Importance of an External Audit - Essay Example

Contents Part 3 1 Sta y Audit 3 (a) Legal Rules Relating To Sta y Audit 3 (b) Nature scope and purpose of external audit 4 2 Audit Fees6 (a) Purpose of Setting Of Fees 6 (b) Appropriate Basis of Audit Fees 6 Part 2 7 2.1 Issues to be considered on Engagement Acceptance 7 (a) Family links 7 (b) Effectiveness of internal control systems 7 (c) Expectation Gap and Purpose Of Engagement Letter 8 2.2 Engagement letter 9 Part 3 11 3.1 Audit Risk and Planning 11 (a) Extract and analysis 11 Turnover 11 Distribution costs 11 Administrative Expenses 12 Interest Expense 12 Going Concern 12 (b) Materiality and Disaggregation 13 3.2 Risk in Audit 14 (a) Risk elements 14 (b) Methods to Gain Audit Evidence 15 3.3 Auditing for using Other’s Work 16 (a) Using Others Work as Audit Evidence 16 (b) Using Sean’s Work as Audit Evidence 17 Appendix: Analytical Review 18 Ratio Analysis 18 Annual Movements 18 References 19 Part 1 1.1 Statutory Audit (a) Legal Rules Relating To Statutory Audit Most companies are required to have an external audit by law annually. However, some companies are exempted from it. The government has made a policy to let the companies make a decision about the appointment of the statutory auditor. To avail the audit exemption in UK, companies must be sizable regarding balance sheet and turnover. According to new rules, exemption will be offered to SME only if it fulfills the two requirements out of the three. These requirements are related to the number of employees hired by the organization, turnover and statement of financial position/balance sheet. This new change allows many companies an audit exemption. In many countries, a wide range of companies fall into the small company’s category as they employ a few people and are mostly owner managed businesses. The criteria for the determination of a company to be small include the following clauses: (1) It must be a private company (2) Two of the three conditions mentioned below must be fulfilled It should have an annual turnover of no more than $10 million It should have gross assets of no more than $10 million It should have employed no more than 50 people When the consolidated accounts are prepared by the parent companies, the private company should qualify as small company if it meets the above criteria for the small companies on a consolidated basis. In UK, companies are regulated by the code of corporate governance. The companies need to have an independent auditor for the financial statements. Board establishes formal arrangements for considering corporate reporting, risk management and internal control principle. Code suggests that to maintain the relationship with the auditor, an audit committee should be set up. Auditor should check the companies applying the code of the governance. (b) Nature scope and purpose of external audit External audit is basically a kind of assurance engagement, carried by an auditor to give an independent opinion on the financial statements, like, balance sheet, cash flows, income statements etc. The objective of the external audit of the financial statements is to enable the auditor to give an independent opinion on the set of the financial statements and in all material respects. The purpose of the external audit is to give an opinion on the financial statements. Auditor has to give the opinion about the truth and fairness of the financial statements. They are not responsible about the correctness, in absolute terms, of the financial statements. This is difficult because it consumes a lot of time in checking each and every transaction. The financial statements are maintained on the estimation basis; which means that these statements can never be completely accurate. External auditor must be an independent person, according to the law. It can be a person, a group of persons or a company that provides its services to the other companies. The duty of the auditor is to give the independent opinion on the financial statements, which means that it should not be influenced by the management of the company. The scope of the external auditor’s work is dependent on the guidelines and standards provided by International Standards on Auditing. There are various people who might read the financial statements of a company. They will also read the statements of many other companies and compare them to take investment decisions. The users of financial statements, hence, require a more stable, consistent and standardized format of reporting. The reliability of these statements must be upheld by the large companies to aid users in understanding, comparing and making decisions using them. To overcome the issues of inconsistencies and unreliability of financial statements, auditors follow International Auditing Standards to ensure the credibility of data presented and the presentation of financial statements. Such standardized format, structure and standards enable users to make informed decisions. The external assurance requires that all financial statements should be audited and are maintained by the shared standards. Auditors must follow the rules of these standards to maintain the trust of users of financial statements. Statutory Audit is an audit which is conducted by the person or entity appointed as statutory auditor. Law requires that audit of the books of accounts has to be done according to legal rules; and on these audited accounts, auditor has to give a report. Independent financial reviews are not required by law but are conducted by many companies to enhance the reliability of books of accounts (Tandfonline, 1970). 