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Prepare a report for the audit senior, which addresses the 3 issues below.

1. The audit partner has suggested that the preliminary assessment of materiality for the financial report as a whole be set at $15,000. Comment on the appropriateness of this figure for your client. Provide evidence to support your view. Include a brief 
discussion of the effect that changing the preliminary assessment would have on the audit budget.

2. Prepare an analytical review (in the form of a trend analysis) using the income statement items from the trial balance. Note: Present your analysis in table format; comments on the results are not required for requirement 2.

3. Use the trend analysis to identify 3 income statement accounts that appear to be atrisk of material misstatement. Provide justification for why these accounts should be subjected to significant audit testing. In your explanations, identify an assertion that is likely to be at-risk for each account (i.e. identify 1 assertion per account; 3 in total).

4. For each account and assertion identified in requirement 3, design and describe an audit procedure that would provide relevant evidence for this (i.e. describe 1 procedure for each account; 3 procedures in total). Note: you need to explain the procedures in your own words with as much detail as possible (for example, if applicable, identify the sampling frame and specific documents required for your procedure).

Preliminary Analytical Review

Introduction

An audit planning (ASA 300) report has been prepared for one of the small companies. The trial balance of the entity has been given and based on the same the preliminary analytical review has been done. As a part of the audit procedures, the materiality level has been determined and also the common size income statement and the trend analysis has been prepared for the 2 given years to find out the major variations and find out the accounts to be audited. Fraud risk analysis has been done for the given client and the necessary audit procedures have been mentioned in the report (Marques, 2018). The report has to be handed over to the audit partner who has asked the same from audit senior.   

The trial balance of the company “Fallow Enterprises” has been shown below and the difference in the debit and credit side of the balance sheet has been assumed the suspense account, which has, not be taken in any of the computations and analysis since the nature of account is not known.

Fallow Enterprises

Trial Balance

Particulars

Jul 1’16 - Nov 30’16

Jul 1’15 - June 30’16

Debit

Credit

Debit

Credit

Cash at Bank

      89,750

      83,000

Accounts receivable

    109,850

    103,585

Inventory

    164,500

    174,000

Machinery

      64,000

      64,000

Accumulated Depreciation

      27,448

      24,000

Motor Vehicles

      66,000

      66,000

Accumulated Depreciation

      32,063

      21,000

Furniture

         7,400

         7,400

Accumulated Depreciation

         2,520

         2,220

Bank Loan

    240,000

    240,000

Sales

      81,052

    187,450

Cost of sales

      24,604

      63,595

Consultancy fees

      24,688

      57,000

Interest income

               20

               50

Bank charges

            145

            350

Depreciation

      14,810

      15,738

Interest expense

         4,792

      12,000

Printing

            154

            375

Miscellaneous

            600

                -   

Wages

      21,904

      53,000

Superannuation

         2,081

         5,035

Total

    570,591

    407,791

    648,078

    531,720

The very first step in the audit planning discusses on the materiality for the company in question. The audit partner has suggested the materiality level to be taken as $15000 but the same is very high considering the trial balance and its number for the given client. Any error, omission or misstatement is considered material, if the same in individual or in aggregate has the ability or the capability to change the economic decision of the user(DeZoort & Harrison, 2016). This has been explained in ASA 320. It helps the auditor in differentiating as to what is the extent to which the checking needs to be done and what can be ignored. There are many international and in country accounting boards which have suggested a way to determine the materiality of an entity. One of those ways is to use a certain percentage of the total assets, gross profit, total sales, net profit and shareholder’s equity. Using these percentages, the materiality has been determined to be between the ranges of $690 to $810. Using this, many of the accounts, which would have been ignored earlier, would now be under the audit scope like the depreciation account, the interest account, the furniture account and the superannuation account (Mock, et al., 2018).

(in $)

Fallow Enterprises

Quantitative estimate of materiality

Criterion

Base

 Amount

Materiality level/range

0.5% to 1% of gross revenue

Gross Revenue

      81,052

405.26 to 810.52

1% to 2% of the total assets

Total Assets

    439,468

4394.68 to 8789.37

1% to 2% of the gross profit

Gross Profit

      34,544

345.44 to 690.88

2% - 5% of the shareholders’ equity

Equity

 NA

NA

5% to 10% of the net profit

Net profit

      36,669

1833.43 to 3666.87

  1. The preliminary analytical review has been done using the trial balance of the entity and based on the same two variance and trend analysis statements have been prepared which will help in identifying the critical and significant accounts, which needs audit attention. The two statements are:
  2. Common Size Income statement, and
  3. Trend Analysis

Fallow Enterprises

Income Statement

Particulars

2017

% of sales

2016

% of sales

Sales

      81,052

76.6%

    187,450

76.7%

Consultancy fees

      24,688

23.3%

      57,000

23.3%

Interest income

               20

0.0%

               50

0.0%

Total Revenue

    105,760

100.0%

    244,500

100.0%

Less: Expenses

Cost of sales

      24,604

23.3%

      63,595

26.0%

Bank charges

            145

0.1%

            350

0.1%

Depreciation

      14,810

14.0%

      15,738

6.4%

Interest expense

         4,792

4.5%

      12,000

4.9%

Printing

            154

0.1%

            375

0.2%

Miscellaneous

            600

0.6%

                -   

0.0%

Wages

      21,904

20.7%

      53,000

21.7%

Superannuation

         2,081

2.0%

         5,035

2.1%

Total Expenses

       69,091

65.3%

    150,093

61.4%

Net Profit

      36,669

34.7%

      94,407

38.6%

Fallow Enterprises

Income Statement

Particulars

2017

2016

 Variance

Sales

      81,052

    187,450

-    106,398

Consultancy fees

      24,688

      57,000

-      32,313

Interest income

               20

               50

-               30

Total Revenue

    105,760

    244,500

-    138,740

Less: Expenses

Cost of sales

      24,604

      63,595

-      38,991

Bank charges

            145

            350

-            205

Depreciation

      14,810

      15,738

-            928

Interest expense

         4,792

      12,000

-         7,208

Printing

            154

            375

-            221

Miscellaneous

            600

                -   

              600

Wages

      21,904

      53,000

-      31,096

Superannuation

         2,081

         5,035

-         2,954

Total Expenses

       69,091

    150,093

-       81,002

Net Profit

      36,669

      94,407

-      57,738

Net Profit %

34.67%

38.61%

Based on the statements above, several accounts have been earmarked for audit. Some of these accounts and the audit risk and assertions with respect to these accounts have been mentioned below:

Sl. No.

