Abbey PLC Auditing - Case Study Example

Auditing Case Study: Abbey PLC Task Introduction The paper contains an analysis of Abbey PLC with respect to auditing, audit risk and substantive audit tests. Auditing practice primarily exists to ensure that the contents of the financial statements are accurate and that the providers of financial information follow the prescribed rules and regulations for the compilation of the financial statement. Based on the financial statement of Abbey PLC for the year 2014, the paper provides the following: first, three areas of heightened audit risk and a quantitative analysis of the areas. Second, the five substantive audit procedures suitable for lowering the audit risk to an acceptable level. Part A The primary income generating activities of Abbey PLC are the construction of residential houses, property development, property rental and plant hire. The company’s stocks are traded on the AIM market in London and ESM in Dublin. The companys operations are conducted in the United Kingdom, Ireland and Prague. Based on the financial statement, the cost of sales comprises of the operating costs and an impairment charge on inventories. The operating costs increased from € 77,904 to € 84,563 in the year 2014. On the other hand, the impairment charge on inventories decreased. The cause of the decline is unclear while the total stocks increased from € 90,408 to 120,641 in the year 2014. The basis of the suspicion is that when sales increase, the level of inventory increases. Therefore, when the inventories increase, the impairment charges should also increase. Consequently, the auditors are advised to conduct further investigation into the area (Annual Report: Abbey PLC 2014, pp. 18-20). The process of auditing, in this context, refers to the evaluation of the financial statement of Abbey PLC to ascertain whether the information presented within, is free of fault, omission, commission or material misstatement. An audit risk is, therefore, the chance that the auditor will fail to identify an error or material misstatement when analysing the company’s financial statement. After reviewing the company’s financial statement, Frank O’Keefe – acting on behalf of Ernst & Young- states the following: first, “the group financial statements give a true and fair view, in accordance with IFRSs as adopted by the European Union, of the state of the Group’s affairs as at 30 April 2014 and of its profit for the year then ended” (Annual Report: Abbey PLC 2014, pp. 17). Second, “the parent company balance sheet gives a true and fair view, in accordance with Generally Accepted Accounting Practice in Ireland of the state of the Parent Company’s affairs as at 30 April 2014” (Annual Report: Abbey PLC 2014, pp. 17). Last, “the financial statements have been properly prepared in accordance with the requirement of the Companies Acts 1963 to 2013” (Annual Report: Abbey PLC 2014, pp. 17). Based on the auditor’s statement, the financial statement of Abbey PLC is free of error or material misstatement. Nonetheless, the following three areas are of heightened audit risk: Inventories (Building land & roads, Work in progress and raw materials), Impairment charge on inventory and finance cost. Building land and roads are valued at the lesser of cost and net realisable value. The items are assessed annually for any impairment costs. The value of work in progress is the sum of the cost of direct labour and direct material used in the construction of uncompleted and unsold properties. The value of the raw material is determined based on the average cost of the net invoice (Annual Report: Abbey PLC 2014, pp. 23). First, based on the financial statement, the value of building land and roads, work in progress and raw materials for the year 2014 are € 93,025,000, 26,920,000 and 696,000 respectively. The financial statement indicates increases in the values as compared to the previous year’s value. The items are areas of heightened risk because the processes of measuring the values are subject to manipulation and misstatement. The total inventory in 2014 increased by 33.44% as compared to the previous year’s value. The increase is attributed to a substantial increase in raw materials, building land and roads and work-in-progress by 165.65%, 41.08% and 11.2% respectively (Annual Report: Abbey PLC 2014, pp. 33). See Appendix 1. Second, the income statement of the company indicates a decrease in the impairment charge on inventories from € 3,539,000 in 2013to € 162,000 in the year 2014, which is a 95.42% decrease. However, the between the same period, the value of inventories increased from € 90,408,000 to € 120,641,000, which is a 33.44% increase. What is unclear is whether the impairment charges should increase or decrease with the level of inventories. The auditors should assess the relationship and review the process adopted by Abbey PLC when determining the impairment charge on the inventories. Third, finance cost is among the expenses the company incurred. Based on the financial statement, there was no finance cost in 2013. However, in 2014, the cost of finance was € 2,000. Finance costs or the interest expenses are incurred on loans and other debts. Surprisingly, Abbey PLC did not seek for any debt between the two periods yet it incurred finance costs. Another surprise is that notes 9 in the financial statement classify the finance cost under interest payable. Payable should be recorded under liabilities. However, the finance cost is not among the company’s liabilities. The auditors should analyse the item and provide clarification