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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.

Accuracy and Valuation Assertion

At the time of providing the audit clients with the auditing and assurance services, the primary responsibility that the auditors have is scrutinizing the accounting books and accounting records of the audit clients in order to make sure that there is not any material misstatements in them that can affect the decision-making process of the company’s key stakeholders like shareholders, suppliers and others (Byrnes et al. 2018). In the process of auditing, the auditors have the responsibility to undertake the testing of many aspects related to the clients’ financial statements and one of them is audit assertions that the management team of the clients use for the preparation and presentation of the financial statements. As per the description of the audit assertions, they are the open or inherent declarations made by the clients’ managements for the preparation and presentation of the financial statements. The main reason behind the use of assertions is to ensure the appropriateness and correct disclosure of the financial information through the financial statements (Green and Zhou 2013). It is required for the auditors of the companies to test that whether the assertions are correctly used by the management team as there is a chance of the creation of audit risks due to the inappropriate use of the audit assertions (Hay, Knechel and Willekens 2014). In case the audit assertions are at risk, the auditors are needed to determine whether they are the key audit matters as per ASA 701. The objective of this report is the examination of the audit risk assertion from the given scenarios.

 Accuracy and Valuation: As per this assertion, inventory transactions are free from error when they are accurately valued. For this reason, the companies are needed to take two major initiatives (Knechel and Salterio 2016). First, they are needed to accurately value the physical inventory figure; second, they must ensure that correct amount of inventory flows from the balance sheet to income statements in the form of cost of goods sold. Hence, the accurate valuation needs to be ensured. Physical inventory count process can be troubled when the whole inventory base is moved to one place to another place or places and the same aspect can be seen in Advanced Computer Solutions (Wood, Brown and Howe 2013). The reduction in the inventory turnover can be due to the fact that there was some errors in the physical inventory count process. Hence, this assertion can be regarded at the risk.

Cut Off Assertion

Cut off: According to this assertion, the companies are needed to ensure the correct reporting of the inventory transactions; it means the transactions are needed to be recorded at the proper dates (Titera 2013). The receiving as well as suppliers documents of inventory assist the companies in doing this. It states that it is wrong when the inventory of current year includes the inventory of previous year as this aspect indicates towards incorrect valuation of inventory. The given scenario of Advanced Computer Solutions states that the inventory in hand of 2018 includes 26 percent sales of 2018 and 18 percent sales of 2017. The main reason for this can be the return of the best-selling computers of the company due to the presence of software problems (AICPA 2017). At the same time, the inventory valuation process of the company includes significant judgements and estimated from the management. Thus, this assertion can be considered at risk.

As a part of this particular audit assertion, it is needed for the auditor to observe the processes under the physical inventory count in the methodical manner (Cannon and Bedard 2016). In this process, the auditor needs to obtain full understanding of the strengths and weaknesses of the internal control for inventory count process. The auditor is needed to observe the inventory counting process when it is being carrying out. After that, it is needed for the auditor to ensure the verification of the all inventory count tags in. Lastly, the auditor is needed to test the inventory in all the six warehouses and ask for the conformation of the count from the central warehouse (Cannon and Bedard 2016).

For the audit assertion of cut off, it is needed for the auditor to undertake the analysis and examination of the inventory vouchers for goods received at warehouses and goods delivered to the suppliers (Ralph 2019). After that, the auditor is needed to verify whether there was any occurrence of unreasonable transactions in the inventory that caused the specific issues. After that, it is needed for the auditor to undertake the examination of the judgements and accounting assumptions that the management of the company used for the valuation of their business inventory (Ralph 2019).

Section 7 of ASA 701 states that the auditors need to determine the key audit matters, prepare the audit opinion based on this and communicate and disclose the same in the auditor’s report. Section 8 of ASA 701 states that key audit matters are the issues or substances that the auditor declare as essential for the audit of the company’s financial reports (auasb.gov.au 2019). Discussion with the governance authority of the companies is needed for the determination of the same. Section 9 of ASA 701 states that the auditors are needed to maintain compliance with three basic objectives in the analysis of key audit matters (auasb.gov.au 2019). They are the consideration of the areas in the financial statements that have high risk of material misstatements; consideration of the presence of uncertainties in the judgments as well as accounting estimated and consideration of the impact of crucial incidents and events on the audit of the financial statements (auasb.gov.au 2019). Apart from this, Section 10 of ASA 701 puts the obligation on the auditors to take into consideration the significant events or transactions that are crucial for the audit of the financial statements (auasb.gov.au 2019).

Accuracy Assertion

There are three rationales that support that these assertions at risks are key audit matters. First, there can be material impact in the financial statements of Advanced Computer Solution due to the inaccurate valuation of the company’s inventory (Cordo? and Fülöp 2015). Second, uncertainties can be seen in the judgements and accounting estimates as the management has used them for the valuation of inventory. Third, the transfer of the inventory from one central warehouse to six regional warehouses is the significant event as per the auditors as it can have major impact on the audit of the financial statements of Advanced Computer Solutions (Cordo? and Fülöp 2015).  

