Analysis of Fraud - Deficiencies Identified in the Internal Control System, Audit Report to Shareholders - Example

Analysis of Fraud Case Table of Contents Table of Contents 2 Task 3 Management Weakness Letter 3 The current situation 3 Deficiencies identified inthe internal control system 4 Effective and practices and procedures 6 Task 2 8 Audit report to Farhan Muscat’s SAOG shareholders 8 Report on financial statements 8 Management’s responsibility 8 Auditor’s responsibility 8 Audit opinion 9 Report on regulatory requirements 9 References 11 Task 1 Management Weakness Letter To, The Audit Committee, Farhan Muscat SAOG In performing the audit for Farhan Muscat SAOG, the deficiencies regarding the inventory audit are stated. These are opinions that are completely based on the financial data provided by the company. Opinions include the deficiencies in the internal control system regarding the valuation and management of inventory. It does not include opinions on the effectiveness of Farhan Muscat’s internal control system. The deficiencies identified in the internal control system were limited to Farhan Muscat’s inventory valuation and management and does not include other deficiencies in their internal control. Deficiencies here refer to material weaknesses that have led to the company in incurring losses since 2011, where the current financial year is also considered. The identification of internal control deficiencies shows the inefficiency of the management or employees to detect or prevent material misstatements. It however does not assert on the intentions of the management but identifies the shortcomings that are associated with such ineffective internal control. The current situation The company has a significant stock portfolio which includes categories like consumable stores, maintenance supplies, spare parts, etc. Inventory includes raw materials, work in process, finished goods and loose tools. The company operated through many stores across places like Rusayl, Sur, Salalah and Sohar. Munira Al Zadjali is the warehouse manager who is responsible for the stock take for all the locations. The company’s business is spread across the Gulf and Oman. The company took a hit owing to the global financial crisis which affected the Gulf region and Oman. This affected its international and local sales which impacted its inventory level. The company has witnessed a cumulative financial loss of Rial 3 million and reduction in the total capital of Rial 7 million. This affected the shareholder’s wealth as it is stock price have also plummeted on the Muscat securities market (Knapp, 2010). Deficiencies identified in the internal control system The internal control system at Farhan Muscat led to high value of cost of goods sold that reduced its gross profit, followed by reduced earnings before interest taxes and depreciation, earnings before interest and taxes and pre tax earnings. The company was not in practice of interim stock takes and was only done in the last weekend of each and every financial year. Munira the store manager was responsible for the stock take for all the locations. Ineffective security and safety measures of its stores led to the loss of inventory data. In adequate allocation of financial resources towards its stores did not allow Farhan Muscat to perform periodic stock take. The management of the company justified that it conducted annual stock take because it would not affect the manufacturing process and production workflow. It ignored the valuation of low valued items. There was no detail stock flow report of such items. The stock take at the company ignored the inspection of the carton contents. It did not validate the large volume of stock that was held by its franchisers and agents. Stocks which was slow moving and had significantly low net realizable value was also valued at regular price. Usually according to the inventory valuation including such stock items that have no market value artificially inflates the cost of revenue that will reduce the pre tax earnings. Though this has a positive bearing on the taxability of the company but will result in net loss. The company’s core business operations include manufacturing of home and office furniture and fittings. Thus, it inventory value is generally high and owing to such deficiencies the value is further inflated which results in further loss in operations. The inventory check of premium stock was not adequately performed that led to significant differences in actual value of the inventory. It mainly had large volume of low priced stock and valued the high price stock based on sample checks. Though the volume of high price stock was less compared to the low price stock, the unit price of the stock is higher than the low priced stock. This led to imbalances in the inventory level and valuation. The store manager did not tally the physical count of the stock with the stock sheet report this added to the ineffectiveness of the control system. The store manager or the warehouse manager was accountable for the stock take of all the stores; this led to ineffectiveness of the control system. Inventory was valued at simple average method that ignored the changes in the market prices of its inputs. The manufacturing process does not include all the stock items in equal proportion thus using average method in inventory valuation will lead to underestimation