit Matters in the Auditor’s Report and the rationale for this auditing 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.

Background of the Case Study

Audit Assertions are the representations made by the management about the various items and information contained in the financial statements. These representations are about the recognition, measurement and presentation of financial data. They are also known as Management Assertions and Financial Statement Assertions (Alexander, 2016). Depending on the item to which it relates to, these assertions are classified into several categories, namely, occurrence, completeness, accuracy, completeness, existence, valuation, rights and obligation, valuation, and classification. Primarily, the purpose of assertions is to assist the auditor in understanding and resolving a wide range of issues. Assertions related to the balance sheet are divided into four broad categories, namely, completeness, accuracy, valuation and rights and obligation. Valuation: The Accounting standards require inventories to be recognized at an amount which is the lower of the cost or net realizable value. It also requires that any abnormal wastage has not been included in the valuation of the inventory. Valuation will also be complicated when there is work in progress. Since Computing Solutions Limited, sell computer presentation package, the chances of inventories becoming obsolete is very high. In the technology driven industries, merchandise get obsolete and outdated within a short span of time. Therefore, their value gets impaired each year, sometimes, each season too (Bromwich & Scapens, 2016).

Rights & Obligation: This assertion is about the ownership and rights of the entity over the inventory. This assertion can be at risk because Computing Solutions has a practice of moving its inventory from the central warehouse to the regional warehouse, which is six in number. As such, there are possibilities of instances where the goods are in transit or are held on consignment basis. The ownership and rights in these instances have to be clearly understood because of the involvement of outside parties like the insurance company, the transporter and the consignee.

1 b) Substantive Audit procedures Substantive Audit procedures are procedures or steps that the auditor performs to gather audit evidence for a matter. These steps are intended to gather detailed and intensive information on significant matters. Usually, substantive procedures are divided into three subheads. They are test of controls, test of details and analytical review procedures. The nature, timing and extent of these procedures vary in accordance with the strength and weakness of the internal controls operating in those specific area (Chron, 2017).

For valuation risk:   The auditor should obtain a proper list of inventories from the management and reconcile them with the general ledger. Proper application of lower of cost or NRV shall be ensured, for this the auditor may take the help of market data too. The inventory count is important audit evidence. Wherever possible, the auditor should frequently observe the inventory count taking place, at least twice a year. Vouching and testing inventory pricing is another method to obtain audit evidence. Special consideration should be given to the valuation of closing stock as it is usually done at the year end and can be easily inflated or deflated as per the needs of the management. Provisioning requirements for goods in transit or on consignment basis shall also be reviewed (Fay & Negangard, 2017).

Assessing the Risk of Material Misstatement

For rights and obligations:  The question of rights and obligation arises mainly when external third parties are involved. Therefore, to obtain substantive audit evidence, the most desirable thing to do would be to determine the existence of agreements and contracts, and to study those agreements. The auditor should also read the consignment agreement and the terms of the insurance policy. The minutes of the meetings of the Boards may also be reviewed to be informed of any major decision in this regard. 

1 c) According to ASA 701, “key audit matters are matters that require significant auditor attention in performing the audit”. The auditor is required to describe in detail, each of the matters, identified as a key audit matter. These matters are to be described using a separate subheading, under a separate section of the audit report. The disclosure shall expressly state that the key audit matters are determined as per the professional judgment of the auditor. The auditor should also communicate that he has not given a separate opinion on these matters, but in context of the audit report, as a whole (Grenier, 2017). The rationale behind the introduction of this concept is to enhance the quality of the audit report and to increase transparency. Users or readers of the financial statements have shown their interest in knowing about matters that the auditor had the most intense discussion on with those charged with governance and the matters where they required additional and detailed explanations from the management. This requirement also develops and nurtures good communication between the entity and the auditor. Management also begins to give more attention on these issues.

Valuation of inventory may be a key audit matter depending on the complexity involved. Provisioning and valuation of inventory requires a lot of judgments, estimates and forecasts from the management’s end and therefore the auditor needs to obtain substantive evidence for the same (Heminway, 2017).

