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.
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.
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 dentified in (a) above would affect the conduct of the (a) audit
There is a need for the application of preliminary analytical procedures so as to carry out audit planning in a prudent manner. In relation to the choice of accounting policy for representation and disclosure, it seems that the entry of current CEO has suggested some suspicious changes which seem to be driven by self-interest rather than the interest of the company (DIPL) and the shareholders. The various changes initiated by the CEO tend to indicate the same as explained below (Arens et.al., 2013).
Before the coming of the new CEO, DIPL had a policy where for storage hazard, provision for inventory obsolescence was charged. However, the new CEO suggested that such a provision was not required. Due to this, in 2015 there was an allowance for inventory obsolescence write off to the extent of $ 155,588 in the income statement. This policy seems to be driven by the intention on part of the CEO to maximise the remuneration as one of the components driving the performance bonus is the 10% rise in net profit after tax.
The CEO has also suggested that the permissible life of the printing press can be extended to 30 years instead of the current 20 years that DIPL takes into consideration. This is despite the fact that a peer group company also pegs the useful life of the asset at 20 years. The intention of the CEO behind increasing the useful life of the asset is to lower the depreciation expense which in turn would lead to higher profits after tax being generated which would maximise the performance bonus.
Also, in wake of the increasing paper (raw material) cost, the CEO has questioned the average cost method of inventory that the company currently deploys. The suggestion is to shift to FIFO or First in First Out. In a situation when the cost of raw material is increasing, the FIFO method would increase the value of closing inventory but underrepresent the cost involved in the book printing. This seems to be again prompted to lower the overall cost in a bid to inflate the profits and hence maximise the performance bonus. The appropriate inventory policy in an inflationary environment would be LIFO (Last in First Out) as it would represent the rising raw material cost in the income statement which is critical to maintain an appropriate pricing for the book printing.
Further, the revenue policy in relation to the e-books seems suspicious as it has been suggested by Cody who has been brought in by the new CEO only. Further, the change in the policy seems to have driven a rise in the revenue which is apparent from the surge in revenue in 2015. This increasing revenue would enable the new CEO to maximise the performance bonus as it is linked to revenue hike coupled with profit rise and both would be served by change of revenue policy of e-books especially considering the growing revenue realisation from e-books.
Also, the financial statements of the company are provided for the preceding three years based on which certain key observations could potentially be made which would be useful from the perspective of audit planning (Caanz, 2016).
The revenue rise during 2014-2015 stands at 17%, however the accounts receivables have surged in excess of 50% which is absurd and it is imperative to understand the reason behind the same.
As a result of change in the inventory valuation from average cost coupled with rising paper costs, there has been a sudden jump in inventory in 2015 balance sheet. This change has been prompted on one hand to keep the costs of goods sold low, profits higher and also to boost the current ratio which is linked to the loan covenant.
Based on the information provided, it is apparent that there are serious questions over the existence of relevance of NPL medical books considering the new research but the 2015 financial statements have failed to recognise this in the financial statements and no provisioning for write down of intangible assets ($ 975,000) has been made. This does not lead to correct reporting on the part of the company.
The given information reflects that the company has assumed an incremental non-current borrowing of $ 7.5 million and also mentions the various related debt covenants. However, it is not highlighted as to why the company would require the same so as to factor in additional risk of any new venture that might be in the pipeline.
Considering that the company has a policy whereby the past credit history is taken into consideration before any new order is processed, the increasing quantum of bas debt on the books of the company seem to be suspicious. A further, disturbing trend in this regard is the constant increase and thus this reflects a lapse in the policy of the company which needs to be identified and suitably modified.
The extent of discount that is being offered by the company has increased at a pace which is higher than the corresponding increase in sales which hints at the business undergoing issues in generation of sales which does not seem to be reflected in the given information.
Additionally, the percentage of bad debt in terms of accounts receivables seems exceptionally high for 2014 while in 2015, this is not reflected. Explanation needs to be sought from the management with regards to this trend.
It is apparent from the various points highlighted above that during the planning of audit the critical aspects would be revenue recognition policy particularly with regards to e-books, valuation of inventory along with obsolescence, accounts receivable and underlying collection of outstanding amount, recognition and reporting of bad debts along with provisions for write off of intangible asset and possible impairment. Besides, management explanation for the current policy with regards to the above along with $ 7.5 million loan assumed in 2015 needs to be sought. The intention of the CEO seems dubious and even though the internal audit department has been appointed, it seems that the internal controls would continue to remain weak due to the influence of the new CEO and relevant provisions in audit planning need to be made to reflect the same (Gay and Simnett, 2012).