Why important

How Audit Resolved the Key Audit Mattes

Relocation of Inventory

On March 2018, the company has relocated their inventories to six new warehouses from a central warehouse which is a significant event for the valuation of inventory. In addition, inventory valuation of this company involves essential estimates and judgments that are crucial to audit.

The audit procedures are:

- Observe the processes under the physical inventory count in the methodical manner

- Obtain full understanding of the strengths and weaknesses of the internal control for inventory count process

- Observe the inventory counting process when it is being carrying out

- Verification of the all inventory count tags

- Test the inventory in all the six warehouses and ask for the conformation of the count from the central warehouse

Inventory of 2018 consists of the sales of 2017 and 2018

Sales of 2017 are included in the inventory in hand of 2018 and it is a significant transaction from the audit perspective. In addition, it includes accounting estimates and judgements.

 The audit procedures are:

- Analysis and examination of the inventory vouchers for goods received at warehouses and goods delivered to the suppliers

- Verify whether there was any occurrence of unreasonable transactions in the inventory that caused the specific issues

- Examination of the judgements and accounting assumptions

Accuracy: As per this audit assertion, business organizations have the commitment towards accurate valuation of their property, plant and equipment (Warren Jr, Moffitt and Byrnes 2015). The use of this assertion also demands that the companies ensure the proper division of the capital and revenue expenses related to property, plant and equipment. In addition, all the data and information relates to the expenses need to be maintained. The provided case study shows the incorrect division of the revenue and capital expenditure by the company and it affects the accuracy assertion of audit. In addition, it indicates that the used judgements and estimates may be at risk due to this improper division of the expenses. For this reason, this assertion can be considered at the risk (Lessambo 2018).

Valuation: As per this assertion, the need for the companies is to record all the assets, liabilities and equity after accurate valuation. In addition, companies are needed to record the property, plant and equipment at cost after deducting accumulated depreciation (da Silva and Dantas 2018). Accumulated depreciation can be obtained with the application of fare rates of depreciation. However, as per the given information of Green Machine Ltd, low rates of depreciation have been applied on the property, plant and equipment that contributed towards the incorrect valuation of these non-current assets. It can misstate the net profit and create material impact on the financial statements. At the same time, depreciation process of the company includes management’s judgements and estimates that can be hampered with this aspect (Alali 2018). For these reason, this assertion can be considered at risk.

In case of the first assertion at risk, the substantive audit procedure for the auditor is reviewing both the capital as well as revenue expenditures associated with the property, plant and equipment with the aim to obtain proper understanding (Feng et al. 2014). After that, the auditor needs to re-examine the policies to capitalize the expenses of the company. The next step for the auditor is to re-examine the used judgements and accounting estimates for the determination of the capital as well as revenue expenditures associated with property, plant and equipment. Moreover, verifying the source documents related to property, plant and equipment expenditures is another major step for the auditors as substantive audit procedures (Feng et al. 2014).

Valuation Assertion

In case of the second assertion at risk in Green Machine Ltd, the most crucial substantive audit process will be reviewing the company’s policies and mechanism for the determination of rate of depreciation (Hall 2015). After that, it is needed for the auditor is recalculating the rates of depreciation while observing the depreciation ratios. In addition, the auditor needs to ensure re-examination of the residual value of property, plant and equipment along with any loss or gain from the sales of the same. Lastly, the auditor needs to undertake the verification of the use judgements and accounting estimates in the depreciation process (Goncharov, Riedl and Sellhorn 2014).

Clause 7 of ASA 701 dictates that the auditors require determining the key audit matters, preparing the audit opinion based on this and communicating and disclosing the same in the auditor’s report (cpaaustralia.com.au 2019). Clause 8 of ASA 701 shows that key audit matters are the issues or substances that the auditor consider as indispensable for the audit of the company’s financial reports. Conversation with the governance authority of the companies is compulsory for the determination of the same (auasb.gov.au 2019).

Clause 9 of ASA 701 tells that the auditors are needed to continue conformity with three basic objectives in the examination of key audit matters (home.kpmg 2019). They are the consideration of the areas in the financial statements that have high risk of material misstatements; consideration of the presence of doubts in the judgments as well as accounting approximates and consideration of the effects of crucial incidents and events on the audit of the financial statements (home.kpmg 2019). Apart from this, Clause 10 of ASA 701 puts the obligation on the auditors to take into consideration the noteworthy events or transactions that are essential for the audit of the financial statements of companies (auasb.gov.au 2019).

As per ASA 701, these assertions at risk are considered as key audit matters in the presence of three reasons. First, the inaccurate consideration of the depreciation rates along with the inaccurate distinction between the revenue and capital expenditures can create major material effects by overstating the expenses and misstating the net profit (Sirois, Bédard and Bera 2018). Second, the above-mentioned aspects in Green Machine Ltd include the crucial accounting estimates of the management along with certain judgments which can include major uncertainties. Third, wrong application of depreciation rate and wrong distinction of expenses can be considered as significant events or transactions that have major impact on the audit of the financial statements of Green Machine Ltd (Sirois, Bédard and Bera 2018).

