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Discuss About The Journal Of Economic And Financial Sciences.

Effects on audit planning due to the results of analytical procedures

A medical device company, Cochlear Limited is a manufacturing company situated in Sydney, Australia. The auditor of the company has decided to conduct analytical procedures on the financial statements of the company for last three financial years including the current financial year ending on June 30, 2018. The analytical procedures would help the auditor to identify possible risks of misstatement and frauds in the financial information of the company.

An auditor conducts analytical and substantive procedures to complete audit of an entity efficiently. Analytical procedures involve calculation of different ratios of an organization for last two or three financial years including current financial year with the objective to identify any unnatural fluctuations in any of the financial ratios to indicate possible vulnerable areas for the audit. In case there is significant fluctuations in any of the profitability ratios such as gross profit ratio, net profit ratio or any other profitability ratio without any valid reason then this could indicate the risk of material misstatement or fraud in financial statements (Jans, Alles & Vasarhelyi 2014). Auditor accordingly, will use substantive procedures of items of revenue and expenditures to the maximum extent possible to unearth the misstatement or fraud.

The financial information containing in the annual reports of the company for last two years have been used to calculate various for analytical purposes. The table below contains the profitability, efficiency, solvency and liquidity ratios of the company (Chan & Vasarhelyi 2018).

The changes in gross profit ratios over the last three years have increased at a constant pace. In 2018 the company has earned a gross profit of 73.46% whereas it was around 71.37% a year back. However, the change in operating margin is quite significant. The company has earned an operating income of AUD 207 million in 2018 whereas in the last two previous years the operating incomes were negative. The change in operating margin from -10.79% in 2016 to 15.18% in 2018 certainly indicate that there could be some misstatement in recording operating expenses of the company (Cao, Chychyla & Stewart 2015). Thus, the auditor will specifically be extra attentive of operating expenditures while conducting substantive audit procedures. The inventory turnover ratio, asset turnover ratio do not indicate any unnatural fluctuations and so are the debt to equity and liquidity ratios. The changes in these ratios have been insignificant and does not raise an eyebrow (The analytical ratio calculations have been provided in table attached as appendix).

Inherent risks

Hence, the analytical procedure and the results of such procedure has provided the auditor with a possible area in financial statements that could have material misstatements or even fraud. Using extensive substantive procedures on each items of operating expenditures will enable the auditor to evaluate the material risks of misstatements and possibility of fraud in this area of financial statements (Chiu, Liu & Vasarhelyi 2018).

It is important to note that the standard procedures that an auditor needs to perform as per the Auditing and Assurance Standards of the country (AUASB) those shall be performed irrespective of the results of analytical procedures. However, in addition the auditor might decide to conduct other verifications and tests of items of expenses and revenues depending on the results of analytical procedures conducted on the financial information of the company. The auditor on the basis of analytical procedures must extend his review and verification of items of expenditures and revenue, especially the operating expenditures to find out whether there is any material misstatement in reporting these expenditures in the books of accounts (Abernathy, Hackenbrack, Joe, Pevzner & Wu 2015).

The simple comparison between amount of revenue, gross profit and net income of the company of last three years would help the auditor to make important assertion about the company and its performance.

All amounts are in rounded off to nearest AUD million

 Fiscal year ends in June. AUD in millions except per share data.

 2016-06

 2017-06

 2018-06

 Revenue

   1,131.00

   1,254.00

   1,364.00

 Gross profit

      797.00

      895.00

   1,002.00

 Operating income

    (122.00)

      (78.00)

      207.00

 Net income

      189.00

      224.00

      246.00

All the performance indicators of the company indicate that over the years the performance of the company has improved. The revenue of the company was AUD 1,131 million in 2015-16. This increased to AUD 1,254 million in 2016-17 and AUD 1,364 million in 2017-18. Similarly the gross profit of AUD 797.00 million in 2015-16 has increased to AUD 1002.00 million after two financial years. The operating income of AUD 207 million certainly moved extraordinarily as it was in negative in last two previous years. The net income again has improved in expected line as it has increased to AUD 246 million in 2017-18 from AUD 189.00 million of 2015-16.

Inherent risk has been defined as the risk that is impossible to be wiped off completely. Such risk include the natural human error, use of personal judgment of accountants in preparing books of accounts due to the accounting principles and policies that allow more than one alternative in number of areas for financial reporting purpose. In case of the company let us discuss the inherent risk at the financial report level for the following five factors (Cannon & Bedard 2016).

Integrity of management

The management of an entity is responsible to conduct the affairs of the entity by using the resources of the entity. It is expected to conduct the affairs of an entity with utmost honesty and integrity. However, there is an inherent risk due to the human nature. Human nature if unpredictable and management in collision can effect fraud at the highest authority of an organization (Soltani & Maupetit 2015).

Rick-Holliday-Smith is the Chairman of the company leading the Board of Directors over the years. Ever since the inception of the company the Board of directors and the management of the have company have conducted themselves with utmost honesty and integrity. No fraudulent activities have ever been reported of the directors of the Board since its inception. However, the inherent risks of integrity of management will continue to remain due to the presence of human element. However, the inherent risk in this regard is very low.     