The auditor is bound to disclose such matter using a separate head, under a separate section. It should be placed in proximity with the auditor’s opinion. Such information may be organized in the order of their importance.

Reasons shall be given as to why the auditor thinks that the matter demands significant attention. While giving reasons, the auditor shall restrict himself from using superfluous words or using purely technical terms. This is required to facilitate understanding by those users who do not have a high level of knowledge but are interested to understand the basis of such a decision.

Identifying Intangible Assets in Acquisition Audits

The extent of management disclosure and representation, with respect to the mater under consideration, shall also be informed (Linden & Freeman, 2017).

Keeping in mind the specific needs and situation of the entity and the audit, if the auditor thinks it fit that there does not exist any matter that can be considered as a key audit matter, then the auditor shall make a statement stating such a situation. This also applies in cases where the matter to be considered as key audit matter has already been disclosed separately as part of compliance with ASA 701. However, it is to be kept in mind that the above-mentioned statement is to be presented under the head ‘key audit matters’, in the audit report.

The auditor shall also disclose and explain the procedures adopted by him to gather audit evidence. He should clearly mention the observations made in this regard and how he used those observations to draw conclusions (Sithole, et al., 2017).

2 a) The importance of Intellectual property is a huge matter of discussion in today’s time.  According to a study, conducted by the American Intellectual Property Law Association, a generation ago, about 80% of a typical company’s assets were tangible, in the form of buildings, equipment, plants, vehicles and the like, whereas 20 % were intangible. With the advent of technology, this ratio has gone topsy-turvy now, where as high as 75 percent of the entity’s assets are held in the form of intangibles. Valuation:   as far as the valuation of intellectual property rights is concerned, the cardinal rule of assigning a commercial value comes into effect. The valuation of the same intellectual property or intangible asset varies from entity to entity, because its utility is perceived differently by different entities. Calculation of the value of intangible assets is not problematic when they have been formally protected through trademarks, patents or copyright. But in case of tangibles such as know-how, (which can include the talents, skill and knowledge of the workforce), technical processes, customer lists, distribution networks, etc., they become quite complex. These assets are more difficult to be assigned a value although they are equally valuable. This is mainly because they cannot be directly associated with earnings or the profit that they generate (Raiborn, et al., 2016).

Rights and obligation:  intellectual property rights are highly characterized by their ownership issues. While trademarks are still less complex, copyrights and patents see a lot of legal suits against them. In fact, in most of the entities, the lawsuits, with regard to these intellectual property rights, form the major portion of the contingent assets or liabilities. These assets cannot be recognized in the books till the time their legal ownership is decided by the law. Issues like deficiencies in license rights, joint rights or ownership and infringement of property rights are reasons that cast high risk on assertions.

Conclusion

2 b) Substantive audit procedures: The first step is to gather initial information about the nature of the asset. Some background research shall also be done to understand the legislations applicable to this specific class of assets. To investigate the history of a product, both current and archived files should be studied. Ownership documents are to be properly studied and understood, so that no ambiguity lies in the mind of the auditor as to who should be the legal owner of the property. In cases, where these assets have been developed in house, end to end accounting of the research and development expenses shall be understood, vouched and verified (Trieu, 2017).

Interview or face to face conversation should be done with the management and other staff, so that any confusion or question can be cleared. Information can also be gathered by developing a questionnaire for all the people involved in the task of developing Intellectual property, or even for people who use it. Physical inspection of the workspaces shall also be done to identify any possible threat of unauthorized access. Inspection of ownership documents, policy documents, contracts with the government or with the patents issuing party shall be carried out. The value assigned to each of these assets shall be reviewed with the industry practices. However, some scope for deviations shall be allowed.

