Auditing Inventory, Intellectual Property: Essay.

Key Assertions at Risk in Relation To Inventory

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. 

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.

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. 

This paper is primarily aimed at identifying and explaining two key assertions which are at risk with regard to inventory as well as identifying and describing two procedures of substantive audit which should be carried out by the auditor in responding to each and every identified risk of assertion. In addition to this, the paper gives an explanation and description of the requirement of ASA 701 with relation to communicating and disclosure of key matters of audit. In addition to this, the paper is purposed for identifying and explaining two assertions which are considered to be at risk with regard to intellectual property intangible asset. Furthermore, this paper is also aimed at identifying and describing a procedure of substantive audit which the auditor should carry out in an effort to respond to each and every risk identified. The requirements of ASA 701 are also explained in this paper with regard to disclosure of intellectual property intangible asset.

1.a. Two Key Assertions at Risk In Relation To Inventory

There are two key assertion which are considered at risk regarding the inventory of Computing Solutions (Eilifsen, Messier, Glover and Prawitt 2013, pp. 27). These are valuation and completeness. Each of these risks have been described in detail in the following sections.

Valuation of inventory is considered at a high risk because Computing Solutions engages and deals with computer packages and computer software which may often become obsolete and outdated with time. This could possibly make their value to be significantly impaired. There is also a possibility that the computer packages and software may not be appropriately valued. This due to the fact that Computing Solutions has been earning high returns resulting from the company’s best-selling packages of computer presentation which have been experiencing software problems and issues. Furthermore, there is a likelihood that Computing Solutions will face difficulties and challenges in returning obsolete and outdated computer packages and software to the specific suppliers involved due to certain issues and technicalities which may not be avoided due to its nature of business. This therefore, puts the inventory of the company at a possible risk of being disvalued (Hayes, Gortemaker and Wallage 2014, pp. 145).

Computing Solutions faces an assertion risk of completeness with regard to its inventory. Completeness relates to appropriate recording of inventory in correct amounts in the financial records. In the process of management of inventory, there is a possibility that the inventory could have been under-stated in the books of the company thus rendering completeness of inventory at a high risk. This can be explained due to the fact that a purchase may be initiated by Computing Solutions but the inventory is not appropriately recorded in the accounting books upon receipt of the inventory (Knechel and Salterio 2016, pp. 231). This risk may be caused by poor or weak controls regarding inventory. For instance, Computing Solutions transferred its inventory from a central warehouse to other six warehouses. There is a possibility that the employees of Computing Solutions could have teamed up and stole the inventory and may not have recorded it in its correct amounts in the inventory account. Also, the consigned inventory which was on consignment should have been appropriately accounted for from the books of the company (Eilifsen, Messier, Glover and Prawitt 2013, pp. 27).

Valuation of Inventory

b. Substantive Audit Procedures that Could be Performed in Response to Each Risk Identified Above

Substantive procedures are those that are carried out by the auditor with a view to verifying or ascertaining the actual figures reported on the financial reports of the client. With regard to the identified assertions risks relating to inventory, the auditor can perform a number of substantive procedures of audit. These have been discussed below in detail (Messier, Glover and Prawitt 2008, pp. 14). These are explained below.

Regarding valuation of inventory, the auditor must inspect the various terms of the various suppliers of the company in order to confirm that there were provisions or terms relating to return of unsold computer packages and other items that were received in imperfect conditions (Louwers, Ramsay, Sinason, Strawser and Thibodeau 2015, pp. 214). Additionally, he must seek to carry out an inspection of inventory records of Computing Solutions with a view to ascertaining if any items or computer packages had become obsolete due to being held for extremely long periods (Hopwood, Leiner and Young 2011, pp. 52). He must confirm that any impairments in the inventory are recorded appropriately and accordingly in the financial records of the company (Eilifsen, Messier, Glover and Prawitt 2013, pp. 27).

Furthermore, according to the requirements of AASB 102, the auditor must consider ascertaining that Computing Solutions has made a valuation of its inventory based on the approach of Lower of Cost or Market value (LCM), which requires inventory to be valued at the lower of cost or market value (Net Realizable Value). To accomplish this, he should recalculate the cost of inventory of the company in order to confirm and ascertain that it has determined the pricing accurately. The auditor must also examine the prevailing trends in the market with a view to gaining an understanding of the current market prices. A comparison of the inventory cost and the prices in the market should be made for purposes of ascertaining whether the inventory was sold for less or more (Hargie and Tourish 2009, pp. 104). Apart from vouching and testing the pricing of inventory, the auditor must also consider carrying out a verification on the quality of inventory of Computing Solutions since some of its computer packages and software have been experiencing problems.

The following procedures must be performed by the auditor with regard to the completeness assertion of the inventory of Computing Solutions (Eilifsen, Messier, Glover and Prawitt 2013, pp. 29).

