Audit Assertions And Key Audit Matters In Financial Reporting

While assessing the risk of material misstatement and determining the appropriate response with regard to the inventory of Advanced Computer Solutions Limited (Advanced Computer 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 5.4 times in 2017 and 3.8 times in 2018

(iii) Advanced Computer Solutions moved its inventory from a central warehouse to six new regional warehouses in March 2018

(iv) Inventory on hand at end of year represented 26 per cent of sales in 2018 and 18 per cent of sales in 2017

(v) Advanced Computer 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.

(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.

Overview of Audit Assertions

Audit assertions are the explicit or implicit representation or claims made by management who are responsible for preparation of the financial statement for appropriateness of various elements from the financial statements as well as the disclosures. While preparing the financial statements, management makes various explicit or implicit claims those are known as assertions regarding the presentation, measurement and recognition of liabilities, assets, expenses, incomes and disclosures as per the applicable framework for financial reporting. ASA 701 - Communicating Key Audit Matters in the Auditor’s Report states regarding the responsibility of the auditor while communicating the key audit matters (KAM) included in the financial report for the particular period audited by the auditors (Auasb.gov.au 2019). Main purpose of communicating the KAM is to enhance the transparency and quality of the financial report and offering additional information to various users of the financial statement. However, it is noteworthy that KAM is not the substitute for financial information disclosures required as per financial reporting framework. Further, it is not the substitute for the audit opinion expressed on the financial report of the company and the KAM are reported for the entire financial report and not for any specific part of the report (AICPA 2017).

As per the given case study during audit procedure while assessing risk related to material misstatement and determination of appropriate response for inventories for Advanced Computing Solution Limited, the auditor went through various issues. The issues are the company recently experiencing high return level for suspected issues in the software. Further, on the basis of the ending inventory it was found that the inventory turnover dropped to 3.8 times in 2018 against 5.4 times of 2017. In addition to that, inventory on hand has been increased to 26 percent in current year against 18 percent for previous year. Irrespective of these issues to prevent the competitors the company take up a contract where it will supply products at 10 percent below the cost price that is in loss (Kachelmeier, Schmidt and Valentine 2017).

2 key assertions found in case of Advanced Computing Solution Limited are as follows –

• Valuation and accuracy – key assertion related to financial statement valuation and accuracy states that various components of the statement like inventory have not been reported as per the reporting criteria. Under this assertion the risk associated is that the value for the transactions is not reported accurately and the valuation has not been carried out as per the applicable valuation model. Valuation of inventory is an important aspect as the inventory is considered as the major component while assessing the company’s liquidity position that is whether the current assets are sufficient for meeting the current debt of the company (Kharisova and Kozlova 2014). Persons who are involved with managing and measuring the inventories are responsible to ensure that the inventories have been recorded using established valuation approach of the company and the inventories are not under-recognized or over-recognized. In the given scenario it is found that the company’s closing inventory for current years has been increased to 22% against 18% for previous years. The assertion involved here that the person involved with sales may have not recorded the sales or the goods which have been sold but delivery for which has not yet been taken are recorded as unsold. These 2 errors will definitely increase the closing inventory than actual. Further selling of inventories below the cost price will understate the profit and will be regarded as an assertion associated with valuation (Köhler, Ratzinger-Sakel and Theis 2016).  
• Completeness – assertion risk associated with completeness of item in the financial report like inventory determines that all the transaction of inventories have not been considered while recognising the entire amount in the financial report. Completeness states that the all the items those are supposed to be included in the financial report for the particular period have not been reported. The auditor found during the audit procedures for Advanced Computing Solution Limited that the inventory turnover rate dropped to 3.8 times in the current year against 5.4 times for previous year (Mock and Fukukawa 2015). One of the reasons behind this may be that as the company transfer its inventories from the central warehouse to 6 regional warehouses, likelihood is there that the recording of number of inventories has been misstated. For instance, the units of inventories despatched from central warehouse does not match with the recorded units of receipt in regional warehouse. Insufficient level of internal control for inventories will be considered as assertion risk for completeness. Further, under-recognition or over-recognition of inventories will also be considered as an assertion associated with completeness (Sultana, Singh and Van der Zahn 2015).

Substantive audit procedures are intended for creating the evidence that the auditor assembles in support of the assertion that no material misstatement is there with regard to validity, accuracy and completeness of financial records of the organization. Hence, substantive procedure are carried out by the auditor for detecting whether any material misstatement in there with regard to accounting transactions (Mock and Fukukawa 2015). For the assertions identified with regard to inventory as above the substantive procedure will be as follows –

