Audit Risk And Substantive Procedures - Green Machine Ltd Essay.

Risks to Assertion Related to Green Machine Ltd

Question 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:

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

Required

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

Question 2

You are the auditor of Green Machine Ltd, a manufacturer. You have obtained a summary of the property, plant and equipment for the year ended 30 June 2018, which identifies cost and accumulated depreciation brought forward, additions and disposals in the year and depreciation charges.

A review of the management letter from the previous year’s audit shows that there were some problems in relation to making a distinction between capital and revenue expenditure; some items were capitalized when they should have been expensed and other capital items were included in repairs and maintenance in the income statement.

Another risk identified from prior years relates to depreciation calculations: there is a range of depreciation rates within categories and there has been concern that the rates applied to some assets have been too low. The depreciation policy disclosed in the financial report shows:

• Building: 2 – 4% straight line
• Plant and machinery: 5 – 10% straight line
• Fixtures fittings and equipment: 5 – 20% straight line

Required

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

ASA 701 is mainly introduced so that whole actual audit matter can be ascertained and computation can be done. Moreover, after such procedure, communication on the auditor part is needed to develop a report that is unbiased. Further, the management should have a direct focus on the story because such disclosure can help in reflecting the genuine state of the company (AUASB, 2015). About this, an investor can take investment decision that can be tagged as the main purpose of communication strategy.

Earlier on are claims made by management which has been entrusted with the preparation and presentation of financial statements? These claims are assumed to be true and fair. Any false assertion can put the management into trouble by making them answerable to the audit team. In the given case, Advanced Computer Solutions Limited has been experiencing high returns due to software issues. There is increasing returns, secondary sales and stocks piling up. The two key assertions at risk, in this case, are as follows:

1. Correct Valuation Assertion- There is huge stockpiling up because of returns of the software and the decreasing sales. Also, since the reputation is at a loss, the company would try to win the tender by all means. If they report a cost which is lower than actual cost, which implies a false way of getting the tender, the correct valuation of inventory won’t be done. Also, if the cost is lower than the NRV (Net Realizable Value), the valuation needs to be done at NRV at not at cost. The company or for this matter any company assets correct valuation of its stocks. And that the valuation is done as per the applicable accounting principles. Here, care has to be taken that all costs need to be correctly apportioned to inventory and if applicable, the valuation has to be done at NRV or net realisable value in case the costs are lower. This is to ensure that the inventory is valued at what can be realised from its sales and no unrealistic profit or loss is booked. In the given case, since the package sold by the company was a best seller, its NRV would be high. However due to increasing returns and lower sales, proper cost computation is a must or else the correct valuation assertion will be at risk (CAANZ, 2016).
2.    Completeness Assertion- The inventory stock of Advanced Computer Solutions Limited has been moved from a centralised location to six new regional warehouses located at different locations, i.e. regional warehouses. There are chances that while evaluating the inventories, all the stocks at all locations are taken care of and the inventory is computed thoroughly. There are also chance that there are stocks of other companies held at warehouses and the chances are higher f the warehouses are not self-owned (Caanz, 2016). Care has to be taken to ensure both scenarios do not occur and in the valuation of inventory, all that belongs to the company is included, that too at true costs and all that does not belong to the company is carefully excluded (CAANZ, 2016). Completeness and ownership are two assertions that are complementary to each other.

Any evidence to support the assertions are called substantive audit shreds of evidence. All the activities performed to procure these pieces of evidence is termed as substantive audit procedures. To confirm the assertions, substantive audit procedures have to be undertaken. These mitigate the risk of false or unfulfilled assertions (Baldwin, 2010). The following substantive procedures can be undertaken against each risk identified in (a) above:

Against the risk of incorrect valuation- some procedures or actions can be taken to eliminate the risk of incorrect calculation. Firstly, thorough checking of the overheads, cost allocation to overheads, the nature of expenses, the pricing of raw materials, human resources wages and salaries, all such costs need to be checked to ensure wastages and redundancy.  After that, market analysis to understand the fair market value, the market surveys to ensure the net realisable value, impairment analysis, these extra computations, can help in efficiently understanding the NRV.

Against risks related to completeness assertion – there are many procedures by which this risk can be mitigated. Firstly a cut off analysis can be done. The audit team can select a cut off period during which nothing can go in and come out from the warehouses. And during this period the stock count is taken so that anything coming to and fro during the count does not create any confusion (Roach, 2010). Secondly, observing the physical count- The physical count of inventory can be observed my being present on the location and supervising the counting process. This is the best way to ensure correctness. Thirdly, matching the count with the accounts books to find out discrepancies and whether these discrepancies are valid or not is an important way to ensure no risk (Cappelleto, 2010). Also, checking for correctness of normal and abnormal wastages is one important procedure, but in this case, for software, there are fewer chances of these.

Substantive Procedures to Mitigate Risks

‘ASA 701- Communicating Key Audit Matters in the Independent Auditor’s Report’ as issued by the AUASB has requirements mainly for listed companies. However, non-listed companies are also covered in this. This standard to a great extent relies on the auditor’s judgment of what comprises of key audit matter and what can be avoided from being communicated. All key matters that can affect the prudence of the user of audit reports and what can affect the independent auditor’s qualifications should mandatorily be a part of the auditor’s report. In the given scenario, the increasing inventory is a key audit matter which deserves elaboration in the report (Gay & Simnet, 2015). This is because all the analytical tools used suggest that the closing stock is increasing, not because of any boom in production but because of increasing defect beyond detected in the software and increasing returns, leading to secondary sales. This can greatly impact the large government tender. The motive is to issue a warning to the users of the auditor's report that they should do further checks and analysis to decide their future action (Beasley et. al, 2009). When the auditor is aware that there is something which is material enough to harm someone's financial health, because of incorrect reporting done by him, it becomes an obligation on his part and questions his qualifications. And in this case, propriety money is involved, and hence needs all the more caution whole reporting (Geoffrey, Joleen & David, 2016).

