Auditing Theory And Practice - Essay Example

Auditing Theory And Practice PART A: AUDIT ESSAY 1.0 Introduction According to the letter dated 30th August 2005 in which we were appointed to audit the financial statements of Krypton company and report on the findings there from, We have laid down an audit report identifying weaknesses in the systems of accounting and internal control that could have led to the preparation of accounts that do not reflect the true picture of the company. We have had a preliminary discussion with the Chief Accountants and the Managing Directors of the subsidiary companies also. But before we explore into our findings, we would like to highlight that the problem about the previous audit fees has not yet been resolved. There should be no disagreement on the auditor’s fee at all. Once an auditing firm has received the letter appointing them as the auditors of a company, they have to consider the needs of the client company as well as its size. May be owing to your big size, the previous audit company needed additional resources in terms of man and woman power and facilities to meet your needs. When the previous audit company held a meeting with the directors in which their responsibilities and the responsibilities of krypton were discussed in details. The Audit Company and krypton agreed on the terms of the audit engagement. The terms of engagement which they agreed upon were documented in a form of a letter of engagement. They then discussed and agreed on the basis on which the audit fee was to be computed and any billing arrangements. We then do not understand why this is still a problem yet to be solved The last audited accounts were those for the period ended 31st December 2003. As we conduct this audit, making comparatives to the year 2004, it will make good sense if we first conduct an audit for the year 2004. 2.0 ANALYTICAL PROCEDURES To determine the implications of the figures, analytical procedures are usually performed on the financial information. Analytical procedures consist of mainly trend and ratio analysis with information being inferred from the resulting figures. From the financial statements of the company the following was established. % change 30.09.05 31.12.04 Turnover Cost of sales Gross profit Distribution costs Administrative expenses Dividends Net profit Stocks Debtors Creditors 38.08% 10.16% 71.44% 213% 7.35% -15.87% 32.48% 58.20% 54.75% 120.84% 14,485 6,290 8,195 3,290 220 530 465 579 4,870 8,370 10,490 5,710 4,780 1,051 2,068 630 351 366 3,147 3,790 I. Stock turnover ration II. No. of days sales in debtors III. No. days purchases on creditors 10.86 123 487 15.60 110 242 30.09.05 31.12.04 Stock Turnover = cost of sales = 6290 = 10.86 5710 = 15.6 Average stock 579 366 No. of days sales in Debtors = 365 (days) Debtor’s turnover Debtors Turnover = Turnover (sales) 14,485 10,490 Average Debtors 4870 3140 = 2.97 = 3.33 No. of days sales in debtors = 365 = 365 365 Debtors turnover 2.97 3.33 123 days 110 days Creditors Turnover = credit purchases = 6290 5710 Average creditors 8370 3790 = 0.75 1.51 N/B : Purchases = Cost of sales : All purchases are on credit. No. of days purchases on creditors = 365 365 365 Creditors Turnover 0.75 1.51 = 487 days 242 days From the analytical procedures the following information can be inferred STOCKS Ordinarily a 10.16% increase in cost of sales should lead to a corresponding decrease in stocks. Yet in this case stocks have increased by 58.20%. The stock turnover ratio has also declined from 15.60 in 2004 to 10.86 in 2005. The stocks were expected to decrease and their increase might imply that employees could be selling their own goods brought from outside. The audit shall then focus on the existence of the stocks and their condition. In order to ascertain the genuineness of the stock figure, a revaluation test of the stocks will have to be performed to see whether their increase was as a result of a revaluation. DEBTORS Ordinarily, a 38.08% increase in turnover should lead to a corresponding increase in debtors. The debtors have increased by 54.75%. Furthermore, the number of day’s sales in debtors has increased from 110 to 123. This means that unlike 2004 when on average debtors were taking 110 days to pay in 2005 they are taking longer i.e. 123 days on average to pay. Credit control has slackened and we must focus on existence of debtors on the balance sheet date and the adequacy of the provision for bad and doubtful debts. A debtors’ aging list also need to be analysed as some debtors may not be likely to be paid. If they have been time barred then the company need to increase its provision for bad and doubtful debts. CREDITORS Creditors are a significant risk point especially when overstated. They can be a loophole for embezzlement of funds i.e. payment to ‘ghost creditors’. Ordinarily, a 10.16% increase in cost of sales or purchases should result in a corresponding