• Valuation and accuracy – the auditor shall verify that the inventories have been valued at cost or market, whichever is lower. This shall be done through comparing the market price with the recorded cost. If considerable part of the inventory is included the finished goods the auditor shall review the material for selected items of finished goods and test those items to verify whether they show the accurate compilation for the components in finished goods items and the correct costs. Apart from this other things those are required to be verified are – (i) inventories pledged with 3^rdparty, if any (ii) inventory price matched with the invoice (iii) propriety for inventory shall be verified (iv) units issued, purchased and sold shall be matched with with the closing inventory (v) terms as well as the existence for purchase and sales of major commitments (vi) if the overhead costs are applied to valuation of inventory the auditors shall verify that the same method is consistently applied as source of overhead cost, irrespective of the fact that the overhead includes abnormal costs and consistency and validity shall be tested for the method used for applying the overhead cost to inventory (Sultana, Singh and Van der Zahn 2015).
• Completeness – the auditor must determine whether amount recorded as allowance for scrap or obsolete inventory are adequate on the basis of the procedures and usage of inventory. If such allowance are not found the company may require creating such allowance. Auditors shall further review the purchase orders for assuring that inventory kept in the warehouse is owned by the entity actually. Further, auditors shall identify the procedures of the entity regarding halting of any receiving into shipments or warehouse while the physical count is carried out so that the items under extraneous inventory are excluded. For ensuring that the auditor may test last few transactions involving shipping and receiving before carrying out the physical count and immediate transactions after the physical count to assure that the proper accounting system are applied consistently. On sample basis the auditor shall choose few events involving transfer of inventory from central warehouse to regional warehouse and verify that the units recorded as despatched from central warehouse match with the units recorded as received at the regional warehouse (Vik and Walter 2017).

Key Audit Matters and Their Significance

Auditing standard ASA 701 was issued by AUASB regarding communication of key audit matters (KAM) under the independent auditor’s report pursuant to requirement of legislative provision. Introduction of the ASA 701 determines the commitment of AUASB with regard to conformity with recent enhancement to the auditor’s report developed by IAASB (International Auditing and Assurance Standards Board). Main features of new standard are as follows –

• Mandating communication of the KAM under auditor’s report for audit of the listed company
• Auditors determines the KAM as follows –
• Determination from matters communicated with those matters charged with the governance and those maters which requires significant attention from auditor
• Considering the accounting areas associated with higher risks, significant judgements from auditors, involved with significant judgements of management and impact of significant transactions or events.
• Determination of most significant matters to include in the auditor’s report (Andersen and Hansen 2018).
• How individual KAM is described by auditor
• Circumstances under which matters determined as KAM are not communicated under the auditor’s report
• Requirements of audit documentation associated with KAM.

Main purpose of KAM communication of the KAM is improving the value of communication of auditor’s report through providing greater level of transparency regarding the audit performed by the auditor. Communication of KAM also helps the intended users of financial statement to understand the organisation and areas those require significant judgement of the management with regard to the financial report audited (Cordo? and Fülöp 2015).

In the given scenario of Advanced Computer Solutions Limited te KAM will be for preventing the competitors the company take up a contract where it will supply products at 10 percent below the cost price that is in loss.

 The disclosure for this KAM will be as follows –

Tenders accepted for supplying items at 10% below the cost

On 30th May 2018, the company entered into a contract with government department to supply the items at 10% below the cost price.  

Management are responsible to provide proper justification for taking up this project and adjusting the price for supplies. Further, the management shall provide justification how this tender will be beneficial for the company.

While auditing the property, plant and equipment (PPE) for manufacturing entity Green Machine Ltd the auditor identified that the accumulated depreciation and costs have been brought forward. From the previous year’s audit review it is identified that numerous issues are there regarding PPE. The issues are that the entity has issues regarding segregation of revenue expenditure and capital expenditure. Some of the items were charged under expenses whereas it should have been capitalised. In the same way some of the items were capitalised whereas it should have been charged under expenses. Another issue found was that the company uses different rates for different items under PPE and as per the auditor’s depreciation rate applied for some of the assets are significantly low.

2 key assertions found in case of Green Machine Ltd are as follows –

• Existence – main assertion associated with non-current asset like PPE is existence risk. Though going through the case study of Green Machine Ltd nothing is reported regarding the existence issue, it is major step of the auditor to check that the assets recognised in the balance sheet is actually in existence. Further, charging under expenses which shall have been capitalised and vice versa will also be considered as associated with existence risk. This risk will be considered as a major assertion as improper treatment of expenses will have great impact on the profitability of the entity (Kharisova and Kozlova 2014). Further, the company does not follow uniform depreciation rate for all the items under PPE and as per the auditors depreciation rate for some of the assets are significantly low. Hence, likelihood is there that the assets which have become obsolete are recorded as in existence.
• Valuation and accuracy – valuation is considered as an important aspect for the non-current asset like PPE. Asset shall be valued in accordance with the requirement stated under AASB 16. If the valuation method is altered or is not followed in accordance with the required criteria it will have great impact on the true and fair value approach of the organisation regarding presentation of financial statement. Valuation issue is there with the company as it charged some of the expenses under expenses whereas it shall have been capitalised and in the same way some of the expenses have been capitalised whereas it shall have been charged under expenses ((Kharisova and Kozlova 2014). Further, company uses different rates for different items under PPE and as per the auditor’s depreciation rate applied for some of the assets are significantly low. These issues will lead to significant variance in the assets value actual value and what is recorded in balance sheet.

