Areas of Heightened Audit Risk - Essay Example

Auditing Task Introduction The users of financial ments rely on the information released by the providers of such information for decision-making. There are various users of financial statements with different needs as follows: lenders, suppliers and other trade creditors, employees, investors, customers, government and their agencies, and the public (Lasher 2008, pp. 63-65). The users need the information for decision-making purposes. The paper presents three areas of heightened audit risk and the substantive procedures necessary to reduce the audit risks to an acceptable low level based on the case of Mobile Streams PLC. Part A Auditing is the process that involves the assessment of the financial statement of a company to verify whether the contents of such statements comply with the required framework. Auditors are charged with the task of ensuring that the financial statement of the company contains all the information considered as material. In a nutshell, the auditors check whether the content of the financial statement is free of fraud, errors or omission of material information. On that note, an audit risk is the possibility that the auditor will not detect any error, fraud or misstatement of material information when reviewing the financial statement (Thompson & Ward 1993, pp. 2-9). Based on the auditor’s opinions, it is fair to conclude that the financial statements of Mobile Streams PLC present a true and fair financial position. That is; they are free from errors, fraud or material misstatements. However, the auditors should pay more attention to the following three areas of heightened audit risks: foreign currency translation, share-based compensation, and financial income. Based on the financial statement, the company’s foreign currency loss is £ 1,347. The Foreign currency loss is encountered if the previous spot rate when selling the local currency is higher than the current spot rate when buying the local currency (Annual report: Mobile Streams PLC 2014, pp. 8 & 15). Close to 99% of the company’s revenues are generated outside the United Kingdom. Therefore, a larger part of the company’s operation is exposed to foreign currency risk. Fortunately, there are strategies used to lessen the exposure. However, Mobile Streams PLC does not use any to reduce the risk. The company relies on the prevailing spot rate for transaction purposes. The exchange rates constantly fluctuate. The company could manipulate the exchange rate to reduce the amount of taxable income. Assume that the loss on foreign currency was £ 690 instead of £ 1,347, the equity shareholders of Mobile Streams PLC would be £ 1,250 instead of £ 1,907. Therefore, auditors are requested to compare the prevailing rates at the time of the transactions and that which was adopted by the company for any similarity or differences (Vij 2002, pp.1-10) Second, share-based compensation is a strategy that involves the payment of salaries or bonuses using shares rather than cash (equity-settled transactions). The strategy is suitable for situations when companies experience unfavorable liquidity position. The cost of the shares is determined based on their fair value at the grant date. The basis for determining the fair value is the black-Scholes model. The Black - Scholes model, is very complex and can be the root of an error or manipulation of figures. Auditors are required to verify the accuracy of the black-Scholes formula adopted by the company. Based on the financial statement, Mobile Streams PLC spent £ 328,000, in the year 2014, on share-based compensation. The figure should be recalculated to verify its accuracy since the company could overstate the amount of share-based compensation (by manipulating the variables of black-Scholes model) in a bid to reduce the taxable income. For instance, if the stated amount £ 328,000 was overstated by £ 8,000, the profit before tax becomes understated by the same amount. The contrary argument is correct. Therefore, the area is a breeding ground for audit risk (Annual report: Mobile Streams PLC 2014, pp. 22). Last, financial income is generated by the financial investments made by the company. Based on the financial statements, the financial income of the company for the year 2014 is £ 170,000. Finance income is influenced by the required rate of return set by the company. The expected rate of return is a function of the risk-free rate, the return on the market portfolio, the risk premium, and the Beta. The risk premium is calculated by the company based on the risks associated with the investment. The auditor is advised to assess the relevance and suitability of the assumptions made by the company while determining their risk premium, thus, the required rate of return. For instance, assume that Mobile Streams issued a loan worth £ 1,700,000 at 13% per annum. The financial income would be (1,700,000*13%) = £ 221,000. If the company decides to manipulate the required rate of return (RRR) to reduce the taxable income, the presented RRR would be 10%, giving a finance income worth (1,700,000*10%) = £ 170,000. Based on the analysis, the finance income is understated by (221,000 – 170,000) = £ 51,000. Therefore, auditors are encouraged to conduct a deep analysis of the area (Annual report: Mobile Streams PLC 2014, pp. 6, 25 & 32). Part B Substantive audit procedures are conducted to minimize the occurrence of the audit risks. In the above part, foreign currency translation, share-based compensation, and revenue are the areas identified to pose audit