One of the components of audit risk is inherent risk which is present in the business intrinsically and is independent of the effectiveness of the controls erected to minimise the audit risk. This is because this is related to the nature of business transactions where some of the transactions are more susceptible than the other (Caanz, 2016). In the given case, it is obvious that print on demand revenues would not be the future growth engine considering the penetration of ebooks. As a result, DIPL is also looking to diversify the revenue stream by venturing into online content. The company has also acquired NPL which has only copyright content. Further, it is also learnt that this business also has higher margins which make it more lucrative. However, with technical content, one risk is the obsolescence risk which is apparent based on the information given in the case. On account of new discoveries, it is possible that the content available may be rendered useless and hence there would a sizable write down of intangible assets that would be required to reflect in the income statement. Ability to reflect any obsolescence in the content in an accurate and timely manner gives rise to the audit risk and is attributed to inherent risk (Leung, Coram and Cooper, 2012).. Also, in relation to the e-books, there is the risk of stealing which would adversely impact revenue and hence give rise to inherent risk.
An additional inherent risk is with regards to the performance bonus of the CEO along with the debt covenants for the company. The performance bonus of the CEO is linked to the profit after tax growth while the debt covenant requires current ratio to be kept over a certain limit. It seems that the accounting policies could be twisted by the CEO with the aid of board so as to simultaneously achieve both these objectives. For instance, consider the FIFO inventory policy suggested in wake of rising paper costs. Through FIFO, the cost of production would be lowered leading to higher PAT growth. Further, the inventory indicated would also be higher which would swell the current assets and hence make the current ratio healthy. Further, the revenue realisation policy may also be misrepresented to book the revenues which imply higher performance bonus for the CEO on one hand and higher accounts receivables on the other thus inflating the current assets. Hence, the incentive structure for the CEO along with the debt covenant present an inherent risk which could prompt misrepresentation (Arens et. al., 2013).
One of the fraud risk factors which is relevant for the given case is the incentive to perpetuate fraud. The incentive structure of the CEO is such that it prompts actions on the part of the CEO which tend to enhance the overall risk of fraud. The given provides a plethora of changes in accounting policy that have been initiated after the new CEO took over and nearly all of these policies are aimed at enhancing the revenue and profit through cosmetic changes such as accounting policies rather than actually transforming the business. This is clearly a worrisome aspect for the shareholders as this enhances the overall risk of misrepresentation of financial statements (Caanz, 2016).
Another risk fraud factor worth mentioning is the rationalisation or justification of the fraud and aligning the same to the interest of the company. This is quite possible as the change in policies prompted by the CEO could have been justified to the board as a result of the accompanying benefit to the company in the form of higher profitability coupled with better current ratios on account of swelling of inventories and account receivables. On one hand, these policies allows the satisfaction of the debt covenant which ensures that the company has enough capital for expansion projects and on the other the overall profit would also increase which would be conducive to the interest of the shareholders. However, it is noteworthy that this is being achieved by the CEO on account of misrepresentation which is not preferred by the shareholders (Arens et. al., 2013).
The audit procedures would be severely impacted by the various risk factors that have been identified above. Firstly, the various accounting policies which have been altered after the induction of the new CEO need to be reviewed in light of the existing policy by the peers and also the external environment. One glaring loophole in this regard relates to the faulty inventory policy which in wake of rising inventory costs should be LIFO but instead of it FIFO has been suggested by the CEO of the company. Additionally, justification from the board should be demanded in relation to the rationale for the change in the accounting policies on the consideration of the CEO. This is imperative to ensure that the board is held accountable for the decisions and also ensures that they have adequate justification for bringing in the various changes especially in the context of accounting policies. In case the management is not able to offer convincing reply which prompted them to alter the policies, it must be brought to their notice that such abrupt policy change is not in the interest of the company.. Further, in case the various disclosures suggested are not made by the company or the suitable accounting policies with regards to inventory valuations, receivable management and revenue recognition are not adhered to, then the auditor can issue a qualifying opinion which would send a strong signal to the external users (Gay and Simnett, 2012).
Arens, A., Best, P., Shailer, G. and Fiedler,I. (2013). Auditing, Assurance Services and Ethics in Australia, 2nd ed., Sydney: Pearson Australia
Gay,G. and Simnett, R. (2012). Auditing and Assurance Services in Australia, 5th ed., Sydney: McGraw-Hill Education
Caanz, S. (2016), Auditing and Assurance Handbook 2016 Australia, 3rd ed., Sydney: John Wiley & Sons
Leung, P., Coram, P. and Cooper, B.J. (2012), Modern Auditing and Assurance Services, 4th ed., New York: John Wiley & Sons