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1.As an auditor, you are conducting your preliminary analytical procedures based on the background information for DIPL contained in the case. Apply analytical procedures to the financial report information of DIPL for the last three years. Explain how your results influence your planning decisions for the audit for the year ending 30 June 2015.

2.You are conducting your risk assessment of DIPL, as part of the planning for your audit for the year ended 30 June. Identify two inherent risk factors that arise from the nature of DIPL’s business operations. Explain why it is a risk and how it may affect the risk of material misstatement in the financial report.

3.As part of your audit of DIPL for the year ended 30 June 2015, you are considering the risk that fraud may have occurred

(a) Based on the background information for DIPL contained in the case, identify and explain two key fraud risk factors relating to misstatements arising from fraudulent financial reporting to which DIPL may be susceptible.

(b) Explain how the risk factors identified in (a) above would affect the conduct of the (a) audit. 

Analytical Procedures and Planning for the Audit of DIPL

1.The procedures performed by the auditor at the end of the year to abet the auditor to form an overall opinion about the financial statements in his report are called Analytical Procedures. It is so worked out to ascertain the fact whether the financial statements are consistent with the auditor’s understanding of the firm. If any inconsistency or any significant changes are being observed, then the auditor will either make enquiries with the management or those charged with governance or the auditor carries out further audit procedures so as to make in depth analysis of his observations indicating towards inconsistency. It helps to compare the financial information with previous years by determining the possible relationships between both non financial and financial data. As per the given case study of DIPL, the main key ratios are being calculated to perform analytical procedures so as to accordingly formulate the planning process based on these results :

  • In interest coverage ratio, we observe a drastic decrease in the paying capability of interest by the company that is, from almost 41% to 5% approximately due to heavy interest expenses on the company.
  • The gross profit margin shows a decrement of 1% almost in the three years which is not of susceptible nature as such. However, due to presence of allot of susceptible factors, gross profit margin also comes under the suspicion (Basu, 2009).
  • The debt equity ratio is calculated only for this year, that is, 0.61. The company has an obligation that it is to maintain a current ratio of at least 1.5 and debt equity should be below 1 otherwise the loan giver would recall the loan amount. Being under pressure, it can be the case that to show a high shareholder's equity balance, the company manipulated the books that the income tax liability came to Rs. 87116 on a profit of Rs. 3059299. Also in comparison to previous year retained earning balances, there in an unusual increase in the value of the retained earnings inspire of facing heavy expenditure in this current year such as new It System, takeover of a new company named as Nuclear Publishing Ltd., purchase of fixed assets in large amount etc. Thus, such a case requires detailed examination of books.
  • The current ratio of current year is 1.50 while of previous years, it is 1.42 (2013) and 1.47 (2014) which indicates a favorable condition as current ratio is an indication of liquidity of the company. However, the true indication of the liquidity of the company is Quick Ratio as the current assets excludes the inventories amount so as to determine the readily cash available in hand as inventories cannot be converted into cash instantly. However, the quick ratio of the current year is 0.85 which is lower than the previous year of 2014 that is, 0.94 meaning that the actual cash is not much available in the hand if in case, the company is required to pay its short term obligations instantly. This is not a good sign as the % of fall in cash in hand has reduced drastically this year in comparison to previous years indicating towards unusual transactions or expenses the company may hand indulged into this year.
  • Coming to Return On Equity % and EPS calculation, the profit before tax in 2015 is Rs. 3059299 but the income tax shows an amount of Rs. 87116, which is just not possible, without any manipulations. It may be so as to show high net earnings as the EPS for 2013 is Rs. 104.85, for 2014 is Rs. 101.84 but the current year's EPS is Rs. 132 approximately. Such calculation of PAT (Profit after Tax) needs a justification as the calculation of income tax is too low according to the operations which may be to show high EPS so as to win the confidence of the investors in the company. Also, such calculation of net earnings may also be done so as to lift up its return on equity % from previous years as it reveals the % of return the investors are receiving on their investment(Blank, 2014).

