Auditing Risks in Nathans Finance - Case Study Example

Nathans Finance NZ Limited Nathans Finance NZ Limited Managing Partner, Ben Ron Chartered Accountants From: Senior Associate Date: May 5, 2014 Subjects: Analytical Review Dear Sir, This report has been prepared as per our discussion, to highlight the probable risk areas in the financial report of Nathans Finance NZ Limited. I have performed analytical review and the results of the same are mentioned below under different headings. (1)High Risk Areas Some of the items that may result in audit risk are mentioned below and these are categorized as inherent risk, control risk or detection risk. Inherent risk (IR) Inherent risk can be defined as the risk that an account balance, disclosure or a note in financial statement is materially misstated due to fraud and errors without considering the relevant internal controls. Some of the inherent risks in Nathans Finance are mentioned below. 1. There is always a risk of human error in the financial reporting and it is not possible for any organization to stop employees to commit honest mistakes. 2. In Nathan Finance there is a greater risk that the management overrides the internal controls for their own benefits. 3. Laws and regulations are altered year to year, these changes would create an inherent risk that Nathans Finance would not be able to meet those requirements and ultimately financial statement would not present the true and fair view. 4. Foreign currency risk 5. Susceptibility of an account balance is a factor that always creates an inherent risk. For example there is always a danger of cash theft in Nathan Finance. Control Risk (CR) Control risk is a risk that the controls that are placed by Nathan Finance will not be able to detect, prevent or correct the material misstatements. Some of the control risks are mentioned below. 1. There is a risk that there are no appropriate controls over revenue recording and the revenue of the next year is included in the current year’s figure which ultimately results in 42.5% increase in total sales. 2. There is a significant amount of transaction between the related parties and it is possible that this would create a significant control risk due to relationships between parties. 3. There is a big increase in the revenue, but advertisement expense is only $53,445 in 2005 against $313,356 in 2006 (Nathans Finance NZ Limited, 2006). This may reveal control risk because this huge increase in advertisement expense may exposed that there are no related controls. 4. Significant increase in cash and bank balance from $5.3 to $12.16 million in 2006. This reveals ineffective cash management by the company and lack of relevant controls. 5. In addition to all control risks mentioned above, there is a risk of weak general and IT controls is financial reporting which would increase the chances of material misstatement. 6. 49% increase in interest expense. Detection risk (DR) Detection risk is a risk that the audit procedures performed by the auditor will not be able to detect and prevent the material misstatement in the financial statement. Some of the detection risks in Nathan Finance are mentioned below, 1. There is a big increase in the revenue, but advertisement expense is only $53,445 in 2005 against $313,356 in 2006 (Nathans Finance NZ Limited, 2006) auditor may not be able to detect the potentioal oversttement in the revenue. 2. Purchase of new vending machines for $11.32 million. It may either be fictitious or it may be leased asset. There is a greater risk that the auditor is unable to detect any potential fraud of error in this significant transaction. 3. Decrease in salaries and wages in comparison to last year may suggest that the management is concealing the expense to show higher profits, because in normal circumstances salaries expense increases. Audit procedures may fail to detect this potential error or fraud. 4. Increase in intercompany advances from $60.7 million to 79.6 million. This is related parties transaction and the management can create fictitious advance which would be difficult for the auditors to detect. 5. Sharp decrease in long-term finance receivables from $45.1 million to $34.07 million in 2006. Changes in this significant account balance may be due fraudulent acts by the management so this concealment may be difficult to detect. 6. Issuance of secured debenture stocks during the year in both current and noncurrent liabilities. 7. Extraordinary rise in financing receivables specially from vending licenses financing may also create detection risk if the proper sample of the clients is not selected for confirmation of balances. (2) Reasons for risky areas Items Reason of misstatement (DR-1) Increase in revenue This is always a risky area because management can overstate the revenue to show better performance than actual. Increase sales revenue would result in higher performance and higher earnings per share (BDO, 2013). Normally bonuses are also attached to the company’s performance so the management also tries to present the most favorable picture of the company’s performance. (CR-3) Advertisement Expense Advertisement expense has a close link with the level of revenue, that is it increases or decrease with the level of revenue. Nathans Finance NZ Limited was able to achieve higher revenue, but there is a significant drop in adverting expenses. This situation indicates that there are chances that the expenses are shown understated. (DR-3) Decrease in salaries and wages This class of transaction indicates an abnormal behavior. Normally salaries and wages are a substantial portion of the total administrative cost, but here they are not only small, but also decreasing with the increase in the revenue (Rittenberg, Johnstone, & Gramling, 2011). Similar to advertisment expenses, there are chances that the management has concealed salaries expense to increase the profit for the year. (CR-4) Significant increase in cash and bank balances. With extraordinary increase in the cash and bank balances, there is always risk that they intentionally overstated by the management to show better liquidity position. Normally cash is treated is a high risk area because it is easily exposed to theft due to its highly liquid nature (Seear, 2012). (DR-4) Increase in intercompany advances In related party transaction, it is a risk that the transaction may be fictitious, or some material terms could be concealed. There is a risk that management has overstated account balance to increase the current assets in order to reflect better liquidity condition (Jones, 2011). These related parties transaction are normally difficult to detect because the parties with the mutual understanding can create fictitious balances which could ultimately result in material misstatements. (CR-6) 49% increase in interest expense This heavy increase in the interest expense may be due to the over recording of the expense because the rate of increase in the long-term debenture is much lower than the rate of