Planning the Audit of Dart Valley Railway PLC - Report Example

Audit Risk Audit Risk The Engagement Partner The Audit Manager s: Planning the audit of Dart Valley Railway PLC Date: As we are about to begin the audit of the financial statements of Dart Valley Railway PLC and as you are well aware of the fact that all the financial statements are exposed to certain risks that the auditor must keep in mind before he begins the audit of the financial statements of the company. While planning the audit of the financial statements of a company, we have to obtain a thorough understanding of the entity as well as their internal control. We also have to consider whether the entity is exposed to any risk of fraud that may be affecting the entity within. While obtaining the understanding of the entity and the environment of the entity, the auditor has to consider various factors in which the entity performs its business. Obtaining the understanding of the entity also involves the understanding of the Nature of business of the entity, its industrial and regulatory requirements, its organizational and business strategies as well as their internal control and performance reviews and measurements. There are various risks that the financial statements of the companies are exposed to, some of which are clint specific whele other are auditor specific risk. These risks are discussed in detail below. AUDITOR SPECIFIC RISK There are some risks which are auditor specific and exist incase the independence of the auditor is impaired. Some of them are discussed below: Client fees The client fees is a strong incentive for the auditor and it is a known fact that auditors obtain a substantial amount of fees for their audit work. The auditors don’t 100% guarantee the fairness of the financial statements which works as a shield for the auditors but in the recent past some cases have been identified which pushes the auditors to impair their independence in order to obtain the fees they charge. This is a risk which should always be kept in mind that the auditors should not obtain fees for the cost of their independence. Substantial Interest in the Client Interest in the client, whether financial or non-financial, is also a cause of the auditor’s independence impairment. The auditor may hold shares of the client which may cause the auditors to impair the independence and give a positive opinion for their personal reasons. Long term association with client A long term association with the client builds a relationship with the client which may cause the auditors to get their independence impaired. This risk can be avoided by changing the combination of the team every time the team is sent for the audit of the same client. CLIENT SPECIFIC RISK The client specific risk are also known as the audit risk. These risks can be further classified as under. AUDIT RISK The audit risk is a product of three risks. These risks are Inherent risk, Control risk and the Detection risk. (Eilifsen, 2006) Audit Risk = Inherent Risk x Control Risk x Detection Risk The audit risk is specific is the risk that tan inappropriate audit opinion may be given on the financial statement by the auditors. This risk arises based on many factors which may or may not be inherent of the entity. It is one of the most fundamental aspects of the auditing process because of the fact that the audit is that of a test nature and the auditors cannot verify all the transactions in an audit because of the limitations which are imposed due to the restricted period and the amount of transactions to be covered in that time. The limitations which are imposed by the virtue of an audit are: Audit is of test nature and involves the use of sampling rather 100% examination. Audit is based on the judgment of the auditor as to how he presumes the matter at hand and in his regard how material is that matter, in short the work of an auditor is permeated by judgments. A variety of the audit evidences are persuasive rather than decisive such that the auditor has to find supporting facts to reach a conclusion regarding a matter at hand. There exists some inherent limitation regarding the internal control of an entity that the auditor has no control over for which he has to decide matter on judgmental basis to overcome those limitations to a certain extent. The components of the audit risk which are Control Risk, Inherent Risk and Detection Risk are discussed in detail below. Inherent Risk Inherent risk is the risk of susceptibility of the financial statements to frauds and errors provided there are no internal controls provided by the entity. This risk is the most where the entity has weak internal controls and the frauds and errors become more obvious. We, the auditors, have to be more devoted in our approach where the entity has weak or no internal control in their environment as the entity becomes more exposed to the risks of fraud and errors. Control Risk Another component of the audit risk is that of the control risk. This is the risk that material misstatements, i.e. fraud and errors, will not be detected, prevented and removed on an appropriate basis with the help of the internal controls. This risk also approaches the risk of weak internal control and needs extra attention from the auditors point of view. The two risks, namely the control risk and the Inherent risk, are collectively known as the risk of material misstatements. Control Risk x Inherent Risk = Risk of Material Misstatement These risks have a direct relationship with the client of the audit and correspond to the entitys internal control. Where the entity has a strong internal control, conversely the risk of material misstatement is reduced to a exceptionally low level, depending on the environment of the entity. Detection Risk Detection risk is the risk which is directly linked with the auditor and is not classified as the risk of material misstatement. It is the risk that we, the auditors, will not be able to perceive and detect any frauds and errors within the entity which affect the financial statement assertions. This risk is always there because of the nature of the audit which is of test nature. Detection risk can be further classified into Substantive test of details risk and the analytical procedures risk. The risk assessment procedures are also performed by the auditor to asses the risk within an entity. This can be done by: Conducting inquiries from management personnel Performing analytical procedures and comparison with prior year accounts and industry data Observations Inspections etc. Inquiries Discussions with the management regarding their key objectives, plans for the future and the goals that they have set for the organization makes the auditor aware of many aspects of which that the entity may be exposed to. Analytical Procedures Performing analytical procedures helps the auditor to identify any unusual and non-routine transactions that may have occurred during the financial year which may have an essence of misstatement due to fraud or error in it. Observations Observation of the clients processes as well has handling of transactions can also give a brief overview of the way that client performs its business. Observation may not be as