Zebra Property Limited: Activity-Based Costing Accounting - Essay Example

Introduction This is a practical review of a case relating to ABC Chartered Accountants dealing with the audit of Zebra Property Limited, a Melbourne electronics firm. This will involve the critical review of the risk factors and materiality issues that relate to the audit. The paper will examine the audit strategy and the formulation of the materiality threshold. A. Risk Factors in the Audit The basic requirement of this audit is to pass an opinion on whether the financial statements of Zebra Limited prepared for the year 2012 – 2013 is free of material misstatements and reflects the true and fair view of activities that occurred in the period. Audit risk refers to anything that will prevent ABC Chartered Accountants from giving a correct and an appropriate audit report about Zebra. Fundamentally, there are four main types of risks and this include inherent risks, control risks, detection risks, and sampling risks (Wittsiepe, 2008). Inherent risk involves the risk that the operations of Zebra within the period had issues that could lead to material misstatements or errors (Collier and Agyei-Ampomah, 2010). This will include the risks that staff members and managers in Zebra can conduct certain fraudulent or wrong activities in course of the operation of the company. The obvious inherent risk involves the pressures and changes that occurred in the period. The obvious increase in the credit period which gives external entities access to funds meant for Zebra and this causes an extended lock up of capital which could lead to the significant defaults and losses to the company. There is also the risk of staff members overstating their earnings and their sales in order to gain the commissions that have been offered. Finally, the pressure to join the Australian Stock Market provides the risk for Zebra staff members to overstate the asset position in order to attain a favourable view before various investors and the Australian public. Control risks involve the possibility that the controls put in place by Zebras management and directors will be overridden in a way that could lead to fraud or errors in the financial statements (Pickett, 2010). This involve the risks of the EFTOS system being abused by some parties in the company to lead to fraud and error. Secondly, the risk of people overstating their sales and indulging in unethical practices plays a significant role in overriding the systems. Additionally, the management of Zebra could override the systems if they all indulge in groupthink and they all second the need to get listed to expand the firm. This could lead to major problems and issues that can involve the complete disregard for internal controls. Detection risks is the possibility of ABCs audit team failing to identify material misstatements and errors that distorts the financial statements and prevents it from showing the true and fair view. Detection risks relate to reliance on old files without critiquing changes that occurred in the period appropriately. This could cause material errors to go unnoticed. In order to conduct a real audit, there is the need for the auditor to take reasonable steps to examine the systems and actual activities that occurred. Wittsiepe (2008) argues that it is rare for an auditor to to examine 100% of the transactions conducted in the period. Hence, there is the need for the auditor to study a representative sample that provides an insight into the activities of a firm. Selecting the sample needs to be done in a way and manner that will reflect the material issues and provide solutions to problems in the situation at hand. B. Risk of Material Misstatement Audit risk is assessed by examining the overall financial statement levels and an examination of the relevant assertions to the account balances and the classifications of transactions (Cranfield and Lloyd, 2009). This involve the nature of risks in the entity, risks of inconsistency, timing and scope of activities and the risks of not presenting a fair perspective (Whittington, 2013). Additionally, inherent issues play a role in setting the materiality scope (Puncel, 2009). Financial Statements From the financial statements, there are a number of changes and modifications that make the 2013 financial statements somewhat different from the previous years. These shows some degree of suspicion about the possibility of financial misstatements. These are quite huge and hence, contain some degree of suspicions about materiality: 1. It appears that the firm has been involved in a move to strengthen its capitalisation position. This is because the Statement of Financial Position (wrongly labelled Income Statement) indicates that there has been a major increase in the assets and liabilities of the company. This shows that reflects a high degree of aggressive capitalisation position. Hence, the main risks of material misstatement can be found in terms of spendings on assets and liabilities rather than in the trading position of the company; 2. From the income statement, it can also be identified that the company, which was steadily increasing its profitability has began to decline. The fall in profits is a major issue that is material to the firms financial matters and affairs. Thus, there profitability levels is material to the assessment of materiality. Significant Events There are two events in the year that hold major indications for the accounts for the year under review. The first is the credit period extension which will obviously cause a significant lock up of capital in certain affairs in the trading of the company. The second element is that the increase in commissions is bound to lead to some degree of aggression. Thus, there is the need for a more critical review of the commissions paid and the kind of work that was done. This is because performance based remunerations almost always lead to some degree of pressured sales and some other unethical issues that causes long-term issues to the firm. Preparation for Stock Exchange Membership There is also a risk that the expansion to get listed on the Australian Stock Exchange provided some kind of sinking of funds into ventures and activities that led to the lock up of funds. The materiality levels will have to be increased for such activities to ensure that they are not overstated to attain the end of presenting an attractive position to stakeholders. C. Overall Audit Strategy In order to conduct an audit, there is the need for the formulation of the audit strategy which involves the key decisions and activities to be undertaken in the audit and this forms the basis for the audit plan which is about the operational activities of the audit (Kan, 2009). This involves the definition of risks, identification of materiality levels, cut offs and the work breakdown as well as the resource management processes (Gray and Manson, 2010). The audit strategy involves the identification of the objectives of the audit, responsibility definition and management and the definition of the audit limits (Graczynski, 2009). In doing this, the audit strategy will involve the distribution of risks and concentration on areas that need attention (Rauws