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Audit Effort and Financial Report Misstatements

Question:

Discuss about the Audit Effort and Financial Report Misstatements.

Answer:

Introduction:

As per the case study provided in the question, Pharmaceutical ltd is engaged in business of chemical manufacturing. The ethical issues which the business is facing is regarding the disposal of toxic wastes of the company. The company is under investigation for a spill of toxic waste in a nearby river. The senior level employees of the business are trying to conceal the matter.

As per Environmental Protection Agency (EPA), no organization is allowed to dispose toxic wastes or chemical wastes in water sources as per the regulation of Water Management Act (Powell 2014). The ethical consideration is that the company is trying to actively cover the spill of hazardous waste in water source which could have serious environmental impacts and also affect the health of humans. Such ethical factors and the case must be considered by the auditor before accepting the engagement (Pitt 2014).

As per the case study provided, Pharmaceuticals ltd is engaged in the business of importing pharmaceutical products from foreign countries. in order to cope up with the fluctuation in prices of foreign currencies the company has engaged in hedging techniques. However there exists certain errors in accounting for the hedge transactions.

The auditor needs to suggest to the management to develop a strong internal control for the business so that the errors and mistakes can be avoided. The management needs to review the transactions which are recorded for hedge transactions so that errors which occurs due to inexperience or weak internal control can be avoided (Johnston et al. 2014).

As per the case study, the auditor Billings and Associates are to conduct an audit for a new manufacturer whose financial statements have never been audited before. The auditor is unable to acquire any sufficient appropriate audit evidences for account receivables as there is no documentations.

The provisions of ASA 705, which deals with Modification of Audit Opinion in an independent auditor’s report. The standard states that the auditor must issues a modified audit opinion when there is material misstatement in the financial statement and when the auditor is unable to collect appropriate audit evidences due to limitation on the part of the management (Carson, Fargher and Zhang 2016). As provided in the case, the auditor is having problem in obtaining sufficient appropriate evidences for account receivable for which proper documentation is not maintained by the business, therefore this can be taken as a limitation on the part of management. The auditor can therefore issue a modified report and moreover, the engagement was for the audit which was provided by the auditor prior to commencement of business. Therefore, on the request the engagement cannot be changed on a review engagement even if the company is not subjected to audit (Habib 2013).

As per the case provided, Hail Pty ltd is engaged has prepared the financial statements of the company which has been approved by the auditor of the company. However, the company admits that it might not have calculated the amount of impairment cost (Paugam and Ramond 2015). As the company is asking the auditor as to how to record the impairments accurately, the auditor is providing non-audit services to the client which can be pose a threat to the principle of independence of the auditor.

The safeguards which can be suggested so that the independence principle is not violated is that the auditor should not be providing non-audit services to the client business for which the auditor is conducting audit.

In the given case, Time travel ltd provides travel services to its customers and also acts as a travelling agent for the auditors of the company. In times of crisis the company has asked the auditor to recommend the name of the business to other auditors. In the situation the case reveals conflict of interest on the part of the auditor and this will be affecting the independence of the auditor (Kouakou, Boiral and Gendron 2013).

The measure which can be suggested in order to protect the independence principle of the auditor is that the auditor should not take services from the clients so that no situation of conflict of interest takes place.

In the given case, the auditor has taken up an audit engagement for a new business. A major part of the shareholdings is being hold by wife of the partner of the audit firm. The basic threat which is associated with the audit of such a company is related to the principle of member of the audit firms or the family members of the partners of the audit firm are not allowed to hold shares or any financial interest in the client. The threat is identified to affect the independence of the auditor of the company (Fiolleau et al. 2013).

In such a situation the audit firm’s partner should be allowed to conduct the audit of the financial report of the business and the business also use the techniques of audit firm rotations.