percentage change in creditors. In the event, creditors have increased by 120.84%. The current value of creditors exceeds the cost of sales, which is our expectation. The audit need to analyse the effectiveness of cut-offs as previous year’s creditors may be incorporated in the accounts. A number of day’s purchases in creditors have also gone up to 487 in 2005 from 242 in 2004 meaning that the company is taking a longer period to pay its creditors than previously was the case of 242 days on average. Creditors will appear to be materially overstated. We shall have to focus on a comprehensive search for unrecorded liabilities. On top of this, a supplier statement needs to be demanded to confirm whether it reconciles with the company’s records. PROFITABILITY Ordinarily, a 71.44% increase in gross profit should lead to similar increase in net profit. The net profit has only increased by 32.48%. This could suggest that included in overhead expenses are expenses that are not genuine expenses. Audit effort would have to be directed towards establishing whether overhead expenses took place and were properly measured and allocated. Failure to comply with expectations is an indication of irregularities. There is a huge increase of net interest expense. These have not been supported by any new long term loans in the year 2005. Investigations need be carried out to find out whether the creditors falling due after more than one year attracted any interest charges. Supplier’s statements can also be used to confirm any interest charge agreements. 3.0 IMPLICATIONS OF OTHER DISCOVERIES 1. That the company conducts all of its business on credit terms. This will create serious financial ramifications. The company needs some cash to effectively carry out its operations. 2. It is essential that your company has factored some of its UK debtor book. Factoring is the process of converting an illiquid asset (Debtors) into a liquid asset (Cash). Because of the steps that the company has taken of factoring debtors, the management of debtors would now be more effective. It is also a way of financing debtors. However the management should be wary of the costs associated with factoring which might further reduce its profitability. These are service/ commission fee which is charged due to the factoring service given. The other cost is interest charges as the factor will charge interest since he has to wait for the credit period to mature and he must be compensated for the time of value of money. Additionally, factor may charge a reserve in case the bottled gas sold on credit are returned by the buyer or are damaged on transit. The reserve required is based on the level of debt i.e. the invoice value of the credit sale. 3. Suitability of accounting policies: - The above inferences can only be reliable if uniform accounting policies have been used. In our audit however, we found out that the company has adhered to the laid down accounting policies. 4. It is normal for the management of Krypton p/c to seek for facilities to expand turnover. The company should also seek the usage of overdraft facilities since these are cheap sources of finance as opposed to long term sources like debentures which are costly. 4.0 CONCLUSION These are just but some of implication of the financial statements. Our scope of audit was commensurate with that in the letter of engagement. We believe that improve on the weak areas shall be improved and that the internal control system strengthened. This would make the company’s accounts more reliable. PART B: The following are the five areas which would be in the knowledge of the business file on Krypton p/c and would be influential in determining inherent risk. a) Adequacy of the financial position of Krypton For many organizations, the desire is to have adequate financial resources and a satisfactory operating performance. Therefore, it the company has no financial problems and the management and the shareholders are satisfied with the performance, they have no incentive to engage in distorting figures hence the inherent risk is lower. However a company whose financial position is inadequate and operating performance is to inconsistent puts the management under pressure to perform and satisfy shareholders. Such management are likely to distort financial information. b) Disagreements (e.g. of Audit fee) By and Large, human beings do not change their nature. Therefore a client with a history of unqualified opinions, no audit disagreement between the auditor and management and few adjustments proposed by the auditors is very likely to maintain that standard of performance. But a client with regular disagreements, numerous proposed audit adjustments qualified opinions is also likely to exhibit those negative characteristics continuously increasing the inherent risk. c) Number of balances and incentive schemes Obtaining audit evidence to confirm the