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(a)List the assertions you will need to test when substantively testing inventory, and identify the most important ones in respect of inventory on this audit. Explain your reasons.

(b)Outline the key procedures you plan to perform prior to and during the stock-take.

(c)What action, if any, would you take on learning of the errors made by one of the stocktaking teams?

Inherent Risks and Control Risks

Audit risks refers to the various risks which is faced by the auditor during the course of audit. Such types of risks affect the overall audit process of the business. In this case, the audit is to be conducted for Natural Supplements (Nelson) limited. The auditor is newly appointed to conduct the audit of the company. The various risks which is applicable to the business needs to be effectively identified by the auditor (Latif et al., 2014). In order to assess the risks which are associated with the business, the auditor first needs to identify the nature of the business and the core activities of the business. The auditor also needs to have a basic understanding of the internal control of the business. The various risks which the business might be subjected to are given below in details:

  • Internal Control Risk: As the business is engaged in manufacturing health supplements manufacturing business, it is expected that the internal control of the business needs to be strong so that the management of the company is able to keep effective track of the inventories of stock and overall management of the business. In many a times, the auditor relies on the internal control of the business for obtaining certain audit evidences (Skaife, Veenman & Wangerin, 2013). Therefore. the reliance which can be placed on such risks ranges from medium to high.
  • External Confirmation:  As per the case study, the business has debtors, creditors and loans which is shown in the financial statements of the company. Therefore, the auditor might need to take assistance from external parties in order to confirm certain balances (McConnell Jr, Charles & McConnell, 2014). There is a risk that the balances which are shown in the financial statements of the business may be misrepresented. Therefore, the level of reliance which can be placed on such a factor can be within the range of medium to high.
  • Risk of Omission:As stated in the case study of NSNL, the business is understaffed which is shown in the sales department where only 3 employees are there. Therefore, the pressure is there for the job of identifying, recording, preparing invoices. There is always a chance that there might be some accidental omission due to which the business might face risk (Lobo & Zhao, 2013). In such a case, the level of significance can be placed ranges from low to medium as such risks can be identified easily when review of the financial records are done.

Risk of Material misstatement refers to the risk that the certain significantly items of the financial statement might be significantly misrepresented either intentionally or unintentionally (Cohen & Simnett, 2014). The risks of material misstatement can be further be subdivided into control risks and inherent risks. The inherent risks which can be identified from the case study are given below:

  • Peter who is one of the directors of the company has a history of going through bankruptcy which can be taken as a risk related to the business.
  • The previous auditor of the company was involved in the auditing of the company for a period of nine years and has issued unmodified report every time. There is a risk that the opinion of the auditor might not be fair due to familiarity which could have been developed due to continuous audit of the same client.
  • There are only three sales staff in the business which handles all transaction related to sales. Even though they are experienced and have efficiency, the volume of sale is increasing which results in more work and there is a high possibility that material misstatement might take place in such a situation.
  • The purchase staff handles the purchase transactions of the business and such staffs are also understaffed which might result in material misstatement.
  • The company prepares management accounts but does not prepare budgets except sales budget, however different areas of business such inventory management, cost analysis, labour budgets are also essential for business as they provide a standard for measuring the performance of the business. In absence of such budgets, material misstatements, especially in cost measurement might take place.

Control risks refers to the risk which arises due to the deficiencies of the internal control system of the business (Knechel & Salterio,  2016). The various control risk which can be identified by the business are given below:

  • The sales orders of the business are approved by Thomas and that too only when he is in office and not outside selling the products of the company. This can result in misstatements and signifies a weakness in the internal control system of the business.
  • The company does not prepare budgets except for sales budget therefore there is wide gap in supervision when it comes to measuring the performance of the employees of the business as per the case study which is given in the question.

As per the preliminary examination of the books of accounts of NSNL for the various risks which are identified by the business are given below on the basis of high risk, medium risks and low risks.