In the case given in the question the auditor of the company is facing a problem where the company is unable to pay the fees of the auditor. This will be resulting in overdependence of the auditor on the fees which is to be given by the client. Overdependence on the fees of the company might provoke the auditor to improve the opinion of the financial reports which might be in the favor of the company which affects the independence principle of the auditor

The measure which can be suggested to the auditor is that the auditor should apply for the fees as soon as possible as the auditor’s report will not be issued unless the audit fees are given by the company.


(a) Deficiencies

Explanations

(b) Control

(c) Test of Control

Website ordering without Checking Inventory Records

The risk which is involved in such a case is that the management might accept order even though there might not be stock of finished goods which can adversely affect the business. The inventory records are also at risks of manipulations by the way of theft or other unethical practices (Griffiths 2016).

The management can control the situation if they integrate the website of the company with the ledger. So that the sales orders are entered in the inventory ledger automatically. Moreover, such records are to be review so that there are frauds

The test control which has been suggested can be checked by the entering a fictitious sales order and see if the inventory accounts are verified and updated accordingly or not. A weekly or monthly review of the ledger accounts will be preventing frauds from occurring.

Courier Services does not record the signature of the customers.

The risk which arises when the signatures are not taken from the customers when the goods are delivered to them by courier is that the there is no proof for the company that the goods were actually delivered to the customer and not some other person. If the goods are misplaced than it will attract legal actions against the company for return of money or compensation.

The company needs to incorporate digital signature system mandatory before goods are delivered to the customers. Goods must not be delivered to the customer even if the specific address is provided, without the signature of the customers.

The company can start its own delivery services where without the signature of the customer goods are not to be delivered to them.

Delay between sales order and receipt of goods.

Another significant deficiency in the internal control of the business is the delay between the sales order and the actual goods received by the customers (Feng et al. 2014). This suggest that the sales and delivery structure of the business is weak.

The business needs to formulate a new sales structure so that the business the gaps in order received and delivery of the goods is removed. The company also needs to start its delivery services which can help in reducing such a gap. The new sales structure will ensure that the recording of sales and dispatching of goods so that it can be received by customers.

The management can check the effectiveness of the new sales and delivery structure by analyzing the sales and receiving feedbacks of the customers as to whether they are satisfied or not.

Allowing of Sales credit and discounts.

The sales credits are set by the sales ledger clerk and also the sales discounts are allowed by the sales team member which might not be appropriate. The decision of the sales credit and also the discount policy of the company needs to be formulated by the senior management like the Sales manager or the Sales Director.

The credit policy and the discounting policy of the company should be set by the top-level management which includes the sales manager or the sales director of the company. They are responsible for taking decision in a business and also policy estimation and will be effective if the credit policy and the discounting policy is set by the senior level management (De Simone, Ege and Stomberg 2014).

The credit policy and discounting policy as set by the senior level management will be more effective. This can be checked by analyzing the departmental meeting records to ascertain whether the decisions about credit and discounting policies are taken by the top-level management or not.

Reconciliation of Supplier Statement

As per the current policy of TUPL, due to frequent staff changes the maintenance of purchase ledger accounts are not done in an appropriate manner. In addition to this the new supplier’s details are not even added to the purchase ledger. The risk which arises due to this is that, the details of the potential suppliers who have provided the business with credit purchases might get lost and it will be difficult to keep track of the total purchases. This will in turn affect the financial statements of the company as it will show purchases with an inaccurate amount.

The management of the company needs to recruit new employee whose sole responsibility will be to update the purchase ledger and keep record of every purchases made by the company whether in cash or credit. In addition to this a weekly review of the purchase ledger will result in scrutiny of the ledger accounts and ensure that the entries are accurately recorded.

The management can check whether the entries of purchase ledger by conducting a weekly review to ensure that the new recruits are doing their job perfectly or not. Moreover, such a technique will also ensure that the transactions in the purchase ledger are effectively recorded and make the work of the auditor easier in such areas.