et al, 2009). Audit Approach The fundamental objective of this audit will be to ascertain whether the figures and financial statement assertions that were used were appropriate and robust enough to provide a true and fair view. Based on the fact that the old system was working, there is the need to draw an audit strategy that will ensure that the old control risks and the old processes that were appropriate in the previous period enabled the accountants of Zebra to produce financial statements that was free of material misstatement. To this end, the new activities in the period will be tested and re-evaluated on the basis of their appropriateness to produce the right figures in the current period under review. After this is established, the analytical procedures will be directed towards a risk based auditing system. Risk Based Audit Approach The significant changes that were made to the current period that might be different from the previous years include: 1. Plans to expand the asset base to go public on the ASX; 2. The extension of the credit period for buyers; 3. Commission based bonuses; These are new arrangements that were put in place in the previous year and there is the need to examine whether the approach used in the previous period was compatible with it. Substantive Procedures There is the need to conduct substantive procedures to confirm or reject the high risk areas in the activities that were not covered. Also, substantive procedures must be carried out on several units of the financial statement to identify the aspects and areas that needs extra evaluations and analysis. Analytical Reviews There must be a critical analytical reviews to provide some kind of insights into the aspects that require extra work and extra reviews. D. Areas for Increased Audit Effort In order to identify the areas that need increased attention and effort, there is the need to conduct analytical reviews and critical evaluations of ratios to ascertain the aspects that do not really needs further investigations. Depreciation Basically, there is a query about the depreciation method that they used in the period. This is because the level of increase of Plant, Property and Equipment was just $2,938 between 2013 and 2012 (66,571 – 63,633). However, the depreciation expense between 2013 had a variance of about $3,000 (12,477 – 9,660). There is the need to recast and conduct analytical reviews to confirm the figure and ascertain the estimation technique and methods that were used to calculate depreciation in the period. Inventory There is a clear issue with inventory. The variance between current ratio in 2012 and 2013 is about 0.42. However, when the acid test ratio (quick ratio) principle is applied, you realise that there is a variance of about 0.28. This shows that the main variance has to do with stocks or inventory. And this needs to be examined critically because there might be some issue with stocks and their related matters. This is complemented by the fact that the average collection periods had huge variances and the selling days had a variance of over 19 days when compared to 2012. This shows that there is something clearly wrong with stocks and there must be a critical review and an insight into stocks to declare its issues and accounting challenges. Sales The sales figure also shows some degree of variance. This is because there is a clear fall in the gross profit margin and net profit margin between the two years. Although they are all above the industrial average, it appears that sales has fallen significantly and there is the need to give it a good look. There is a question about the new commission and why sales fell within the period after commissions were introduced. Was the reduction due to the commissions? Or was it not properly accounted for. The audit must focus on sales to provide an insight into the shortfalls and the changes. Times Interest Earned This is an inquest into the earnings before interest and tax. Clearly, the 2013 levels of earnings before interest and tax was significantly low. There is the need to examine it in the broader context in relation to sales and try to find out what caused it so that calculations can be redone to confirm whether earnings were accurate or there were issues with earning management with the hope of getting to meet a certain threshold. E. Preliminary Materiality Threshold In setting the materiality levels, there is the need to use a reliable method and approach to do it. One obvious option is to use the current year (2013) figures to calculate materiality and risks. However, due to the fact that there is a chance of material misstatement, there might be the need to use the previous years figures (2012) to set the materiality ranges. This might lead to some degree of adjustments and reviews. In terms of materiality, there is a general tendency to use the following ranges in practice: Turnover 0.5% - 1% Gross Assets 1% - 2% Profit 5% - 10% In this table, the lower the materiality threshold, the higher and the more critical the evaluation will be. Turnover In this case, it appears that there is a major risk with turnover this is because sales has fallen significantly over the period. Thus, there is the need to reduce sales significantly to 0.5% in order to undertake a more critical and thorough review of the period. This will mean $167,087 * 0.5 which is $835.345. Thus, any error or misstatement in sales that is above this amount must be subjected to further testing and were necessary, reported where satisfactory answers are not obtained. Gross Assets Zebra has invested significantly in assets as compared to trading. Therefore there is the need to evaluate and critique assets more in the period under review. Therefore, the gross asset materiality level will be set at 1% which is $1,355. This will enable the auditors to check and critique the spendings on assets and anything that is beyond that which cannot be accounted for must be treated as reportable. Profit Due to the fact that profits were not increased in the period, there is the need to have a less stringent and a less thorough evaluation of profits and other earning matters. Therefore materiality for profits can be increased to 10% which is $642 References Collier, P. M. and Agyei-Ampomah, S. (2010) Management Accounting Risk and Control Structures London: Elsevier Cranfield, M. A. and Lloyd, D. S. (2009) Local Government and Single Audits 2008 Sydney: CCH Publishing Delaney, P. R. (2010) Auditing Mason, OH: Cengage Graczynsku, M. F. (2009) Knowledge Based Audits of Healthcare Entities Sydney CCH Gray, I and Manson, S. (2010) The Audit Process: Principles, Practices and Cases Mason, OH: Cengage Gupta, D. (2012) Contemporary Auditing London: McGraw Hill Kan, S. (2009) Audit and Assessment Singapore: CCH Asia Pickett, K. H. S. (2010) The Internal Audit Handbook, London: Wiley Publishing Puncel, L. (2009) Audit Procedures 2008 Sydney: CCH Publishing. Rauws, M, Kerr, W. and Georgiades, G. (2009) Knowledge Based Audits of Commercial Entities Sydney: CCH Whittington, O. R. (2013) Wiley CPA Examinations Review Hoboken, NJ: John Wiley and Sons Publishing. Wittsiepe, R. (2008) IFRS For Small and Medium Sized Enterprises London: Springer Read More