regarding its source and classification to eliminate audit risk. Part B As mentioned above, audit risks are the chance that the auditor will fail to notice mistakes or material misstatement when assessing the financial statement of the company. The financial statements are prepared under the supervision of the director of the company. The director and other parties responsible for the preparation of the financial statements may intend to doctor the financial information deliberately in a bid to create a false impression about the company’s financial performance. It is the duty of the auditor to conduct an in-depth analysis to verify the completeness, occurrence, accuracy and existence of the items included in the financial statement. From a different perspective, the contents of the financial statement are claims made by the directors (Fortney 2015, pp 1-5). The purpose of substantive audit tests is to verify the validity of the claims. The five substantive audit procedures are as below: First, building land and roads are physical assets. The auditors are required to conduct tests to verify their existence. Like mentioned above, the value of building land and roads is the lesser of the cost and the net realisable value. The substantive audit procedure appropriate is the physical inspection of the assets. During the process, the auditors are required to check the location of the land on the blueprints and the actual site (Messier, Simon & Smith 2013, pp. 1-9). The procedure will ensure that the claimed building land and roads are in the right spot and are the same size as is indicated on the financial statement. Similarly, the auditors should very the physical existence of the raw materials. The procedure can be done more effectively by checking the storage facility for raw materials. The process should be accompanied by a series of crosschecks on invoices sent by the supplier. The invoices would provide the details of the raw materials, which facilitates the verification process. The procedure will prove that the claimed assets exist, thus, minimise misstatement, which will in turn, reduce the level of audit risk (Messier, Simon & Smith 2013, pp. 1-9). Second, the auditor should conduct appropriate audit tests to verify the ownership of the building land and roads and raw materials. The appropriate substantive audit procedure, in this case, is the identification of the buildings and the inspection of documents that indicate their ownership. The auditors are required to inspect the supporting documents of the purchase of the assets. Land ownership can be verified through searching the land registry database. In addition, the auditors should examine the property deeds to prove the ownership. The mentioned processes help to reveal a forgery and fraudulent activities, thus, minimise audit risk (Messier, Simon & Smith 2013, pp. 1-9). Third, the ownership of the assets is transferred after the terms of contracts are honored by both parties to a contract. The auditors are, therefore, required to verify the occurrence of the transactions. The substantive audit procedure suitable for the verification process is checking the contents of the contract document to determine the terms, the assets involved, costs involved and the period involved. The auditors are also expected to review information relating to the past contracts to ascertain the trends in terms of cost and time. In addition, the auditor should analyse the documents that support the transfer of cash between Abbey PLC and the third party. The procedure will help minimise the audit risk (Coglitore & Berryman 1988, pp. 2-7). Fourth, based on the financial statement, Abbey PLC values its work-in-progress based on the direct material and direct labour costs of uncompleted and unsold properties. The auditors are required to verify the suitability of the valuation methods adopted by the company. Therefore, the suitable substantive audit procedure is to assess the suitability of the method used to determine the direct cost of both labour and material. The procedure will ensure that the valuation method is the most appropriate, thus, minimise the audit risk (Coglitore & Berryman 1988, pp. 2-7). Last, the auditors are encouraged to analyse the procedure used to classify the labour and material costs as either direct or indirect costs. The auditors should ensure that there is an establishment of a clear distinction between the direct and indirect costs. The procedure will eliminate duplication of costs; thus, ensure accurate ascertainment of direct cost of both labour and material (Coglitore & Berryman 1988, pp. 2-7). List of References Annual Report: Abbey PLC 2014, viewed 15 April 2015, http://abbeyplc.ie/financials/annual-reports/ Coglitore, F, & Berryman, R 1988, Analytical Procedures: A Defensive Necessity, Auditing: A Journal Of Practice & Theory, 7, 2, p. 150, Business Source Complete, EBSCOhost, viewed 15 April 2015. Fortney, SS 2015, Ethics Corner: Preventing Legal Malpractice and Disciplinary Complaints: Ethics Audits as a Risk-Management Tool, Business Law Today, pp. 1-2, Business Source Complete, EBSCOhost, viewed 15 April 2015. Messier, J, Simon, C, & Smith, J 2013, Two Decades of Behavioral Research on Analytical Procedures: What Have We Learned?, Auditing: A Journal Of Practice & Theory, 32, 1, pp. 139-181, Business Source Complete, EBSCOhost, viewed 15 April 2015. Appendix 1: Quantitative analysis 2014 2013 % change Building land and roads 93,025 65,937 41.08164 Work in progress 26,920 24,209 11.19831 Raw materials 696 262 165.6489 Total 120,641 90,408 33.44062 Read More