1.2 Audit Fees (a) Purpose of Setting Of Fees The main purpose of setting of audit fees is to ensure any audit firm is not reliant on its clients. If the firm has a high percentage of fees to recover from one client they is a possible that its objectivity and impartiality may be infected. The firm may not want to lose such client hence may hand out a positive audit report in case where an a disclaimer or adverse report was to be given on the other hand the client may also pressurize the firm to give out a positive audit report and threaten them that fees shall not be paid to them otherwise. The maximum recurring fee is set to a range between 10 to 15%. (b) Appropriate Basis of Audit Fees The appropriate base for the audit fee setting is any from the following  the time of Audit (depending on the assessed risk and amount of work required to reach appropriate audit opinion) the Auditors Disbursements According to the professional conduct there are certain rules and regulations that how much auditors should be paid for their audits According to the practice of the certain industry According to the fee structure mentioned in ISAs According to the fee set by the law There are no issues regarding competitive tendering but it can be beneficial for the company to avail the best services in low price and according to the company quoted price through tendering. Part 2 2.1 Issues to be considered on Engagement Acceptance (a) Family links As Chris stays busy on the road and his responsibility comes to David, the senior manager, who is the brother of the colleague of our firm’s auditor. This family link gives rise to the self-interest threats. David also handles Amanda’s works which also create the self-interest threats for the company. This also creates the contingent or fewer fees to accept by the auditor to the close relationship with the client. This will also create to charge the low fee threats for the company. This process gives rise to intimidation threats as the auditor may be influenced by his colleague to change his opinion due to the close family relations. (b) Effectiveness of internal control systems Internal control is a system designed by the management of the company and those charged with governance, to regulate the company’s activities according to the company’s objectives and different laws and regulations. This system is maintained to ensure the effectiveness of the company’s operations (Small Business, 2009). Company’s internal control system is defective as there is no segregation of duties. For instance, Chris is responsible for sales affairs that include sale negotiations, product distribution, sale invoicing, Banking customer receipts and maintenance of the sales ledger which automatically provide enough space to Chris to misstate sales by including dummy clients. Moreover, the unavailability of Chris provides David Chizande, the senior sales manager, with the power over sales operations. There is a possibility that David commits a fraud or misstates the sales records or steals cash and so on. One person who is maintaining the accounts is also responsible for forecasting the profits and losses for the company’s coming years. There is no proper monitoring authority to, for instance, authorize the sales and receipts independent of the sales negotiation staff. In order to provide a better view of their sales performance, the sales manager may overstate the sales and mask it completely as he has the sole responsibility from sales negotiations till cash receipts. An effective internal control system provides the management with the reasonable assurance regarding the company’s objective completion, because the absolute assurance is not possible. Internal control risk are the risk which may affect the entity’s ability to properly record and interpret the financial data due the effect of the changing environment and changing rules and laws. (c) Expectation Gap and Purpose Of Engagement Letter The expectation gap is the gap between the auditors actual performance and the various public potentials regarding the expectations of auditor’s performance. The following are some examples which ultimately create the wide expectations gap between the actual and required performance (Ventureline, 2013). Auditors are required to detect the errors and frauds Auditors are supposed to provide the 100% check of all the material items Auditors are supposed to give an independent opinion on the financial statements Auditors are supposed to report on the audited statements Engagement letter has the same purpose and nature of the traditional contact letter. It is carefully written in it that the scope of the engagement of the auditor, completion deadlines of the projects, addresses any conditions regarding job and any other compensation arrangements will be made by the company for the person. This is helpful in creating the understanding of the engagement terms which latter on might create the misunderstandings and cause many cost loss. This is a good way to enter into the contract by the informal way because it is an informal letter. It helps the people which might feel hesitant to enter into the legal contract. 