A closer look at the annual reports of the company containing details information about the Board of directors of the company will reveal the huge experience and talent the Board of the company has to conduct the day to day affairs of the company. The following table contains the information about few of the directors appointed in the Board of the company:

Name of the director

 Position

Experience

Rick Holliday-Smith

Chairman

Appointed in the Board since March 01, 2005.

Yasmin Allen

Non-executive director

Appointed in the Board since August 02, 2010

Prof.. Edward Byrne

Non-executive director

Appointed in the Board since July 01, 2002

Dig Howitt

CEO, Preseident and MD

Appointed in the Board since in November 14, 2017

Andrew Denver

Non-executive director

Appointed in the Board since February 02, 2007.

Donal O’Dwyer

Non-executive director

Appointed in the Board since August 01, 2005

Glen Boreham

Non-executive director

Appointed in the Board since January 01, 2015

Thus, from the above it can be easily understood that there is no dearth of talent and experience in the Board of the company. However, it is not only about the amount of experience that the Board of directors have that only matters it is also about the coordinated efforts put in by the combined Board of an organization that makes the difference between a successful and unsuccessful company (Coronel & Morris 2016).  

The company has clearly mentioned in its charter that no director or manager shall be pressurised by the senior management personnel to influence the operations and financial statements of the company. The Board and management are definitely under pressure to perform at a high level and deliver profit and favourable results for the company. However, there has been no undue pressure on the directors and management from senior executives to manipulate the books of accounts financial statements of the company (Ferrell & Fraedrich 2015).

Thus, the inherent risk in relation to pressure on directors and management from higher authority is negligent at the best.  

As already mentioned earlier that Cochlear is a manufacturing company involved in designing, manufacturing and supplying of Nucleus implants specifically developed and manufactured by Cochlear. Apart from that the company also manufactures and supplies Electro Acoustic and bone conduction implants. The entities business involve use of highly technical materials and designs that are necessary for manufacturing the different types of implants (Commerford, B. P., Hermanson, Houston & Peters 2016). An auditor must have knowledge of the manufacturing and development process of these implants in order to conduct audit of manufacturing expenses and other operating expenses related to the business. Thus, considering that the auditors are not supposed to have technical knowledge in scientific field thus, it would be highly improbable to expect them to have significant knowledge about the manufacturing and development process of these implants. Inherent risk in this case for the company has been assessed as quite high (Haimes 2015). The auditor accordingly, must take conduct necessary substantive procedures to ensure that the inherent risk as low as possible.        
Factors specific to the industry of which the entity is a part of:

Experience and knowledge of the management and changes in the management

The entity is part of medical implant industry which is a very competitive industry as there are number of companies that vying for market share in the country. The company is regulated by the provisions of Corporations Act, 2001 and due to the importance of the implants the industry is also subjected to the professional and medical ethics standards. The company must comply with the provisions of Corporations Act, 2001 as well as abide by the industry norms and guidelines (Serpella, Ferrada, Howard & Rubio 2014). The auditor must in addition to the requirements of Corporations Act shall also consider the implications ethical and professional standards of medicine to which the company is subjected to.

Overall the inherent risks of auditing the company from the above five elements are significantly low and this is a positive sign for the audit of the company.

Taking into consideration the results of analytical procedure and based on the inherent risk assessment the following three specific account balances have been identified for significant risk of material misstatements.

  1. Sales or revenue of the company.
  2. Sales, general and administrative expenses.
  • Other income.

The reasons for choosing above three account balances are provided below:

Reasons

Sales or revenue of the company: Simply due to the immense importance of the account balance it has been chosen. A complete verification of sales and revenue of the company would enable the auditor to express significant confidence on the financial statements (Hislop, Bosua & Helms 2018).

Key assertion

The transactions in the sales day book has been recorded as and when sales have been effected. Thus, there have been no misstatements in the above account balances hence, the risk is not valid (Brink, Tang & Yang 2016).

Substantive audit procedures

Sales: For sales the auditor has firstly checked the sales orders and then the delivery that have been made has been tallied with the sales orders. The journal entries recorded in the books of accounts for cash and on account sales have been verified separately. The sales invoices have been checked to verify whether the amounts have been correctly recorded in the books of accounts.

Practical internal control

Sales order should be received by different person, the order shall be delivered by a different person and the entry in the books shall made by another person (Segal 2017).

Reasons

In the current financial year there has been a significant drop in sales, administrative and general expenses as a result the negative operating income experienced by the company in last two previous years, losses of $122 million and $78 million respectively, have suddenly turned into positive operating income of $207 million. The results of analytical procedure has aroused suspicion on the account balance (Bromiley, McShane, Nair & Rustambekov 2015).

Key assertion

The sales, general and administrative expenses balance showed no discrepancies with the vouchers and supporting documents.