1. Performing cut off tests for purchase returns, purchases, sales and sale returns. He should make sure that the amounts of these transactions have been recorded appropriately, if any.
2. Carrying out tests for transactions which are possibly omitted as well as testing for transactions which have been regarded invalid with respect to the tagged inventory of the company, Computer Solutions.
3. Verifying the numerical and clerical accuracy of the listing of the items of inventory of Computer Solutions.
4. The perpetual records of the company’s inventory must be reconciled with its physical inventory.
5. The auditor must also consider reconciling the physical counts of the inventory of the company with the totals of the general ledger control account (Hayes, Gortemaker and Wallage 2014, pp. 145).

c. The Requirement of ASA 701 Communicating Key Audit Matters in the Auditor’s Report and the Rationale for This Auditing Standard

ASA 701 was issued or introduced in pursuit of the requirements of the provisions and strategic direction of the legislation that are described below. This standard was set by the AUASB, which is mandated by the Corporations Act of 2001 to make any amendments in the standards of auditing for the primary purposes set out by the legislation of the corporations Act (Moeller 2009, pp. 145). This auditing standard highly conforms to ISA 701. According to the strategic direction that was issued to AUASB by FRC, the former is required to pursue development of standards of auditing which have a clear interest of the public as its major focus, and which are of the best quality (Eilifsen, Messier, Glover and Prawitt 2013, pp. 27). Therefore, this standard was issued or introduced by AUASB with a view to representing the Australian equivalent of ISA 701, which requires independent auditors to communicate or disclose in their audit reports key matters of their audit. As such, this standard was introduced to:

• Mandate disclosure of Key matters of audit in the audit reports of independent auditor for listed firms (Singleton and Singleton 2010, pp. 78).
• Enable independent auditors providing audit services to other non-listed firms to make a decision as to whether or not to disclose the key matters of the audit in their reports.
• To set the guidelines on how the auditor should determine the key audit matters (Eilifsen, Messier, Glover and Prawitt 2013, pp. 27).

Completeness

According to paragraph 9 and 10 of ASA 701, the auditor should determine key matters of audit by examining the matters which are communicated or disclosed by the individuals who are charged with the responsibility of governing the firm (Singleton and Singleton 2010, pp. 78). From these matters, he should identify those which require significant attention in the performance of the company’s audit. With regard to this, the auditor must consider the following in determining the key matters of audit (Eilifsen, Messier, Glover and Prawitt 2013, pp. 27).

• Areas which have a higher assessment of material misstatement risk, as well as significant risks according to ASA 315.
• Significant judgment of the auditor with regard to financial statement areas in which significant judgment of the company’s management has been involved. This includes areas such as estimates of accounting which may have been highlighted to have a high uncertainty of estimation (Singleton and Singleton 2010, pp. 78).
• The impact on significant events’ audit as well as on transactions which took place in the course of the financial period of the company.
• Evaluating matters that are most essential for inclusion in the report of the independent auditor.

Therefore, the independent auditor must seek to determine the matters of audit which required significant attention in the audit of Computing Solutions for the financial period concerned (Porter, Simon and Hatherly 2008, pp. 45).

According to section 11 of ASA 701, the auditor is required to make a description of each and every key matter of audit with an appropriate sub heading “Key Audit Matters” under a separate section of his audit report (Elder, Beasley and Arens 2011, Pp. 14). In the introductory statement, the auditor must mention that “Key audit matters are those which in his professional judgment, were of most significance in the financial audit of the company’s reports and that those matters were addressed in the audit of the financial statement of the entity taken as a whole”. However, it is not a requirement for the auditor to make a report on the situations in which a particular audit matter was regarded as key. The auditor must also give a description of the audit documentation with regard to the key matters of the audit (Nigrini 2012, pp. 123).

According to the requirements of ASA 701, there are a number of disclosures that the auditor must include in the section of Key Audit Matters of his audit report regarding valuation and completeness of inventory of Computing Solutions. For instance, he must make an adequate disclosure on the method of inventory valuation used by Computing Solutions because it is a key audit matter. In addition to this, the auditor must make disclose adequately the completeness of the inventory of Computing Solutions since it appears that it is not appropriately entered in the accounting books of the company in the correct amounts (Cosserat and Rodda 2009, pp. 102).

2.a. Key Assertions Most At Risk In Relation To the Intellectual Property Intangible Asset

The main assertions which are at risk with regard to intellectual property intangible asset of Beautiful Hair Ltd are existence and valuation. These two assertions have been described fully in the following sections.

The existence assertion of intellectual property intangible assets of Beautiful hair ltd is at a high risk. The firm faces a potential risk that the intellectual property intangible assets such as copyrights and production formulas that were held by the acquired firm, Shimmer Pty Ltd, have not been received by Beautiful Hair Ltd and therefore cannot be included in its financial records. This is due to the fact that the secrets of ingredients of production are still concealed and documented by Shimmer’s solicitors, instead of being controlled by the acquiring firm, Beautiful Hair Ltd (Zadek, Evans and Pruzan 2013, pp. 15). This therefore puts the existence of such assets at a risk since it is not certain that they are actually received by the company (Beautiful hair ltd).