2.2 Engagement letter To Edward Goulbourne Ltd Respected Sir, We are pleased to have an opportunity to work as auditors for your organization. This letter is to confirm the terms of our appointment. The letter provides the basis on which we are to act as auditors and the respective areas of responsibility of management and ourselves. We affirm to follow the ethical guidelines provided by professional bodies and the applicable regulatory authorities. Period of Engagement The period of engagement is from Ist august 2011 to 30th September 2012. That is our opinion shall be based on the financial statements issued related to this period. Responsibility of the management It is the responsibility of the management to prepare proper accounts and detect any fraudulent activities and mitigate any possibilities of any fraud to occur.. Responsibility of Auditor The responsibility of auditors is to form an opinion on the true and fair view of the stated financial statements. Fees Fees will be charged on the level of expertise and time spent on each activity to determine the reliability of the financial statements. Audit scope The Audit will be conducted according to the related national standards, in this case, the UK auditing standards (GAAP) Agreement of terms Once the terms are agreed it remain effective during our audit period, until and unless it is changed by its scope Yours faithfully, Bonney Kuteszko & Co. Date ----------------------------- Part 3 3.1 Audit Risk and Planning (a) Extract and analysis Turnover The turnover has been increased by 25% in 2012, as compared to the company budgeted increase at 27% in 2012. There is a need to properly audit the basis on which the sales increase was budgeted. The significant increase might be a result of an overstatement of turnover. The risk of misstatement is high and requires a careful analysis of turnover records. It must be noted that the company has given an extended credit term as observed by the stretched out debtors collection period during 2012. The budgeted debtors’ collection period was 34 days as opposed to the 2011 collection period of 32 days. The draft 2012 results show a 42 days collection period when industry show a collection period of 35 days. The increased sales may be a result of lengthening the credit terms which provide relaxation to the clients. However, the risk of bad debts increases with the increase in collection period. The bad debt provision is not set up which shows an overstated position of the company. There is also a risk of overstatement of trade receivables as uncollectable amounts are not taken into account. The increase in sales of 25% is significant and calls for more procedures to check if the cut-off procedures are followed appropriately. The higher sales may place a burden on the management and sales department and flawed cut-off might be mistakenly or deliberately performed. The internal control system under such stressing periods might not be working efficiently. Distribution costs The distribution costs have increased by 100% as compared to the financial year 2011 and 50% compared to the budgeted record. Due to insufficient information, it is not possible to identify the reasons behind this increase. It may, however, be an attempt by the company to extend its operations geographically and provide its clients with more comfort. Administrative Expenses These costs have been increased by 61% compared to the budgeted increase of 70%. These costs are expected to increase in line with the proportion of increase in production and sales volume; however, this does not seem to be the case. There is a need to review the broken down costs of administrative expense and analyze them separately to find the reasons of such disproportional increase. Management may be enquired of any unusual trends. Interest Expense Interest expense has been increased by 39% in 2012. This is partly reflected by the increase in long-term debt of 25%. The emergence of bank overdraft is also suggesting a portion of this increase in interest charges. There is a need to perform further procedures like inspecting the debt documents and external confirmation to reduce the risk of overstatement to an acceptably low level. Going Concern The company’s Earnings per share have been reduced significantly as compared to the year 2011. It has gone down to 19p during 2012 from 41p in 2011. However, the current EPS is acceptable when compared to the industry average of 20p per share. This huge reduction, if analyzed closely, seems to be a result of increase in number of shares. The number of ordinary shares has been increased by approximately 