Substantive audit procedures

The vouchers against individual payments for sales, administrative and general expenditures have been verified. The vouchers have been checked to authenticate that there was proper authority for payment made on different vouchers. The total amount of these vouchers and on account payment have been tallied with the expenditures to evaluate the authenticity of the account balance (Griffith, Hammersley & Kadous 2015).

Practical internal control

Each payment made for the expenditure must be accompanies with relevant vouchers and supporting document. The vouchers and supporting document must have the signatures of authorized signatories to pass the payments.

Reasons

Another important think that was followed in the analytical procedure is that despite the huge jump in operating income the net income of the company remained almost at the previous year’s level. While analysing the reason for that it was discovered that other income of the company in 2016 and 2017 were $385 million and $394 million respectively have suddenly taken a nose dive to $142 million in 2018.

Key assertion

After verifying the account balances with documents, vouchers and other supporting documents it has been made clear that there indeed has been certain investment that have been sold by the company in the current year as a result the other income has reduced.

Substantive audit procedures

The sale of investments have been documented with appropriate supporting documents. These have been checked to understand the reason for reduction in other income.

Practical internal control

Other income shall only be received in the bank account of the company and properly documented in the books of accounts.

 

Conclusion: 

An auditor has a huge responsibility on his shoulder to independently verify the financial statements of an organization as the users of financial statements takes the auditor’s report as an assurance to trust the financial information provided in these statements. Thus, an auditor must conduct an audit in accordance with the applicable ASAs to ensure that the opinion expressed on the financial statements are appropriate and correct. In case of Cochlear Limited it can be concluded that analytical procedures has certainly helped the auditor to identify the possible area of misstatements in the financial reports. Conducting substantive testing on these areas will help the auditor to come to a particular conclusion regarding the presence of material error in financial statements.      

References:

Abernathy, J., Hackenbrack, K. E., Joe, J. R., Pevzner, M., & Wu, Y. J. (2015). Comments of the Auditing Standards Committee of the Auditing Section of the American Accounting Association on PCAOB Staff Consultation Paper, Auditing Accounting Estimates and Fair Value Measurements: Participating Committee Members. Current Issues in Auditing, 9(1), C1-C11.

Brink, A. G., Tang, F., & Yang, L. (2016). The Impact of Estimate Source and Social Pressure on Auditors' Fair Value Estimate Choices. Behavioral Research in Accounting, 28(2), 29-40.

Bromiley, P., McShane, M., Nair, A., & Rustambekov, E. (2015). Enterprise risk management: Review, critique, and research directions. Long range planning, 48(4), 265-276.

Cannon, N. H., & Bedard, J. C. (2016). Auditing challenging fair value measurements: Evidence from the field. The Accounting Review, 92(4), 81-114.

Cao, M., Chychyla, R., & Stewart, T. (2015). Big Data analytics in financial statement audits. Accounting Horizons, 29(2), 423-429.

Chan, D. Y., & Vasarhelyi, M. A. (2018). Innovation and practice of continuous auditing. In Continuous Auditing: Theory and Application (pp. 271-283). Emerald Publishing Limited.

Chiu, V., Liu, Q., & Vasarhelyi, M. A. (2018). The Development and Intellectual Structure of Continuous Auditing Research 1. In Continuous Auditing: Theory and Application (pp. 53-85). Emerald Publishing Limited.

Commerford, B. P., Hermanson, D. R., Houston, R. W., & Peters, M. F. (2016). Real earnings management: A threat to auditor comfort?. Auditing: A Journal of Practice & Theory, 35(4), 39-56.

Coronel, C., & Morris, S. (2016). Database systems: design, implementation, & management. Cengage Learning.

Ferrell, O. C., & Fraedrich, J. (2015). Business ethics: Ethical decision making & cases. Nelson Education.

Griffith, E. E., Hammersley, J. S., & Kadous, K. (2015). Audits of complex estimates as verification of management numbers: How institutional pressures shape practice. Contemporary Accounting Research, 32(3), 833-863.

Haimes, Y. Y. (2015). Risk modeling, assessment, and management. John Wiley & Sons.

Hislop, D., Bosua, R., & Helms, R. (2018). Knowledge management in organizations: A critical introduction. Oxford University Press.

Jans, M., Alles, M. G., & Vasarhelyi, M. A. (2014). A field study on the use of process mining of event logs as an analytical procedure in auditing. The Accounting Review, 89(5), 1751-1773.

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

Segal, M. (2017). ISA 701: Key Audit Matters-An exploration of the rationale and possible unintended consequences in a South African. Journal of Economic and Financial Sciences, 10(2), 376-391.

Serpella, A. F., Ferrada, X., Howard, R., & Rubio, L. (2014). Risk management in construction projects: a knowledge-based approach. Procedia-Social and Behavioral Sciences, 119, 653-662.

Soltani, B., & Maupetit, C. (2015). Importance of core values of ethics, integrity and accountability in the European corporate governance codes. Journal of Management & Governance, 19(2), 259-284.

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