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Definition of Audit of an Entity

Question:

Discuss about the Data Analytics and Risk of Fraud.

Audit of the entity may be defined as an independent examination of the books of accounts of an entity, whether profit making or not, small or big, government or private, prepared by the management. It is using accounting policies and procedures and making use of the estimates and judgements with the view to express and opinion on the financials, whether it is showing the correct view and has been prepared on an unbiased basis. This activity post the closing of the books gives a reasonable assurance to both the internal and external users of the financial statements, a certainty and confidence on the figures quoted. Auditors may use diverse procedures during the audit of an entity depending on the nature of the entity like for a manufacturing concern, emphasis would be on the production areas, sales, purchases of raw material, for a software entity, the emphasis would be on the manpower costs and subcontracting costs, etc. For this, they may use both the substantive and compliance audit procedures, besides checking compliance with the regulatory and reporting norms prescribed by Accounting board and IFRS committee. Substantive audit procedures include the checking the recording of the incomes and expenses in the books with the respective evidences, invoices, bills, delivery challans, whether they are properly dated and signed and stamped, whether appropriate tax has been calculate and paid on it. Furthermore, it also includes within it ambit the verification of the assets and liabilities recorded in the statement of affairs. This includes checking the basis on which respective assets have been recorded, the basis on which the provision is accounted for, etc. This is mainly performed with the objective of determining and confirming that whatever has been recorded in the books materially exists and a false representation or the window dressing has not been done. In case any discrepancies are noted upfront, these are brought to the notice of the management and proper justification is asked for. All the substantive audit procedures are done with the methods including inspection of books of accounts and calculations, observation of the records, external confirmation to be taken from the debtors, creditors, banks, etc., inquiry from the external parties, recalculation and reperformance of significant adjustments, etc. All these substantive procedures are mainly aimed at getting the comfortability on the five basic assertions i.e., completeness, rights, existence, valuation and existence of the assets and liabilities (DeZoort & Harrison 2016).

Substantive and Compliance Audit Procedures

If the materiality of the errors is found to be more, the auditor has to increase the extent of the audit procedures and apply further checking through the use of analytical audit procedures which generally include analysis of key financial ratios, comparison of the actual from the expected and the budgeted figures, variance analysis, etc . Besides this, the auditor also takes note of the internal control existing in the organisation, if it is strongly built, then the risk would be low and hence the level of checking required would be less. Similarly, if the internal control processes and test of designs are adequately built in the organisation, then automatically the risks would be low and hence the level of checking would be low. All this helps the auditor to plan the audit and to determine the nature, extent and timing of the audit (Sonu, Ahn & Choi 2017).

In the case study, DIPL is a printing press, which is being subject to audit by Stewart and Kathy, the newly appointed auditors of the company. The company has undergone many changes with respect to the change in the accounting policies and internal IT system, which again was implemented without much testing and validation by the management, therefore the need to do the extended verification and checking arises so that they can give the reasonable assurance about the financials to its users. We have done the ratio analysis based on the information given for the last three financial years to check the status of liquidity, asset management, debt management and solvency, etc (Raiborn, Butler & Martin 2016).

  1. From the above analysis, it can be inferred that both the current and the liquid ratio are well below the industry trends of 2 & 1 respectively. However, it has somehow reached the figure of 1.5 in current ratio in the last financial year which was required to be maintained as per the loan terms for the loan taken from BDO Finance Ltd.
  2. The debt equity ratio here has increased almost thrice from 41% to 113%, which shows that the company iis now focusing on meetng its financing needs from the outside sources rather than own souces, However, in road to this, the ratio has exceeded the limit of maximum 1 as was asked to do by the loan financing company.
  3. Both the critical asset management ratios, i.e., the receivables cycle and the inventory turnover cycle have shown a drastic increase by approximately 50%, which shows that the company has lost control in maintaining its lag period and collections as a result of which these have increased.
  4. In profitability ratios, all the three ratios show that the company’s profitability has remained more or less constant over the 3 years indicating there is no growth, i.e., stagnancy in the company. (Jones 2017).

Risk identification and mitigation is an important part of nay audit. It is very important that auditor must verify all the records properly so that any kind of risk can be mitigated. It is important on part of the management to support the auditor in all these cases. Three types of risk are a part of the overall auditing process. The first type of risk is inherent risk. Inherent risk in cases where even if the management establishes control, it is not in its hand. This risk does not occur in the general day-to-day activities. These risks cannot be eliminated from the system, they can only be reduced. The second type of risk is the control risk, which occurs when the management has not installed that proper internal control measures, it occurs because of lack of proper management. The management can be held responsible for any kind of damage that might occur because of the same. The last major type of risk is the detection risk which happens when the management, accountant or the auditors fails to identify the errors and flaws in the accounting books and system. The auditor can be held responsible for the same, and it occurs due to lack of professional scepticism on his part (Grenier 2017).