122%. Such a huge increase in shares directs towards the risk of cash flow problems which are managed by attracting more investors. Keeping track of the cash and bank situation further increases the risk of the company to manage its cash needs by exposing a nil cash on the face of SFP in 2012(draft). Average Stock turnover have increased from 42 to 61 days and debtors’ collection period has increased from 31 to 42 days from 2011 to 2012 respectively. Due to delay in the receipt of payments the cash flow problem is further exacerbated resulting in an increase in the creditors’ period from 40 to 56 days when compared with 2011 results. The Gross profit margin, Net profit Margin and Dividend per share results show a satisfactory performance of the company as compared to the industry average and the company’s own financial records of prior year. However, the reduction in ROCE and interest cover requires a careful review of the trends form past. If the company shows a continuous reduction in the interest cover ratio, there is a need to perform further procedures to affirm the going concern assumption of the company. As of now, the company seems to meet its liability with the available funds; however, the excessive increase in shares to meet the cash needs does not seem to be appropriate in the longer run. (b) Materiality and Disaggregation The omission or misstatement of information that may influence the financial and economic decisions of its users with respect to the financial statements is known as materiality. It provides a cut-off point that information must have for it to be useful. Materiality is of significant importance for a company. It may differ from business to business. Auditors make their own judgments on materiality for the financial statements and it must be determined at the planning stage.. This materiality for the financial statements is reviewed throughout the audit if it is required (Accountingexplained, 2011). Disaggregated data is also important for the auditor. After extracting the aggregated data it is divided into smaller pieces of the information. It is an advanced step of getting the increased information from the aggregated data. The diversification and nature of a business have a great impact on the risks of material misstatement being masked due to the presence of offsetting factors. In order to escape this risk, analytical procedures may be performed on disaggregated data. The disaggregated data may be chosen on the basis of time (i.e. weekly, fortnightly or monthly), geographic region (i.e. Southern region, Eastern region etc.), Product or any other source. Disaggregation data helps to reduce risk. 3.2 Risk in Audit (a) Risk elements Inappropriate and incomplete opinion by the auditor is said to be an audit risk. This occurs when the documents are redundant. There are three risk elements of the audit risk. Control risk Inherent risk Detection risk AUDIT RISK = CONTROL RISK x DETECTION RISK x INHERENT RISK (Gray 2007) Inherent risk is the openness of an affirmation to a misstatement that could be material individually or aggregated with other misstatements, when we assume that there is no internal control in the company. It is the risk which is affected by the nature of the entity. Auditors use their professional judgment to analyze the inherent risk of the company. Material misstatements that occur in financial statements individually or in aggregation with the misstated financial statements are not going to be prevented or corrected on time by the internal control of the entity. This risk is known as the control risk. Detection risk is the possibility that an auditor does not find any material misstatements regarding to the assertions of the company’s’ financial statement through analysis and substantive procedures. It is the risk that the auditor may conclude that no material mistakes and errors are present even though there are. Sampling risk and non-sampling risk are detection risk elements. (b) Methods to Gain Audit Evidence Following are the five methods that the auditor may use to generate audit evidence from internal control systems. Confirmation Inspection of tangible assets Inspection of documents Observation Analytical procedure Recalculation Re-performance Enquiry Auditor can inspect and check the tangible assets recorded in the financial statements which provide the audit evidence to support the audit report. This inspection provides the evidence that the tangible assets are recorded in the accounting books completely. The observation method provides the auditor with the audit evidence that involves observing the procedures, methods and processes that are being performed by the company. This method has its own limitation because the auditors can only observe and confirm the procedure and process and could not analyze that these procedures and process are being performed correctly. In addition, observation can be made for a specific point in time and cannot confirm the adherence of procedures and processes as reported throughout the year. This further limits the scope of audit opinion. Inquiry tool is helpful for the auditor