As per the case study, Unique Furniture Manufacturing Pty ltd is engaged in the manufacturing of grandfather clocks. The two assets accounts which are under the risks of being materially misstatement are:

Cash Balance: The cash balance of the business is under the risk of being materially misstated. As the prices of labour is increasing and also the business imports timber which is the main raw material for the business in manufacturing has a high cost, the cash balance might be overstated so that a favorable cash balance is shown. The import of the timber requires foreign currency which is increasing therefore the cost of imports are also increasing. The reduction gross margin and the net margin of the company is evidence that the cost of the company is high and the overall sales of the company are more or less same (Lobo and Zhao 2013). Hence, the management might want to show a favorable cash balance in order to give the shareholders hope that the liquidity position of the company is still secure (Brunnermeier, Gorton and Krishnamurthy 2013).

Inventory Account: As the company follows Sales or Return basis for recording sales transactions. The inventory account of the business is at risk of being materially misstated (Knechel and Salterio 2016). The management might accidently or knowingly record the inventory stock of the company as sales of the business as under the method when the prices of the finished goods are received then it is considered as sales of the business otherwise it is kept as stock. The inventory balance might be overstated or understated as the case may be.

The prior period figures of sales and inventory might be materially misstated as the company follows Sales or Return basis under which sales is only to be recorded when the price for the same is received (Johnstone, Gramling and Rittenberg 2013). There is a chance that due to inexperience of the accountant potential inventory under this method might be recorded as sales of the business.

  1. The three factors which can bring in the going concern concept of the management under question are given below:
  2. The net profit margin and gross profit margin of the business suggest that the company is not able to make much profits as the company is incurring high costs. Moreover, as mentioned in the case study the management of the company is unable to recover amount of cost from the customers which is a factor which contributes to the low profits of the business.
  3. The increasing cost of materials of the business which the management imports. The foreign exchange prices of the imports are increasing which is also contributing to the high cost of companies.
  • The availability of cheap labour is also a difficult for the business and the cost of skilled labour is very high and also contributes to the cost of the company.
  1. The audit planning process will be carried out considering all the factors which affect the cost of the company. In addition to this, the auditor needs to have a clear understanding of the Sales or Return basis policies which the business follows and ensure that such a basis is constantly applied for measuring the sales transaction of the business (King, Oracle International Corp 2014). The auditor also needs to plan for the valuation process of the inventory of the business and also plan the substantive and compliance level of audit procedure for collection of audit evidences.
As per the case provide in the question, the system of recording of sales transaction which is on sales or return basis, therefore proper records of stocks are to be maintained by the management of the company. The recording of sales transactions can be improved so that no discrepancies occur in the records.
  1. The bonuses which is allowed by the management of the company for increase over the budgeted sales can be manipulated as the inventory which are not returned can be shown as sales for the month and bonuses can be claimed. Secondly, there is a risk of manipulating the sales entries by the marketing manager as he has the power to approve goods sent on sales or return basis as sales when the goods are not returned with in a period of 60 days even if price for the products are not received.
  2. The account balance which is at risk of being manipulated is the balance of sales as per the case given in the question. The risk that the bonuses which are given to the marketing staff and the marketing manager might be manipulated is there. For the bonuses to be earned the sales of the company should be higher than the budgeted sales figure of the business which might not be the case.
  3. The audit procedures which can by the auditor to ensure that any fraudulent activities of the business are kept in check are a detailed examination of the sales ledger and all the ledger associated with the same such as debtor ledger, cash books to ensure that all the transaction recorded are on genuine. The entries which are passed for Sales or Return basis are to be examined.

For the purpose of reviewing the auditor will be applying vouching techniques for sales transactions and also use external confirmation technique to satisfy himself that the entries of sales are appropriate and correctly recorded.


Event

Description

Impact on Materiality

Explanation

Sale’s Finance Manager resignation with no replacement made.

The sales finance manager of the company is responsible for the sales activities of the business and also looking after financing requirements of the sales team.

No impact on materiality

The sales finance manager’s resignation will not affect the materiality of the components of the business (William Jr, Glover and Prawitt 2016).