risks. The five substantive audit procedures as follows: completeness, occurrence, classification, accuracy, and cut off. First, the financial statement of Mobile Streams PLC contains the three accounts considered as the areas of heightened audit risk. That implies that the company’s director claims the existence of the accounts. The auditors are required to conduct tests to verify whether all the relevant information relating to the mentioned areas is included in the financial statement. In other words, the auditors should test the completeness of the information regarding the three areas. For instance, completeness tests on revenue require the auditors to obtain the total download and price per down. The following step is to reconcile the total revenue with downloads based on the retrieved information. In addition, the auditor should check the cash book and receipts kept by the company to verify the amount stated as revenue. The procedures will ensure that the sources of the stated revenue are all included and the amount recorded is accurate, thus, minimize the audit risk (Liu, Woo & Boakye-Bonsu 1997, pp. 2-11). Second, the fact that the financial statement of Mobile Streams PLC contains the three areas of heightened audit risk implies that that the transactions that led to the mentioned accounts occurred. On that note, without verification, the occurrence of such transactions is considered as assertions made by the company’s director. Therefore, auditors are asked to conduct tests prove whether the transaction were conducted, and when they were conducted. The period of occurrence is another significant factor to be considered when reviewing the company’s activities. For instance, the auditors should check the company’s registry to verify the occurrence of downloads of mobile contents and their respective payment details. Download registry will show the details of the download such as the size and time of the download. The tests will prove the occurrence of the transactions that generated revenue, thus, eliminates any doubt about the validity and accuracy of the financial information (Liu, Woo & Boakye-Bonsu 1997, pp. 2-11). Third, the company’s financial statement provides the values of revenues, financial income etc. Based on revenue recognition policy, all the terms of the transactions leading to revenue generation must be met for the revenue to be recognized in a particular year. On that note, the auditors should review the invoices and cash receipts for the financial year 2014 to ensure that 2014 revenue is neither overstated nor understated. The suitable audit procedure is cut off tests. Based on the test, the cash receipts for the year 2014 should be used when determining the total sales amount. The process is effective in minimising audit risk (Hirst & Koonce 1996, pp. 2-10). Fourth, the company’s financial statement contains the loss (£ 1,347) caused by foreign currency movement. The auditors are required to conduct tests to verify the accuracy of the figure. The auditors will be required to obtain the spot rates used by the company and verify their validity and relevance. After determining the spot rates used by the company, the auditor should use the information to conduct fresh computations to determine whether there was a foreign currency gain or loss. The auditors should also use their data to perform another set of calculations and check for similarities or differences. If the answers are similar, the information on foreign currency gain/loss is true. Otherwise, it is false (Hirst & Koonce 1996, pp. 2-10). Last, the auditors should review the journal entries of the company, check the documents kept by the third party, check the documents kept with Mobile Stream PLC, make inquiries on the accounting policies regarding revenue recognition and reviewed the dates of the transactions to determine the accuracy of classification and the degree of disclosure of the information related to the foreign currency translation, share-based compensation, and financial income. The information is helpful in the verification of whether the relevant accounting procedure has been followed in the process of classifying transactions as revenues and financial income (Hirst & Koonce 1996, pp. 2-10). Conclusion Auditing helps verify the validity of the financial information. Substantive auditing tests are done to minimise the audit risks. Based on the auditors report, the financial information about Mobile Stream PLC is free of errors, material misstatement, and fraud. However, the information regarding the company’s foreign currency translation, share-based compensation, and financial income are areas of heightened audit risk. The following substantive audit tests should be conducted to minimize the risks to a lower level: Completeness, occurrence, Cut off, accuracy, and classification. List of References Annual Report: Mobile Stream PLC 2014, Viewed 12 April 2015, http://www.mobilestreams.com/investors Hirst, D.E. & Koonce, L. 1996, "Audit analytical procedures: A field investigation", Contemporary Accounting Research, vol. 13, no. 2, pp. 457. Lasher, W 2008, Practical financial management, Thomson South-Western, Mason, OH. Liu, J., Woo, H.S. & Boakye-Bonsu, V. 1997, "Developing internal auditing procedures in UK organizations using a benchmarking approach", Managerial Auditing Journal, vol. 12, no. 9, pp. 464-478. Vij, M. 2002, "Forward Foreign Exchange Rates as an Unbiased Predictor of Future Spot Rates: The Empirical Evidence", Journal of Management Research, vol. 2, no. 2, pp. 79-86. Read More