Inherent risks which is related to peter having gone through bankruptcy which can also be due to his aggressive decision makings as specified in the case study, the risk associated in this case is medium (Johnstone, Gramling & Rittenberg, 2013). The second risk which was identified is related to material misstatement being carried forward from previous years and also the opinions of the previous auditors might be affected by familiarity with the client. In this case the risks associated is very high as there is a certain possibility of material misstatement being carried forward (Brazel, Jones & Prawitt, 2013). The risk which is associated with the sales and purchased staff being understaffed and there is a high risk that material misstatement might have occurred.

In the case of control risk, the sales orders is handled by Thomas who when away on business trips faces control risks as the internal control system is weak. The level of risks faced by business in such a case is high. The company also does not prepare budgets which is very important for the purpose of supervision and this is another area where the business faces control risks. In this case as well the level of risk which the company face is high.

Financial Ratio Analysis

As per the financial statement and the ratio which are calculated are to be analyzed. The current ratio of then company has significantly increased from the previous year’s figure which shows that the liquidity of the business has increased. The debt to equity ratio of the company shows that the ratio has decreased from the previous year’s estimates which shows that the business has reduced the debts which the business possessed. The auditor needs to verify the debts records of the business so as to establish that the business has recorded accurately. The inventory turnover ratio of the business shows the efficiency of the business. The inventory turnover ratio of the business is shown to be 1.59 which has reduced from previous year estimate which is shown as 1.61. The auditor needs to check the inventory records and thereby establish whether the figure recorded in the financial statement are showing true and fair view. If need arises the auditor also might need to conduct a physical stock take if the auditor has doubt about the valuation of the inventory. Similarly, with the account receivable turnover ratio of the business, the auditor needs to ascertain whether the value which is shown in the financial statement is showing true and fair view. For such purpose the auditor can also ask for external confirmation if such a need arises. As most of the sales of the business is on credit basis therefore the auditor needs to apply more audit procedures in order to confirm or deny whether the account balance is fairly represented or not.

Planning materiality refers to the materiality which is set by the judgements of the users of the financial statements of the business (Eilifsen & Messier Jr, 2014). The auditor in such a situation decides the level of materiality on items of financial statements on the basis of the significance of the items to the users of the financial statements of the business.

On the other hand, performance materiality refers to the errors and omissions which are expected by the auditor to be present in the financial statements of the company and such errors or omissions do not affect the opinion or the objectivity principle of the auditor (Emby & Pecchiari, 2013). The basic difference between planning materiality and performance materiality depends on the level of the materiality that allows fair representation of then items in the financial statements of the business (Messier & Schmidt, 2017). In addition to this, both planning and performance materiality changes overtime for the business.

Planning Materiality and Performance Materiality

Specific Materiality refers to the misstatement which takes place in sensitive areas of the business such as legal contract compensations or areas where misstatements might attract legal consequence (Jones, Comfort & Hillier, 2016).

Planning Materiality

2017

Single Rule

Computation

Materiality

5% of pre-tax income

5% x $970,878

$ 48,544

0.5% of total assets

0.5% x $7,318,486

$ 36,592

1% of equity

1% x $4,937,454

$ 49,375

0.5% of total revenue

0.5% x $8,434,638

$ 42,173

The planning materiality as calculated is shown above which is followed under single rule method. As per earlier discussions it is clear that the business has a high risk of material misstatement. In order to compute the performance materiality, it is important to consider the materiality of an assets as a base (Eilifsen & Messier Jr, 2014). As the business is considered to have high risk of material misstatement therefore performance materiality will be calculated at 50-60%. Thus, the results come to about $ 22,200 ($ 37,000*60%).

The following formula can be used for the purpose of calculating specific materiality of the business in terms of intangible assets of the company.

Intangible asset – development / (total assets + total liabilities)

350,445 / (7,318,486 + 4,937,454) = 2.86%

$22,200 x 2.86% = $635

The research expenditure which has been wrongly capitalized needs to be corrected as soon as possible as such will be misstating the financial statements. The materiality of the transaction is also eminent and therefore the management cannot ignore the same. Unless the management changes the entries and disclosures, the auditor will issue a qualified report.