increase in the interest expense. The company has issues further debenture in 2006, but relatively higher increase in the interest rate may reveal other concealed liabilities. (IR-1) Human error No one can ignore the presence of human errors in the financial reporting process. These errors may occur due to reason that the entries are posted with misstated amounts or in wrong account. Some of the error may be negligible, but aggregated amount of these errors may be material. This risk is inherent to the business of Nathan Finance and it is beyond auditor’s confines to decrease this risk. (IR-2) Management Overriding the control With financial reporting process there is generally a danger that the management would have unnecessary influence. As discussed above management tries to present the most suitable picture so they can force accountants to record the transaction by apply the most suitable policies. For example charging depreciation using methods giving lesser depreciation charge. (3) Relevant Auditing Standards There are basically certain auditing standards that are most important as far as Nathans Finance NZ Limited is concerned. These are mentioned below. ISA 550- Related Parties There is a huge impact of related party transaction in the financial statements. This ISA provides guidelines on the auditing procedures that are necessary to ensure that the risk from the related party transaction is at acceptably low level. Auditor is responsible for making sure that all the related party transactions have been disclosed properly. New Zealand Institute of Chartered Accountants have also raised objection that the disclosure given in the financial statement is not appropriate (New Zealand Institute of Chartered Accountants, 2009b). ISA 520- Analytical Procedures This standard stress on the need of analytical procedures to be used as risk assessment procedures as well as it requires the auditor to use them as substantive procedure when arriving at the conclusion. In Nathans Finance, there are account balances and classes of transaction where ARP would reveal the hidden relationship, for example, sales to receivable and sales to advertising expense. Therefore, it is essential for the auditor to use ARP is this case to keep the risk at reasonably low level (New Zealand Institute of Chartered Accountants, 2009a). Other Standards Other standards that might be useful in this area include ISA 330 - Auditors Responses to Assessed Risk. This standard provides guidelines on the risk assessment procedures are overall business understanding. ISA-210 Recurring Audits would also be relevant because the Nathans Finance has been audited by Ben Ron Chartered Accountants. In addition to this ISA- 540 Estimates is also applicable because the company has made estimates in bad debt expense. (4) Evidences on Risk Sufficient appropriate audit evidence is required by auditors to keep the audit risk at reasonably low level. These evidences may include the following; Inquiries from the management and appropriateness of the responses keeping in view the nature of the business as well as markets conditions. Testing internal controls is the most important part of the audit because it determines the nature timing and extent of the audit procedures. For this purpose, check whether the audit files has reasonable information regarding the test of controls. For example both design and operation has been checked properly. Confirmation of the balance for the selected debtor. Conformation of the balances from selected creditors. Bank conformation each of the company’s bank account Analytical review procedures including review of the performance of the Nathans Finance with the industry as well as previous year’s results. Recalculation of the balances provided to the auditors. Re-performing the procedures. Inquiries from internal auditors and other personnel involve in recording financial data and appropriateness of their responses. Percentage of the data that has been chooses to verify for every account balance and classes of transaction. Check foreign currency rates at which foreign account balance have been translated. For example, average rate for income statement items and year end rates for balance sheet items. (5) Audit Opinion Unqualified opinion in these conditions cannot be expressed because of certain major issues. There are significantly material amounts involved in related party transactions, which are not properly mentioned, in the financial statements as required by auditing standard on related parties. The tribunal has also referred to this fact that the related parties were not properly disclosed. In addition to this tribunal also concluded that advances provided to one of the associate company, which were classified as current asset and it was misleading to the users of the financial statements. As mentioned earlier, the company recorded fictitious balances in order to show a better financial position than actual and the auditors were not able to detect the material misstatements in the financial statements of the company. The complexity of the business structure made it impossible for the auditors to detect the error and fraud in the financial statements. Nathan’s Finance management obtained the loan from the investors and instead of investing this money into a profitable business they invested in associate companies and other businesses from where the company could not even recover the cost of capital and ultimately sustained continuous loss. Furthermore, there are certain unusual relationships in the financial statements such as advertisement expense decreased in contrast to increase in sales, decreased in the salaries expanse from previous years. All these facts requires auditor to consider qualifying the audit report. References BDO. (2013). Risk Areas in Revenue Audits. Retrieved May 5, 2014, from http://www.bdo.ie: http://www.bdo.ie/sites/default/files/bdo_risk-areas-in-revenue-audits-feb13.pdf Seear, David J. (2012). ISO 9001 Audit Trail: A Practical Guide to Process Auditing Following an Audit Trail. Bloomington: Author House. Jones, Michael J. (2011). Creative Accounting, Fraud and International Accounting Scandals. New Jersey: John Wiley & Sons. Nathans Finance NZ Limited. (2006). Annual Report 2006. Auckland: Nathans Finance NZ Limited. New Zealand Institute of Chartered Accountants. (2009a). International Standard on Auditing 520- Analytical Procedures. Retrieved from http://www.nzica.com/Technical/Audit-and-assurance/~/media/NZICA/Docs/Tech%20and%20Bus/Ethical%20and%20professional/Expired%20Exposure%20Drafts/Expired%208 New Zealand Institute of Chartered Accountants. (2009b). International Standard on Auditing 550- Related Parties. Retrieved from http://www.nzica.com/~/media/NZICA/Docs/Tech%20and%20Bus/Audit/Standards%20and%20Guidance/Audit%20Standards/ISA%20550%20-%20Related%20parties.ashx. Rittenberg, Larry, Johnstone, Karla, & Gramling, Audrey. (2011). Auditing: A Business Risk Approach. Mason: Cengage Learning. Read More