2.While carrying out the auditing process, to identify the risk where the material misstatements exist or not Risk assessment procedures are being used. It is an important step as to find out whether the books are free of misstatements or not is the whole aim of auditing the financial statements (Boynton & Johnson, 2006).

One of the major types of audit risk is Inherent risk which means the risk arising out of manipulating information or omission in financial statements due to certain reasons but not due to failure of controls. The reason behind the occurrence of Inherent risk is due to heavy use of sampling, large number of similar transactions, disclosure to the misstatements that can be material, human intuitions, or a number of small misstatements contributing to a material misstatement together. The auditor assesses this kind of risk on the basis of his intuitions & judgment and his understanding of the firm’s nature and operations (Cahill & Kane, 2011).

Taking into account, the present case of Double Ink Printers Ltd. (DIPL), where the books are being closed on 30th June, following are the two inherent risk factors that arises out of the company's nature & operations (GUPTA., 2016):

Control over Inventory: The inventory of this company basically consists of paper, ink & binding materials, which are to be specified as materials not of high value. The inventory when received is kept at the warehouse and the entry is being made by the accounts payable clerk on the arrival of it specifying the value & quantity in the books. The risk observed in this case :

It is nowhere mentioned that when the inventory is being received, there is a physical check of inventory. Only one in-charge is being appointed who passes the entry on the arrival. However, it is a susceptible point because it may happen the person responsible may record the entry of less inventory in his books rather than what is being actually received and the balance he sells it personally to the outside parties and enjoys the entire earning without actually paying for any cost of production (Horngren, 2017).

Inherent Risk Factors Arising from the Nature of DIPL’s Business Operations

The warehouse closes only at the year end for the last two days which can be susceptible as inventories are something that can be stolen. The employees can use the raw materials for their own personal use. A periodic stock counting should take place rather than conducting it only at the year end as stock taking only at the year end won't reveal the regularity or irregularity of stock at the month end. Theft is a very common risk in this case as the items missing can either be ignored or can be claimed as discrepancies and therefore, the employees remains on the safe side.

Appointment of New CEO & a new internal audit firm in January, 2015: The Company appointed a new CEO in almost in the mid of the financial year without mentioning much reasons and explanations (Griffin, 2009). The previous CEO was semi-retired but wasn't on the verge of being replaced. Enquiries are to be made so as to analyze the true reasons of such a step either by having a word with previous CEO or the other members of the company. Also, the board now formed an internal audit department that indicates that previously it had no such internal audit procedures. This is susceptible in a way as it indicates a pressure over the company or maybe some problems in the operations of the company or maybe the level of misappropriations are increasing which the company is not being able to identify but is only facing the consequences. All these can together create a pressure on the firm that made it to form an entire separate audit department so as to rectify the areas prone to errors or frauds (Hooks, 2011).

3.Fraud is an act which is performed by one or more individuals, intentionally, among the management itself be it the third parties or employees or the top level management, so as to enjoy an illegal advantage (Knechel, Salterio & Ballou, 2017). The factors that gives rise to a pressure or an incentive that can result in committing fraud is called Fraud Risk Factors. It can be generally classified into three conditions that usually exist when a fraud occurs – opportunities, Attitude/Rationalization and incentives.

Based on the given case study, DIPL is susceptible to the two key fraud risk factors which is hereunder:-

Plant and Equipment Asset Valuation : There is an increment of Rs. 5,25,000 in the value of plant and equipment from 2013 to 2014 while the accounts shows a purchase of Rs. 76,50,000 of plant &  equipment in 2015. However, the loan obtained from BDO Finance Ltd. is Rs. 75, 00,000. Also, the company made an unusual hasty decision of adopting a computerized accounting system in June, 2015 itself (Khan and Jain, 2013). Thus, the purpose of loan is not being clearly understood. Also, it is susceptible that under what conditions, the company directly took the decision of taking such a big amount as loan as well as on the other hand, it is suddenly showing a high value of asset in its books. Therefore, the following points are to be considered :

Fraud Risk Factors Relating to Misstatements Arising from Fraudulent Financial Reporting for DIPL

(i).  In the board year meeting, the estimated life of the printing presses was changed to 30 years instead of 20 years which is commonly adopted in the industry for the depreciation purpose. Changing the estimated life from 20 years to 30 years would definitely be showing less depreciation but it may also happen that it is to compensate for the overall heavy depreciation amount in comparison to previous two years(Whittington & Pany, 2016).