The factors which are needed to be tested in case of a stock take are discussed below:

  • Completeness: As per this principle, all the transactions which are related to the stock needs to ne recorded accurately and fairly without any omissions.
  • Accuracy: As per this principle, the stock value which are recorded should not be misstated and must be accurate. Accuracy is an important factor as this determine the value of the inventory in the books of accounts.
  • Existence: The value of inventory which is recorded in the books of accounts should be physically present and should not be some cooked data.
  • Valuation: The valuation method which is used by the management to value the inventories should be accurate and as per standard and effectively disclosed.

Out the above discussed assertation, accuracy is the most important as if the figure of inventory is accurately recorded in the financial statements that there will be no misstatements and the financial statements will be fairly represented (Granderson et al., 2016). In most cases manipulations takes place in the inventory figures of the financial statements.

The key procedures which the auditor can employ during the valuation of the inventory are:

  • Supervise the Physical Count: The auditor can supervise the physical count of inventory in order to ensure that the physical verification of the same is being effectively done. In such a way the auditor will be able to verify the balance which is shown in the financial statements.
  • Reconcile the balance of general ledger accounts with the Physical stock take results: This is an efficient process which allows the auditor to accurately check the valuation of the inventory and also determine whether the same is misstated or not.
  • Ownership test: The auditor can check the ownership of the inventory with the stock purchase records of the business.

If an error is detected in the physical stock take process, the auditor needs to ensure that corrective measures are taken so that correct valuation of the stock can be established. The auditor can ask the management to reconduct the physical stock verification. In addition to this, it would be recommended to the management if they follow ABC system for inventory valuation so that inventory is sorted on the basis of importance or value which the material generate for the business.

Reference

Brazel, J. F., Jones, K. L., & Prawitt, D. F. (2013). Auditors' reactions to inconsistencies between financial and nonfinancial measures: The interactive effects of fraud risk assessment and a decision prompt. Behavioral Research in Accounting, 26(1), 131-156.

Cohen, J. R., & Simnett, R. (2014). CSR and assurance services: A research agenda. Auditing: A Journal of Practice & Theory, 34(1), 59-74.

Eilifsen, A., & Messier Jr, W. F. (2014). Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), 3-26.

Eilifsen, A., & Messier Jr, W. F. (2014). Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), 3-26.

Emby, C., & Pecchiari, N. (2013). An Empirical Investigation of the Influence of Qualitative Risk Factors on Canadian Auditors’ Determination of Performance Materiality. Accounting Perspectives, 12(4), 281-299.

Granderson, J., Touzani, S., Custodio, C., Sohn, M. D., Jump, D., & Fernandes, S. (2016). Accuracy of automated measurement and verification (M&V) techniques for energy savings in commercial buildings. Applied Energy, 173, 296-308.

Johnstone, K., Gramling, A., & Rittenberg, L. E. (2013). Auditing: a risk-based approach to conducting a quality audit. Cengage learning.

Jones, P., Comfort, D., & Hillier, D. (2016). Materiality in corporate sustainability reporting within UK retailing. Journal of Public Affairs, 16(1), 81-90.

Knechel, W. R., & Salterio, S. E. (2016). Auditing: Assurance and risk. Taylor & Francis.

Latif, R., Abbas, H., Assar, S., & Ali, Q. (2014). Cloud computing risk assessment: a systematic literature review. In Future information technology (pp. 285-295). Springer, Berlin, Heidelberg.

Lobo, G. J., & Zhao, Y. (2013). Relation between audit effort and financial report misstatements: Evidence from quarterly and annual restatements. The Accounting Review, 88(4), 1385-1412.

McConnell Jr, D. K., Charles, H., & McConnell, S. C. (2014). The External Confirmation Process. The CPA Journal, 84(1), 40.

Messier, W. F., & Schmidt, M. (2017). Offsetting Misstatements: The Effect of Misstatement Distribution, Quantitative Materiality and Client Pressure on Auditors' Judgments.

Skaife, H. A., Veenman, D., & Wangerin, D. (2013). Internal control over financial reporting and managerial rent extraction: Evidence from the profitability of insider trading. Journal of Accounting and Economics, 55(1), 91-110.

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