Substantive Audit Procedures that Could be Performed in Response to Each Risk Identified Above

Valuation of intellectual property intangible asset is also considered at a high risk because the management of Beautiful Hair Ltd has been advised that is related to the formulas of production is potentially a material and valuable asset of the company (Coderre 2009, 31). The management has therefore recognized it as an intangible asset that has arisen from the acquisition of Shimmer Pty Ltd as required by AASB 3. However, it is clear that the secret ingredients of production are only known to the owner, Shimmer Pty Ltd, and have been documented apparently by their solicitors. Although the intellectual property intangible assets have been recognized as assets by Beautiful hair Ltd in its financial records, they have not yet been passed to the company. This therefore results into a risk that the company could have inappropriately valued the assets and made an incorrect recognition and disclosure.

b. Substantive Audit Procedures That Could Be Performed In Response to Each Risk Identified Above

Regarding existence assertion of intellectual property intangible assets, the auditor inspect and examine the purchase vouchers of Beautiful Hair ltd and perform tests of audit with a view to ascertaining if the company actually owns the intellectual property intangible assets as recognized in their financial records. Additionally, the auditor must review the board minutes with regard to acquisition of Shimmer Pty Ltd in order to ascertain whether or not the formulas of production were actually acquired by Beautiful hair ltd (Bodnar and Hopwood 2012, pp. 21).

The auditor must carry out an inspection of intellectual property intangible asset records of Beautiful Hair Ltd with an aim of ascertaining and confirming the amounts which have been recorded in the financial record of the company. With regard to this, he must seek to make a confirmation as to whether or not the company has consequentially recorded appropriately the impairments that could have occurred to the intangible assets of intellectual property (Eilifsen, Messier, Glover and Prawitt 2013, pp. 27). Furthermore, according to the requirements of AASB 3, the auditor must ascertain that Beautiful Hair Ltd has valued the Intellectual property intangible assets appropriately as per the provisions of this standard (Chan and Vasarhelyi 2018, pp. 25). He should make a confirmation that the intellectual property intangible assets have been valued by the company using either cost-based method of valuation, cost-based approach or income-based approach.

c. The Requirement of ASA 701 Communicating Key Audit Matters in the Auditor’s Report and the Rationale for This Auditing Standard

ASA 701 is a standard which was set by the AUASB, a body that is mandated by the Corporations Act of 2001 to make any amendments in the standards of auditing for the primary purposes set out by the legislation of the corporations Act. This auditing standard highly conforms to ISA 701. This standard was issued or introduced by AUASB with a view to representing the Australian equivalent of ISA 701, which requires independent auditors to communicate or disclose in their audit reports key matters of their audit. As such, this standard was introduced to mandate disclosure of Key matters of audit in the audit reports of independent auditor for listed firms (Singleton and Singleton 2010, pp. 78). The standard also enables independent auditors providing audit services to other non-listed firms to make a decision as to whether or not to disclose the key matters of the audit in their reports. Furthermore, it sets or establishes guidelines which should be used by the auditor determining key audit matters (Eilifsen, Messier, Glover and Prawitt 2013, pp. 27).

Inventory Valuation

Paragraph 9 of the standard sets out guidelines on how the auditor should determine key audit matters. For instance, the auditor can determine key matters of audit by examining the matters which are communicated or disclosed by the individuals who are charged with the responsibility of governing the firm (Singleton and Singleton 2010, pp. 78). From these matters, he should identify those which require significant attention in the performance of the company’s audit. With regard to this, the auditor must consider several areas in determining the key matters of audit. For instance, he must consider the areas with a higher assessment of material misstatement risk, as well as significant risks according to ASA 315. He must also take into account audit areas which require significant judgment of the auditor with regard to financial statement areas in which significant judgment of the company’s management has been involved (Singleton and Singleton 2010, pp. 78).

With regard to the audit of Beautiful Hair Ltd, valuation and existence of the intellectual property intangible assets are both considered key matters of the audit since they must be significantly focused on by the auditor. This is because the level of production made by Beautiful Hair Ltd is highly impacted by the formulas of production which have not yet been disclosed to the company by the acquiree, Shimmer Pty Ltd. (Bodnar and Hopwood 2012, pp. 12). As per the requirements of ASA 701, the auditor must therefore make appropriate disclosures which seek to explain or describe the key audit matters to the intended users of the company’s financial statements. For instance, he must consider making sufficient disclosures with regard to existence and valuation of the intellectual property intangible assets for purposes of assuring the users that such assets are actually controlled by the company and their valuation has been appropriately made as per the requirements of AASB 3 (Arens, Elder and Beasley 2013, pp. 23).

Conclusion

According to the above discussion, the two key assertions with regard to inventory of Computing Solutions are completeness and valuation. In addition to this, the two key assertions which are at most risk regarding the intellectual property intangible assets of Beautiful Hair Ltd are valuation and existence. With regard to these risk assertions, the auditor must perform substantive audit procedures as discussed in the above sections. He should also determine if the assertions are key audit matters and make necessary adequate disclosures as set out by the requirements of ASA 701 (Singleton and Singleton 2010, pp. 77).

References

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