Why important

How Audit Resolved the Key Audit Mattes

Incorrect distinction of capital and revenue expenses

It can be seen from the given scenario that the company has capitalized certain revenue expenses and certain capital expenditures have been included in the income statement; and this incident is crucial for the audit of the company. In addition, it includes judgements and estimates that are crucial for the audit.

The audit procedures are:

- Reviewing both the capital as well as revenue expenditures associated with the property, plant and equipment

- Re-examine the policies to capitalize the expenses

- Re-examine the used judgements and accounting estimates for the determination of the capital as well as revenue expenditures

- Verifying the source documents related to property, plant and equipment expenditures

Application of low rates of depreciation in property, plant and equipment

Too low rates of depreciation have been applied on the property, plant and equipment and it can lead to material impact on the company’s financial statements. Moreover, the management has used accounting estimates and judgements that are crucial for auditing.

The audit procedures are:

- Reviewing the company’s policies and mechanism for the determination of rate of depreciation

- Recalculating the rates of depreciation while observing the depreciation ratios

- Re-examination of the residual value of property, plant and equipment along with any loss or gain from their sales

- Verification of the use judgements and accounting estimates

Conclusion

It can be concluded from the above discussion that the audit assertions form a crucial part in the whole audit process due to the fact that it assists in the determination of key audit matter. The managements of both Advanced Computer Solutions and Green Machine Ltd used certain assertions like accuracy, valuation and cut off. The above discussion also shows that the auditors can obtain the required guiding principles to derive the key audit matters from the standards of ASA 701 Key Audit Matters where the auditors are needed to consider certain requirements. In addition, the auditors are needed to develop the substantive audit procedures after the detection of the key assertions at risk.

References

AICPA, 2017. Audit guide: Audit sampling. John Wiley & Sons.

Alali, F., 2018. Teaching Students Financial Statements’ Assertions: Crisp-Drinks Case. Journal of Forensic & Investigative Accounting, 10(3).

Auasb.gov.au. 2019. [online] Available at: https://www.auasb.gov.au/admin/file/content102/c3/ASA_701_2015.pdf [Accessed 19 Jan. 2019].

Byrnes, P.E., Al-Awadhi, A., Gullvist, B., Brown-Liburd, H., Teeter, R., Warren Jr, J.D. and Vasarhelyi, M., 2018. Evolution of Auditing: From the Traditional Approach to the Future Audit 1. In Continuous Auditing: Theory and Application (pp. 285-297). Emerald Publishing Limited.

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.

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).

Cpaaustralia.com.au. 2019. [online] Available at: https://www.cpaaustralia.com.au/~/media/corporate/allfiles/document/professional-resources/auditing-assurance/submission-auasb-exposure-draft-on-auditor-reporting-issues.pdf?la=en [Accessed 19 Jan. 2019].

da Silva, T.C. and Dantas, J.A., 2018. Audit Assertions and Change of Auditors' Opinion in the Brazilian Market. Revista de Educação e Pesquisa em Contabilidade, 12(1).

Feng, M., Li, C., McVay, S.E. and Skaife, H., 2014. Does ineffective internal control over financial reporting affect a firm's operations? Evidence from firms' inventory management. The Accounting Review, 90(2), pp.529-557.

Goncharov, I., Riedl, E.J. and Sellhorn, T., 2014. Fair value and audit fees. Review of Accounting Studies, 19(1), pp.210-241.

Green, W. and Zhou, S., 2013. An international examination of assurance practices on carbon emissions disclosures. Australian Accounting Review, 23(1), pp.54-66.

Hall, J.A., 2015. Information technology auditing. Cengage Learning.

Hay, D., Knechel, W.R. and Willekens, M. eds., 2014. The Routledge companion to auditing. Routledge.

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

Lessambo, F.I., 2018. Financial Statements’ Audit. In Auditing, Assurance Services, and Forensics (pp. 289-307). Palgrave Macmillan, Cham.

Ralph, C. 2019. KAM: Auditor’s report snapshot – March 2017. [online] KPMG. Available at: https://home.kpmg/au/en/home/insights/2017/03/key-audit-matters-auditor-report-28-march-2017.html [Accessed 19 Jan. 2019].

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.

Titera, W.R., 2013. Updating audit standard—Enabling audit data analysis. Journal of Information Systems, 27(1), pp.325-331.

Warren Jr, J.D., Moffitt, K.C. and Byrnes, P., 2015. How Big Data will change accounting. Accounting Horizons, 29(2), pp.397-407.

Wood, J., Brown, W. and Howe, H., 2013. IT Auditing and Application Controls for Small and Mid-Sized Enterprises: Revenue, Expenditure, Inventory, Payroll, and More (Vol. 573). John Wiley & Sons.

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