The method of inventory calculation, the reason for its increase in inventory, the reason for the decrease in sales, estimate of costs and determination of NRV should form a part of the disclosure.

 (a) As discussed earlier, assertions are claims made by management which has been entrusted with the preparation and presentation of financial statements. These claims are assumed to be true and fair. Any false assertion can put the management into trouble by making them answerable to the audit team. property plant and equipment is the most important asset for a manufacturing company. It forms a larger part of the assets of a manufacturing company. Also, most of the work of a manufacturing company is done with its Property, plant and equipment. It is very important to value and classify these assets properly. Else there are huge chances of fabrication of the financial results of the company (Glover & Reidenbach, 2012). The following are the two risks to assertion related to Green Machine Limited, as per the given case.

1. The risk to classification assertion- the assets should be clarified correctly. The expenses should also be classified properly. All capital and revenue expenses should be correctly classified and charged according. All repairs and maintenance expenses to be charged to revenues, and major expenses to improve the current state of the assets to be capitalised, and all new purchases to be included in the block of assets. All classification to be done as per the generally accepted accounting principles (Hoffelder, 2012). However, in the given case of Green Machine Limited, the expenses in the last year have been all mixed up. The capital and revenue expenses have been misinterpreted and have been respectively charged to wrong accounts, thereby giving wrong information about the current carrying value of the property, plant and equipment. Also, the value of profit or loss would also have been incorrect because of the charge of capital expenditures to revenue (Brant et. al, 2012).
2. The risk to accuracy assertion- this risk entails that there is a calculation which is not done efficiently and accurately, and this calls for a qualified audit report. As mentioned in the management report of the previous year, the depreciation rate on some assets has been applied too low. This damages the existence of fair and correct value of assets in the books of accounts. Inaccurate valuation can be very detrimental to the financial health of the company (Beasley et. al, 2009). Lower depreciation leads to the following consequences- inflated financial results, the creation of deferred tax liability, inflated carrying the number of assets. These affect the Funchal health in the coming years (Niemi & Sundgren, 2012). A risk to accuracy in the current year, and that too if the case is like that of Green Machine Limited, where the depreciation rate application is lower than prescribed, the bigger impact will be in future years (Elder, Beasley & Arens, 2010).

Role of Auditors in Ensuring Accurate Representation of Financial Statements

Any evidence to support the assertions are called substantive audit evidence. All the activities performed to procure these evidence is termed as substantive audit procedures. To confirm the assertions, substantive audit procedures have to be undertaken. These mitigate the risk of false or unfulfilled assertions. In the given case of Green Machine Limited, the following substantive procedures have to be adopted to mitigate the risk to the assertion:

1. Mitigation of risk to classification assertion- in the given case, there had been an error of computation in the past. Thus, in the current year, the audit team needs to authenticate last year's as well as this year's information so that a cumulative effect can be given and arrived at the correct values. Checking of the last year's computation and then giving effect in the current year and then the computation of the current year's figures (Sikka, 2009). The task is tedious but needs to be done properly. Classifications to be checked. Correct values to be classified into the review and capital expenses. A separate team can be alotted to physically check for capital assets, verify the additions and changes, and also check for all expense reports and supporting purchase documents related to property plant and equipment. Care to be taken to educate the finance personnel responsible for the computation, to avoid such mistakes in future. Also, ask for internal control mechanisms applicable within the company to keep checks in these transactions of capital nature (Brant et. al, 2012).
2. Mitigation of risk to accuracy assertion-  accuracy assertion is all the more important because there are chances of great mistakes because of incorrect computation, incorrect estimates and incorrect valuation. Classification is an error at a macro level. But at the micro level, accuracy plays a vital role. To avoid this risk, the list of assets have to be checked for, the purpose of those assets to be understood and then the depreciation rate has to be understood properly (Church , Davis & McCracken, 2008). Incorrect depreciation rates can as discussed before hamper in the long run, the financial health of the company. Therefore, deep down analysis and computation is an important substantive measure.

‘ASA 701- Communicating Key Audit Matters in the Independent Auditor’s Report’ as issued by the AUASB has requirements mainly for listed companies. However, non-listed companies are also covered in this. This standard to a great extent relies on the auditor’s judgment of what comprises of key audit matter and what can be avoided from being communicated. All key matters that can affect the prudence of the user of audit reports and what can affect the independent auditor’s qualifications should mandatorily be a part of the auditor’s report. With a major portion of asst of Green Machine Limited being fixed asset,( this is an assumption since it is a manufacturing company) the computation of depreciation, accumulated depreciation, the casting amount of assets, Viz property, plant and equipment, is a very important activity. Mistakes in it are a key matter that requires a reporting or qualification in independent auditor's report (Matthew, 2015). This is because these are not errors that can be overlooked or that have low impact. They can affect the financial decisions of a great section of stakeholders. Hence the auditor must report about them.

Disclosure about the period or errors, the reason for the same, the correct computation in the year of failure, the and the respective effect in the current year and a comparison between the incorrect and correct figured should be properly projected in the independent auditors report. There should also be disclosure regarding the method of computation used (Sharp, 2006).

Conclusion

It can be commented that the company should pay heed to the relevant accounting standards so that it can have access to the financial concern needed to be implemented during the financial statement preparation. Hence, it can be commented from the discussion, that the main responsibility of the auditor is to help the companies in projecting the true financial position so that the companies are protected from the legal issues. This can aid in increasing the reputation of the company in the long run.

References

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