2 C) As per the provisions of the ASA701, matters that require the auditor to devote significant degree of attention while performing the audit and the audit procedures, are termed as key audit matters. For matters identified as key audit matter, the auditor is required to give out detailed information in his audit report. This detailed information shall be given in the form of separate heading that would appear under a separate section. The auditor shall, in clear terms disclose that such matters has been identified as such, only after exercising professional judgement. They are not baseless doubts. In his communication, the auditor shall state that he is not giving a separate opinion on those matters, but while expressing an opinion on the financial statements, he is also required to express an opinion on the key audit matters. This opinion is given only in the context of the financial statement under audit. This concept was introduced in the year 2015, with a view to enhance the quality standards of auditor’s reporting and to increase the extent of transparency in the financial report. The decision maker who read the financial statements have displayed their concern in knowing about matters that the auditor had the most intense conversation on with those charged with governance and the matters where they required added and detailed clarifications from the management. This requirement also improves and fosters good communication between the entity and the auditor. Management also initiates to give more attention on these issues as they are aware that these will be forming part of the financial statements, that is a public document (Werner, 2017).

Valuation of intellectual property rights may be a key audit matter based on complication involved. Provisioning and estimation of inventory involves a lot of verdicts, approximations and predictions from the management’s end and therefore the auditor needs to obtain substantive proof for the same. Also, the actual existence of the intangible assets, like technical know-how, expertise and goodwill can never be said to be complete and accurate.

The auditor is required to disclose such matter using a distinct head, under a distinct section. It should be positioned in close vicinity with the auditor’s opinion. Such information may be structured in the order of their significance.

Explanations shall be provided as to why the auditor considers that the identified matter demands substantial attention. While giving reasons, the auditor shall restrict himself from using superfluous words or using purely technical terms. This is required to facilitate understanding by those users who do not have a high level of knowledge but are interested to understand the basis of such a decision.

Information should also be given about the extent of management disclosure and representation on topics that are part of key audit matters.

Depending on the circumstances of the entity and the audit, if the auditor determines that there is no such matter that can be termed as key audit matter or that the matters to be termed as key audit matter have already been described in some other part of the report, he shall give a statement to this effect. Such statement shall be given under the heading key audit matters” (Dumay & Baard, 2017).

The auditor shall also disclose and explain the procedures adopted by him to gather audit evidence. He should clearly mention the observations made in this regard and how he used those observations to draw conclusions (Auditing Standard ASA 701 Communicating Key Audit Matters in the Independent Auditor’s Report, 2015).

References

Alexander, F., 2016. The Changing Face of Accountability. The Journal of Higher Education, 71(4), pp. 411-431.

Bromwich, M. & Scapens, R., 2016. Management Accounting Research: 25 years on. Management Accounting Research, Volume 31, pp. 1-9.

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Dumay, J. & Baard, V., 2017. An introduction to interventionist research in accounting.. The Routledge Companion to Qualitative Accounting Research Methods, p. 265.

Fay, R. & Negangard, E., 2017. Manual journal entry testing : Data analytics and the risk of fraud. Journal of Accounting Education, Volume 38, pp. 37-49.

Grenier, J., 2017. Encouraging Professional Skepticism in the Industry Specialization Era. Journal of Business Ethics, 142(2), pp. 241-256.

Heminway, J., 2017. Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and Organic Documents. SSRN, pp. 1-35.

Linden, B. & Freeman, R., 2017. Profit and Other Values: Thick Evaluation in Decision Making. Business Ethics Quarterly, 27(3), pp. 353-379.

Raiborn, C., Butler, J. & Martin, K., 2016. The internal audit function: A prerequisite for Good Governance. Journal of Corporate Accounting and Finance, 28(2), pp. 10-21.

Sithole, S., Chandler, P., Abeysekera, I. & Paas, F., 2017. Benefits of guided self-management of attention on learning accounting. Journal of Educational Psychology, 109(2), p. 220.

Trieu, V., 2017. Getting value from Business Intelligence systems: A review and research agenda. Decision Support Systems, 93(1), pp. 111-124.

Werner, M., 2017. Financial process mining - Accounting data structure dependent control flow inference. International Journal of Accounting Information Systems, 25(1), pp. 57-80.