assertions about a balance or transactions can involve complicated procedures can be inherently subjective. Some transactions are extremely difficult to audit as are some balances. Therefore, the more of such balances / transactions, the higher the inherent risk. The most assuring audit evidence is direct audit evidence. The ideal situation would be for the auditor to verify a 100% of transactions and balances i.e. the only way the auditor would be assured that all transactions have been properly dealt with in the books and in the financial statements and that the balances are fairly stated. If the auditor was to attempt that approach the audit would be too expensive and would take too long and still he may not have acquired the 100% confidence. After all, management can still conceal information from him. The auditor if he were to succeed in this approach will find that he may have been effective but he has been highly uneconomical and inefficient. It makes sense therefore the auditor to consider initially whether the management and staff are competent people meaning that the more competent they are the less likely they are to make mistakes. Then considering their integrity and the pressures under which they are operating the more integrity they are and the less pressure they are operating under the less likely they will perpetrate irregularities and frauds. Checks and balances would help in determining inherent risk. They ensure that competence and integrity one maintained and where they are not maintained, they can be detected and corrective action taken. The checks and balances (also referred to as a system of accounting and internal controls) if well designed and effectively operated would prevent, detect and correct on a timely basis, errors and irregularities. This means that the auditor can be more efficient and economical by relying on the competence and integrity of the management and the effectiveness of the accounting and internal control systems. He can also achieve this by consequently examining only a sample of transactions and balances and base his conclusion on the population as a whole on the results of the sample. Whenever the auditor examines less than 100%, he runs the risk of reaching a wrong conclusion by projecting the results of the sample to the population as a whole. Where the management bonuses are related to the reported results, management have a strong motive to deal with matters so that the highest possible profit is reported. Therefore where management contracts have incentive schemes based on reported results, the inherent risk is higher d) Research and Development expenditures How to treat an internally generated asset whether under research or development expenditure would greatly determine inherent risk. Krypton p/c has treated the cost of equipping the laboratory as an investment in the accounts. It would be important first to determine at what point in time the laboratory would start becoming beneficial to the company as a whole. However, the enterprise would have to assess whether the project meets the criteria for classifying its generation into I) A research phase and II) A development phase Failure to clearly distinguish the research phase from the development phase would then force the management of Krypton to treat the expenditure as if it were incurred only in the research phase. e) The control environment The key question regarding the control environment is: Does Krypton p/c maintains an informal or a formal control environment? Inherent risk becomes much higher if Krypton we re to maintain an informal control environment mainly based on faith/ trust/ loyalty. But if it were to maintain a formal control environment than the inherent risk will be subsequently lower. An internal audit functions of an independent review of the activities of other people. Where in the auditor’s opinion, the competence and integrity of the management and staff is considered to be very low i.e. they can perpetrate irregularities or make errors and also there is no system of accounting and internal control or if there is one it is neither suitably designed nor effectively operated. The auditor can only achieve the desired degree of confidence or assurance by selecting a very large sample for substantive tests. References Alexander, D., Britton, A. and Jorissen, A. (2005): International Financial Reporting and Analysis, Second Edition, London: Thomson Eiteman, D.K., Stonehill, A. I, and Moffett, M.H (2006): Multinational Business Finance, 11th Edn, London, Addison Wesley Elliott, B. and Elliott, J. (2006): Financial Accounting and Reporting, Eleventh Edition, Harlow: Prentice Hall Klein, W.A, John, C. and Coffee, Jr. (2004): Business Organization and Finance: Legal and Economic Principles, 9th Edn, London, Foundation Press Wood F., and Sangster A., (1999): Business Accounting I, London, Financial Times Professional Ltd. Read More