Resignation of HR manager

The HR manager of the company is concerned with the recruitment process of employee and the HR manager of Sail ltd resigns.

No impact on materiality

There will be no impact on the materiality component but the recruitment process of employees might suffer (Eilifsen and Messier Jr 2014).

Material Variances detected in reconciliation of data between SuperD IT and SuperB IT.

The business is in transition from SuperD IT to SuperB IT which is supposed to improve the business.

Increases the materiality on the area of reconciliation of data

Th auditor needs to increase the audit process which is applied on Data Reconciliation between SuperD IT and SuperB IT. The auditor needs to conduct substantive process on the area.

No purchase Documents on a transaction

Out of the sample size of 40, a transaction with Dune ltd makes a 14% unlisted investment for which no purchase documents are present and as per the management a week is needed for the documentation to arrive (AICPA 2017).

Increase in the level of materiality of the business.

The area of the purchase is an important area of concern for the business and therefore the auditor needs to provide ample audit procedures on the same (Leung et al. 2014).

Reference

AICPA, 2017. Audit Guide: Audit Sampling. John Wiley & Sons.

Brunnermeier, M., Gorton, G. and Krishnamurthy, A., 2013. Liquidity mismatch measurement. In Risk topography: Systemic risk and macro modeling (pp. 99-112). University of Chicago Press.

Carson, E., Fargher, N. and Zhang, Y., 2016. Trends in auditor reporting in Australia: a synthesis and opportunities for research. Australian Accounting Review, 26(3), pp.226-242.

De Simone, L., Ege, M.S. and Stomberg, B., 2014. Internal control quality: The role of auditor-provided tax services. The Accounting Review, 90(4), pp.1469-1496.

Eilifsen, A. and Messier Jr, W.F., 2014. Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), pp.3-26.

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.

Fiolleau, K., Hoang, K., Jamal, K. and Sunder, S., 2013. How do regulatory reforms to enhance auditor independence work in practice?. Contemporary Accounting Research, 30(3), pp.864-890.

Griffiths, P., 2016. Risk-based auditing. Routledge.

Habib, A., 2013. A meta-analysis of the determinants of modified audit opinion decisions. Managerial Auditing Journal, 28(3), pp.184-216.

Johnston, S., Falck, J., Troxel Jr, C., Farrell, J.W., Thiruthuvadoss, A.S., Ariathurai, A. and Salvadori, D., Chicago Mercantile Exchange Inc, 2014. Derivatives trading methods that use a variable order price and a hedge transaction. U.S. Patent 8,630,941.

Johnstone, K., Gramling, A. and Rittenberg, L.E., 2013. Auditing: a risk-based approach to conducting a quality audit. Cengage learning.

King, N., Oracle International Corp, 2014. Audit planning. U.S. Patent 8,712,813.

Knechel, W.R. and Salterio, S.E., 2016. Auditing: Assurance and risk. Taylor & Francis.

Kouakou, D., Boiral, O. and Gendron, Y., 2013. ISO auditing and the construction of trust in auditor independence. Accounting, Auditing & Accountability Journal, 26(8), pp.1279-1305.

Leung, P., Coram, P., Cooper, B.J. and Richardson, P., 2014. Modern Auditing and Assurance Services 6e. Wiley.

Lobo, G.J. and Zhao, Y., 2013. Relation between audit effort and financial report misstatements: Evidence from quarterly and annual restatements. The Accounting Review, 88(4), pp.1385-1412.

Paugam, L. and Ramond, O., 2015. Effect of Impairment‐Testing Disclosures on the Cost of Equity Capital. Journal of Business Finance & Accounting, 42(5-6), pp.583-618.

Pitt, S.A., 2014. International standards for the professional practice of internal auditing.

Powell, M.R., 2014. Science at EPA: Information in the regulatory process. Routledge.

William Jr, M., Glover, S. and Prawitt, D., 2016. Auditing and assurance services: A systematic approach. McGraw-Hill Education.

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