because it involves the direct communication with the client staff. This involves seeking of the desired information from the client’s staff and external sources. This tool has its own limitations because information is not correctly given by the staff. Analytical procedures are helpful tool to gain audit evidence. It involves the evaluating and comparing of the financial and non-financial data. It also includes the examination of the fluctuations and inconsistent changes in the relationships with the other derived information and predicted amounts. Recalculation is the method of collecting the audit evidence which is time consuming. This involves checking the each and every accounting figure to determine the accuracy of the data. This is computer based method of getting the desired result. All of the above methods can be used by the auditor for the company. There are many other procedures which the auditor can use in getting the audit evidence and to support the audit opinion on the financial statements. 3.3 Auditing for using Other’s Work (a) Using Others Work as Audit Evidence Auditor can use the information generated by the company and any type of information associated with the company generated by a third party, as audit evidence; under the circumstances when the auditor feels that it is relevant and significantly reliable for the auditor’s purpose. The auditor may use the work of an expert which has the expertise and skill in the areas other than accounting and auditing if the auditor feels that this is useful in obtaining audit evidence. Auditors can use the work of others in the following circumstances, (Pcaobus,2010) Identifying the risk of material misstatement of the company Assessing and implementing the responses to the examined risk to the financial statements An understanding of the company’s environment that also includes its internal control system Analyzing the significance of the audit evidence in forming the report on the books of accounts The external auditor may use the work of others to gain significance audit evidence but this will not limit the auditor’s responsibility, as the external auditor is solely responsible, to give an independent opinion on the financial statements. (b) Using Sean’s Work as Audit Evidence As Sean has worked for the firm earlier and there is a huge possibility that people on the audit team know him it is essential that the familiarity threat be minimized by asking people who have not interacted with Sean, while he was at the firm, to be on the team. Other than that, the work should be reviewed by someone who again does not know and has not been interacting with Sean during his stay at the firm. Extra care should be taken while assessing Sean’s work and any threats to objectivity and impartiality minimized as much as possible. Sample sizes should be increased and the work carried out according to professional skepticism rather than in view of Sean past performance at the firm and his influences over people at the firm. Appendix: Analytical Review Ratio Analysis Ratio Formula 2011 2012 2012 (draft) Industry ROCE Operating profit / capital employed 1100/3930=28% 1560/5760=27% 1100/5790=19% 24% Interest Cover EBITA/Interest Expense 1100/90=12.2 1560/220=7.09 1100/125=8.8 10 Average stock turnover COGS/Avg. inventory 365/(4160/480)=42days 365/(4840/530)=41days 365/(5050/830)=61days 40 Debtors collection period Debtors / sales * 365 (540/6120)*365=32days (730/7800)*365=34days (880/7650)*365=42 35 creditors collection period Creditors / purchases *365 (455/4160)*365=40 (665/4840)*365=50 (775/5050)*365=56 50 EPS Profit after tax / ordinary shares 737/1800=41p 940/2000=47p 760/4000=19p 20p GP Ratio Gross profit / sales 1960/6120=32% 2960/7800=38% 2600/7650=34% 35% Net Profit Net profit / sales 1100/6120=18% 1560/7800=20% 1100/7650=14.4% 15% Dividend per Share Dividends/ No. of Shares 600/1800=33p 810/2000=41p 1850/4000=46p 30p Annual Movements 2012(budget) 2012(draft) Turnover (7800/6120)-1=27% (7650/6120)-1=25% Manufacturing Costs (4840/4160)-1=16% (5050/4160)-1=21% Distribution Cost (450/300)-1=50% (600/300)-1=100% Administrative Exp. (950/560)-1=70% (900/560)-1=61% Interest & Similar Exp. (220/90)-1=144% (125/90)-1=39% References Cfo.com (2010). Audit Fee Report - CFO.com. [online] Retrieved from: http://www.cfo.com/benchmarks/fees/ [Accessed: 5 Feb 2013]. Companieshouse.gov.uk (2006). Companies Act - Overview. [online] Retrieved from: http://www.companieshouse.gov.uk/companiesAct/companiesAct.shtml [Accessed: 5 Feb 2013]. Crowehorwath.net (n.d.). Statutory Audit | Crowe Horwath. [online] Retrieved from: http://www.crowehorwath.net/AE/services/audit/Statutory_Audit.aspx [Accessed: 5 Feb 2013]. Sba.gov (2010). What is SBAs definition of a small business concern? | SBA.gov. [online] Retrieved from: http://www.sba.gov/content/what-sbas-definition-small-business-concern [Accessed: 5 Feb 2013]. Small Business - Chron.com (2009). Importance of an External Audit. [online] Retrieved from: http://smallbusiness.chron.com/importance-external-audit-17630.html [Accessed: 5 Feb 2013]. 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