• Existence – At the very 1^ststep of carrying out the substantive procedure for audit of PPE the auditor shall verify the fixed asset register for verifying that the PPE is registered in the name of the entity. Apart from that the fixed asset register will help to verify the additions made to PPE and disposals made during the year. The auditor shall further select some of the vendor’s invoice s and freight bills to verify the purchases made during the year, re-compute the overhead, interest capitalisation. For the constructed PPE the auditor shall check material requisitions, labour rate sheet to analyse the value of constructed asset (Knechel and Salterio 2016). For any disposal made during the year the auditor shall check authorisation of sale, bank statement and deposit slips and remittance advice randomly. Further, the legal title for high value assets under PPE shall be verified.  
• Valuation and accuracy – valuation method established by the organisation for PPE shall be confirmed with the methods actually followed by it for valuing the PPE. Rate of depreciation used for particular item of PPE shall be matched with applicable rate of depreciation for the item and in case of any variance the management shall be asked to provide justification. Further, the repairs and maintenance account maintained by the entity shall be verified to confirm the items those actually should have capitalised and instead they are charged under expenses and vice versa (Carson, Fargher and Zhang 2016).  The auditor shall further verify that the dismantled as well as unsuitable assets are excluded from the amount recognised for PPE under balance sheet.

In case of Green Machine Ltd following key audit matters identified and shall be disclose as follows –

• Different rates of depreciation

Application of Audit Assertions and KAM: Case Studies

Company uses different rates of depreciation for different items recorded under plant, property and equipment

Management are responsible to provide proper justification for applying different rate of depreciation for different items under plant, property and equipment (Gimbar, Hansen and Ozlanski 2015).

• Distinction between capital and revenue expenditure

Some of the items were charged under expenses whereas it should have been capitalised. In the same way some of the items were capitalised whereas it should have been charged under expenses.

Management are responsible to provide proper justification for charging capital expenses under revenue expenses and the revenue expenses under capital expenditure (Cannon and Bedard 2016).

Conclusion 

It is concluded on the basis of above discussion that ASA 701 plays important role while the auditors issue their report as it enhance the quality of the report.  Main assertions contained in the financial statement of Green Machine Ltd were existence and valuation and accuracy. On the other hand, main assertions contained in the financial statement of Advanced Computer Solutions Limited were valuation and accuracy and completeness. Hence, the auditors while issuing their report must mention the key audit matters related to assertions.

Reference 

AICPA, 2017. Statement on Auditing Standards, Number 126: The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern (No. 126). John Wiley & Sons.

Andersen, J., and Hansen, N. B., 2018. Key Audit Matters: En undersøkelse av norske foretak (Master's thesis, Handelshøyskolen BI).

Auasb.gov.au., 2019. Auditing and Assurance Standards Board (AUASB) - Home . [online] Available at: https://www.auasb.gov.au/ [Accessed 16 Jan. 2019].

Cannon, N.H. and Bedard, J.C., 2016. Auditing challenging fair value measurements: Evidence from the field. The Accounting Review, 92(4), pp.81-114.

Carson, E., Fargher, N., and Zhang, Y. 2016. Trends in auditor reporting in Australia: a synthesis and opportunities for research. Australian Accounting Review, 26(3), 226-242.

Cordo?, G. S., and Fülöp, M. T. 2015. Understanding audit reporting changes: introduction of Key Audit Matters. Accounting & Management Information Systems/Contabilitate si Informatica de Gestiune, 14(1).

Gimbar, C., Hansen, B., and Ozlanski, M. E., 2015. Early evidence on the effects of critical audit matters on auditor liability. Current Issues in Auditing, 10(1), A24-A33.

Kachelmeier, S. J., Schmidt, J. J., and Valentine, K. 2017. The disclaimer effect of disclosing critical audit matters in the auditor’s report.

Kharisova, F.I. and Kozlova, N.N., 2014. Applying the category of «Assertions (or preconditions)» In audit of financial statement. Mediterranean Journal of Social Sciences, 5(24), p.180.

Knechel, W.R. and Salterio, S.E., 2016. Auditing: Assurance and risk. Routledge.

Köhler, A., Ratzinger-Sakel, N. V., and Theis, J. 2016. The Effects of Key Audit Matters on the Auditor's Report's Communicative Value: Experimental Evidence from Investment Professionals and Non-Professional Investors.

Mock, T.J. and Fukukawa, H., 2015. Auditors' risk assessments: The effects of elicitation approach and assertion framing. Behavioral Research in Accounting, 28(2), pp.75-84.

Sirois, L.P., Bédard, J. and Bera, P., 2018. The informational value of key audit matters in the auditor's report: evidence from an Eye-tracking study. Accounting Horizons.

Sultana, N., Singh, H. and Van der Zahn, J.L.M., 2015. Audit committee characteristics and audit report lag. International Journal of Auditing, 19(2), pp.72-87.

Vik, C., and Walter, M. C. 2017. The reporting practices of key audit matters in the big five audit firms in Norway (Master's thesis, BI Norwegian Business School).