effective as other audit procedures because the client may perform better when he is aware of the fact that he is being observed by another person. Inspections Inspection of documents may give a good idea about the effectiveness of the internal control and conversely the amount of risk involved in the client. Inspection may involve the checking of authorization of documents, completeness of documents and recording of proper transactions etc. MATERIALITY The auditor performs risk assessment procedures to assess the risk in an entity and on the basis of these risks, the auditor determines its materiality level that how many procedures does the auditor has to perform and the extent to which the auditor has to inspect and examine the entity and the financial statements of the entity for frauds and errors. While setting the threshold for the materiality and the risk, the auditor has to look for the various factors that affect the entity directly and indirectly. These factors can be the environment in which the entity does business, the norms of the entity, the kind of business that the industry operates and the extent to which the authority is centralized in the entity. After assessing the factors, we have to set up our level of materiality level. Amounts which are individually material as well as amounts which are collectively material are given special attention and are conveyed to the management for adjustment. We have to give special attention to the factors in the financial statements of the company such as the wages account as the company belongs to a labour intensive sector. Another important section is that where the directors have special interest in. DART VALLEY RAILWAY PLC Dart Valley Railway PLC is a tourist services company and operates through railways, busses and boats. They run railways, boats and busses for travelling as well as for tourism purposes all over. (Dart Mouth Rail, 2010) The major revenue is generated by the company though sales of tickets and provision of catering and bar services. AUDIT RISK IN FINANCIAL STATEMENTS OF DART VALLEY RAILWAY PLC Looking at the financial statements and the nature of the business of the company, we have identified certain risks that the business is exposed to which would need considerable attention from the point of view of the auditors. These risks are discussed in detail below: Acquisitions and Mergers Recently, the company merged with another company and extended its operations from being just a railway company to a steam boat and bus service provider. (Dart Mouth Rail, 2010) This involves more risk in the business and so creates an alarming situation for the auditors. The risk of the fact that the acquisition took place in the proper environment and the companies have maintained proper accounts for the transaction still remains. Management manipulation There always remains the factor of management override of the controls as they have the opportunity to manipulate the controls. As the senior management has a great deal of involvement in the day to day functions of the company which gives them the opportunity to take advantage of their position and manipulate the accounts of the company to make a gain for themselves. In order to contest with this risk, the auditor has to obtain information the extent with which the management can take decisions and can alter situations to effect the entity as a whole. Risk of employee fraud As this is a labor intensive company and runs through the labor workforce, it creates an opportunity for the labor to take advantage of their position and to manipulate the by means of fraud. (PLC, 2009) As the Chairman’s statement clearly shows that the major expense of the company pertains to Direct and Indirect wages, there is always a risk that the employees get the best of their position. Unusual Accounting treatments Being a tourism industry, the entity has an unusual system to recording and generating accounting entries. This creates an audit risk in the assignment as more complex the accounting treatments and transactions are, the more difficult it gets to verify them in the course of an audit. New Ventures and Operations The company has planned some new ventures in the coming years, as the Chairman’s report clearly suggests. (PLC, 2009) The new initiatives include some new boat trips as well as some train journeys. As these new ventures have not been conducted before and involve a substantial amount of company’s reserves, extra care needs to be given to these areas where there can be significant indication of risk factors. Director’s Interest The 2009 year financial statements indicate significant director’s interest and also indicate significant responsibilities and duties, this gives a chance to override the controls and make inappropriate gains. (PLC, 2009) A significant decrease in the director’s remuneration can also be seen as the remuneration falls from 105,808 to 20,000. Related Party Transactions The company has taken advantage of the section of the companies’ ordinance and has not disclosed the related parties with which they have incurred transactions with. (PLC, 2009) This creates a key risk of non disclosure of the related parties in their financial statements. There always remains a risk that the company incurs transactions with its related parties at lower rates that it carries on transactions with other parties. This may lead to tax evasion and showing of lesser income to its shareholders which results in low distribution of dividend. Increment in Cash Flow A significant increase in the net cash flow generated from operating activities can be seen in the 2009 financial statements of the company as the cash flow 72,277 to 637,433. (PLC, 2009) This significant change points out towards another risk factor for the audit of this year’s financial statements of the entity. Involvement in a rapidly changing industry The business of the company is of that kind of a nature that it involves a rapid changing industry. The tourism industry is changing very quickly and new ways of business are coming up. This brings the going concern issue into play which calls for extra concern in key areas of the entity such as the investing activities, debtor turnovers and revenue generation. Conclusion These are the areas which would require keen audit supervision as well as concern throughout the audit. Dedicated planning and understanding of the entity, by all the audit team members would be necessary before the beginning of the audit to avoid any situations which cause us to overlook the key items of the entity. As the audit involves complete planning exercise which has to take care of all the factors which have a direct connection with the audit of the client. We have to be sure that none of the factors get overlooked during the planning stage. All the key areas have to be taken in to consideration even during the course of an audit such that we are able to complete this task with dedication and contemplation. Looking forward to the audit of Dart Valley Railway PLC. References Dart Mouth Rail. (2010). Retrieved from http://www.dartmouthrailriver.co.uk/ Eilifsen, A. (2006). Auditing and Assurance Services. McGraw-Hill. PLC, D. V. (2009). Annual Report. Read More