Account Name

Audit Assertion and risk

1.

Sales

The sales has dropped by 57% as compared to the last completed year but as a percentage of the total receipts, it is still at 77%. It needs to be scrutinized if the sales prices have changed or if the quantity sold has decreased or the fall in revenue is due to the competitive pressure in the market. Thus, there might be issue in relation to right to recognise revenue towards the period end. (Deegan & Shelly, 2014).

2

Cost of sales

The cost of sales has also declined by a massive 61%. Though the sales has declined and the proportionate amount is expected to decline in cost of sales as well bit if cost of sales is calculated as a percentage of the total receipts, we can see that the percentage of costs has gone down from 26% to 23.3%. There might be an issue in the recording of complete transactions and therefore the reason for the same needs to be found as it has effect on profitability as well. Thus, there might be an issue relating to completeness in recording and incorporating the cut off balance in the costs (Axelsen, et al., 2017).

3

Interest Expenses

The interest expenses is something which is expected to be fixed across years but in the given case the same has declined drastically by 60% even though the loan balance is same. This poses one of the major audit risks as the management might have faultered in using the accrual basis and might not have taken requisite provision in books.Thus, this might be an issue relating completeness and accuracy in recording of transaction (Sithole, et al., 2017).

  1. Few of the audit procedures and the steps which needs to be taken by the auditors in this regards have been mentioned below for all the above 3 accounts:
  2. Sales: The sales needs to be verified from the sales register and the auditor should go for vouching of few of the invoices for tax and other scrutiny. Also, the revenue recognition criteria of the company needs to be checked if the company is following the requisite accounting standards and the guidance notes. The change in the prices of goods, if any, should be supported by evidences and calculation(Erik & Jan, 2017).
  3. Cost of Sales: The cost of sales has declined more than the drop in sales so it needs to be checked if the accounting is done properly. Again, the vouching of purchase orders and purchase invoices is required and the auditor should check the management estimates and judgements, if any, in this regards(Choy, 2018).
  4. Interest Expenses: The interest expenses have declined even when the loan balance of the entity is same as compared to the last year. Therefore, it needs to be checked if the company is taking proper provision in the books and is following the accrual basis of accounting. The auditor can also look at the bank loan repayment interest and check the interest records as well(Timothy, 2004).

Conclusion and Recommendation

  1. The last step, which has been mentioned in the audit planning procedure for the given entity is fraud risk analysis but the audit partner has suggested that the fraud risk analysis need not be carried out for the entity as the client, is a trustworthy one. Here, the audit partner is wrong in his contention for the reason that the auditor should always maintain the professional scepticism while auditing the accounts and should exercise his professional judgement all throughout(Fukukawa & Mock, 2011). In addition, it has been mentioned in APES 110 that the auditors should subject all the clients to fraud risk analysis irrespective of what is the situation. Here also in the given case, there have been certain cases and accounts where there can be a possibility of the fraud. Some of these accounts are interest expenses account and cost of sales account for which the reasons have already been explained above. In addition to this, the depreciation account also needs to be checked as the balances of assets is same as per last year but the expenses have gone down. Furthermore, the drop in superannuation expenses show that the employees have left the company and the current head count should be less as compared to the last year. The same should be checked and verified (Bumgarner & Vasarhelyi, 2018). 

References

Axelsen, M., Green, P. & Ridley, G., 2017. Explaining the information systems auditor role in the public sector financial audit. International Journal of Accounting Information Systems, 24(1), pp. 15-31.

Bumgarner, N. & Vasarhelyi, M., 2018. Continuous auditing—a new view.. Continuous Auditing: Theory and Application, 20(1), pp. 7-51.

Choy, Y. K., 2018. Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, p. 145.

Deegan, C. & Shelly, M., 2014. Corporate Social Responsibilities: Alternative Perspectives About the Need to Legislate. Springer, 121(1), pp. 499-526.

DeZoort, F. & Harrison, P., 2016. Understanding Auditors sense of Responsibility for detecting fraud within organization. Journal of Business Ethics, pp. 1-18.

Erik, H. & Jan, B., 2017. Supply chain management and activity-based costing: Current status and directions for the future. International Journal of Physical Distribution & Logistics Management, 47(8), pp. 712-735.

Fukukawa, H. & Mock, T., 2011. Audit risk assessments using belief versus probability. Auditing: A Journal of Practice & Theory, 30(1), pp. 75-99.

Marques, R. P. F., 2018. Continuous Assurance and the Use of Technology for Business Compliance. Encyclopedia of Information Science and Technology, pp. 820-830.

Mock, T. J., Ragothaman, S. C. & Srivastava, R. P., 2018. Using Evidential Reasoning Technology to Enhance the Audit Quality Assurance Inspection Process. Journal of Emerging Technologies in Accounting, 15(1), pp. 29-43.

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.

Timothy, G., 2004. Managing interest rate risk in a rising rate environment. RMA Journal, Risk Management Association (RMA), November.

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