(ii). Also, such a decision is being taken only on the basis of the CEO's experience which actually goes against the policy being adopted in the printing industry(Pitt, 2014).

(iii). It may happen that by showing a high value of assets in its books, the company wants to show its financial position strong to the stakeholders so as to enjoy smooth public funding in future. 

Adoption of New IT System : The board under extreme pressure invested in the new IT system so as to automate the entire accounting processes (Ramaswamy, 2015). It created a heavy pressure on the IT department to install the system in the June, 2015 itself when the company is supposed to close its books. The IT manager claimed that sudden change of the entire system of recording accounting transactions is messing up the entire scenario as neither the staffs are presently being properly trained nor proper testing or handling of the installations is being created (Messier, 2016).

Such an action is an opportunity to conduct fraud as it can clearly be stated at the end that during the transfer of accounting information into computerized system, the transactions were missed or lost due to the inefficiency or less knowledge about the system by the staff. Also, in this way, the person intending to commit fraud can misappropriate the cash balance or can make the management overlook the fraudulent transactions that has been conducted in the respective financial year. For example, a director conducted some transactions with the third party on the name of the company and sold the goods & enjoyed the earnings on his personal account. Taking advantage of his position, he painted the scenario in such a way that the goods sold were actually considered as goods lost in the eyes of the management (PAVAN, 2014). Now suddenly, a new internal audit team in January, 2015 was formed which would clearly rectify such a fraudulent activity. Therefore, under immense pressure, it may happen that the new IT system was formed in June, 2015 itself so as to get such fraudulent activities ignored and at the end, the accounting department's inefficiency could be blamed.

It is credulous in a manner that such valuation can be for the purpose of winning the stakeholders trust to as to enjoy the funding in the future and use such funding for fraudulent purposes. Thus, Such unusual transactions & unjustified decisions serve as indication of Fraud risk factors.

References

Basu, S. (2009). Fundamentals of auditing. Delhi: Pearson.

Blank, R. (2014). The Basics of Quality Auditing. Hoboken: Taylor and Francis.

Boynton, W., & Johnson, R. (2006). Modern Auditing. Hoboken: John Wiley and Sons.

Cahill, L., & Kane, R. (2011). Environmental health and safety audits. Lanham, MD:Government Institutes.

Griffin, M. (2009). MBA fundamentals. New York, NY: Kaplan.

GUPTA. (2016). FINANCIAL ACCOUNTING FOR MANAGEMENT. [S.l.]: PEARSON EDUCATION INDIA.

Horngren, C., Datar, S. and Rajan, M. (2017). Horngren's cost accounting. Harlow, Essex, England: Pearson Education Limited.

Hooks, K. (2011). Auditing and assurance services. Hoboken, NJ: Wiley.

Knechel, W., Salterio, S., & Ballou, B. (2017). Auditing. New York: Routledge.

Messier, W. (2016). Auditing & assurance services. [Place of publication not identifiedMcgraw-Hill Education.

Khan, M. and Jain, P. (2013). Management accounting. New Delhi, India: McGraw-Hill Education (India).

Kumar, P. (2014). CA-IPCC Auditing and Assurance. Delhi, India: S. Chand Publishing.

Pitt, S. (2014). Internal audit quality. Hoboken: Wiley.

Ramaswamy, M. (n.d.). Finance for nonfinancial managers.

Whittington, O., & Pany, K. (2016). Principles of auditing & other assurance services. NewYork, N.Y.: McGraw-Hill Education.

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