Risk Mitigation in Auditing


The case study of DIPL has many risk factors, the major amongst which are two. First, the company is changing the routine transactions and methods that are used in the course of accounting. The company is adopting new methods without any proper research. It is highly possible that it will lead to misstatement in the books of account of the company. Here, the company has calculated the depreciation using 20 years useful life of the assets as compared to the industry where the useful life has been assumed to be 30 years. It is also changing the method of valuation of the inventories (Knechel & Salterio 2016). All these might lead to over or undervaluation of the accounts and affect the overall functioning of the company. Thus, it is the duty of the company that proper disclosures are given in the books of account, the auditor must check the validity of the same and then make an opinion. It will help in reduction of the overall risk factor that might be involved. The major inherent risk that the company is suffering with is  the installation of the new IT system without proper planning, testing and control. The company is undertaking the same, without conducting nay reconciliation or research. It might affect the overall productivity of the company. The books might be over or dune valued because of the same. It is thus important that before applying such changes, the management of the company must take expert opinion from outsiders, must judge the overall profitability of the system and then take a decision on the same. The auditor must verify the records properly so that any chances of material misstatement are reduced and the company is able to show the true view of its financials (DeZoort & Harrison 2016).

Fraud is generally entered into for the profitability puposes by any of the employee or management of the company in order to make the profist by window dressing the books of acounts. Often there are certain personal motives involved behind taking such actions. It is important that while conducting audit, the auditor must apply all kind of procedures so that fraud risk factor can be easily identified and mitigated by the company. This is the most important work of an auditor and it is very necessary that the management of the company provide full support to the auditor. In the given case study of DIPL, there are many fraud risk factor which indicates that there may be material misstatement. Some of them are identifiable and can be mitigated. The major one of them is non segregation of duties amongst the management. Single person handles all the major departments, if that person defalcates the accounts. It will be very difficult for the management to ascertain the same. In this case, we can see that a single personnel has been given all the responsibilities of invoicing, collection, verify the payment, manging all the ledger accounts and reconciliation of the accounts at the end of the period. Moreover the entire cash department which is one of the critical resouces is being handled by a single person in the organisation is there is no control over it. Thus, what is important that the company properly segregate the work, so that proper authority and responsibility can be established? The auditor must see to it that the boos of the company and checked weekly and surprise checks must be undertaken to judge the sincerity of the employees. If any of the employees is found guilty, he must be restricted form the work. Proper it security locks and control system moist be there so that any somewhat mis-happening can be easily avoided (Fay & Negangard 2017).


The second fraud risk factor might be present in the installation of the new It system; the management of the company installed the same without taking any precautions. The management may themselves be directly responsible for all this as there might be personal hidden motives behind all this such that no one is able to track the frauds, if any, amidst all this. It is thus important as an auditor to gets all the necessary information regarding the new system and reconcile the overall cost and profit. In such a case, it becomes immensely significant that nothing is undervalued or overvalued. The management must take expert opinion, pre installation cost and the management must properly segregate post installation result. It is not only the responsibility but the control mechanism which must be set and practiced by both the company as well as the auditors to have a surprise audit and continuous tracking of the major financials to avoid any fraud by the employees of the company. All this will lead to paving the way for quality audit and follow up procedures and clean books of accounts. (Bae 2017)

References

Bae, SH 2017, 'The Association Between Corporate Tax Avoidance And Audit Efforts: Evidence From Korea', Journal of Applied Business Research, vol 33, no. 1, pp. 153-172.

DeZoort, FT & Harrison, PD 2016, 'Understanding Auditors sense of Responsibility for detecting fraud within organization', Journal of Business Ethics, pp. 1-18.

Fay, R & Negangard, EM 2017, 'Manual journal entry testing : Data analytics and the risk of fraud', Journal of Accounting Education, vol 38, pp. 37-49.

Grenier, J 2017, 'Encouraging Professional Skepticism in the Industry Specialization Era', Journal of Business Ethics, vol 142, no. 2, pp. 241-256.

Jones, P 2017, Statistical Sampling and Risk Analysis in Auditing, Routledge, NY.

Knechel, WB & Salterio, SE 2016, Auditing:Assurance and Risk, 4th edn, Routledge, New York.

Raiborn, C, Butler, JB & Martin, K 2016, 'The internal audit function: A prerequisite for Good Governance', Journal of Corporate Accounting and Finance, vol 28, no. 2, pp. 10-21.

Sonu, CH, Ahn, H & Choi, A 2017, 'Audit fee pressure and audit risk: evidence from the financial crisis of 2008', Asia-Pacific Journal of Accounting & Economics , vol 24, no. 1-2, pp. 127-144.

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