of stock value of high priced item which are used in low proportion and overestimation of the value of those stocks which are used in high proportion. The company also practiced valuing slow moving, non moving and obsolete stocks at purchase price. This led to increasing the value of the inventory. The real value of the inventory would have been significantly low if such stock items would not have been considered in inventory valuation. Thus, financial loss was inevitable and could not be reduced that continued in the current year from earlier periods starting from 2011. Stock take of stores in UAE was not performed in detail owing to high audit cost in that region. The stock data was retrieved from the system. This led to high audit risk in the form of high detection and control risk. The system generated data was also unaudited leaving potential risk of material misstatement of inventory value of stores in UAE. There were some stocks which were held by third party vendors in the books of Farhan Muscat. Such ineffective valuation has led to the increase in high value of inventory which led to the high price of cost of goods sold, resulting in net loss for the company. Farhan Muscat followed the standard stock taking method to physically count the inventory, which led to a significant time gap in fetching the stock data. The standard stock taking was done annually which considered the level of stock as on that date and ignores any major fluctuations in the value of the stock prior to that date. There could be chances of wrong information reporting or system errors which cannot be resolved as such stock taking practices are performed at the end of the financial year. The wrong valuation of the stock will be carried forward to the next fiscal and will thus be continued if a periodic stock take is not performed (Knapp, 2010). Effective and practices and procedures Farhan Muscat SAOG has witnessed numerous problems in its inventory audit practices that have led to significant rise in the value of the inventory which has resulted in loss for the company over the years from 2011. It employed only one store manager Munira Al Zadjali who was responsible for the stock take for all its stores which is spread across the Gulf States and Oman. Employing more store managers would also reduce the probability of errors and risks. Detection and control risks will be lowered. The annual stock taking method should be altered as it was practiced by the company for a long time which led to significant loss. It should perform periodic and automatic stock verifications. The periodic stock taking will be much more effective for stock items which are high priced than the ones which are low priced. This will lead to recording of price changes in the valuation of the high priced stock. This would result in accurate valuation of the closing stock. Automatic stock verification will allow the company to verify stock level of material inputs based on the level of priority. High priority items will be verified thrice a year than the less priority stocks which will be verified either bi annually or yearly. This will effectively help the internal committee in identifying stock discrepancies. It should include low priced stocks in its stock taking. Despite having low volume it should be considered else the inventory value will not reflect the fair value. Stocks held by third party vendors should be separately accounted and should not be included in the books of the company. This will lead to lower inventory level which will result in lower cost of goods sold. Non marketable stocks, slow moving stocks and damaged stocks should be priced at net realisable value or actual cost whichever is lower. Such stocks should not be valued at purchase price as this would artificially inflate the price of the inventory resulting in lower profits. It should shift from standard inventory cost method to weighted average method of costing. Under the weighted average method of costing, the proportion of the individual stock item is multiplied with the market price or the actual price whichever is lower to determine the value of the inventory. This method eliminates the over and underestimation of the stocks. Under standard cost method the company fixes a fixed cost to all its stock items, which will lead to overestimation of inventory value and simultaneously increase the cost of sales. Under the weighted average method there are two more methods which can be employed by Farhan Muscat to value its inventory. The first method is FIFO, first in first out where stocks which are first added to the inventory are sold first. It considers the chronological order of the stock movement. Under the LIFO method stocks which move into the inventory last are the ones which are sold first. Out of the two methods there are certain restrictions on using LIFO method under IFRS. In an inflation situation, LIFO method is not preferable as it will lead to higher cost of goods sold compared to LIFO which will exhibit lower COGS. Goods that move into the inventory first are least expensive and thus during inflation valuing inventory using the FIFO method will prove to be beneficial for Farhan Muscat SAOG (Bragg, 2011). Task 2 Audit report to Farhan Muscat’s SAOG shareholders Report on financial statements The audit report of Farhan Muscat comprises the financial statement for year ending 31st December, 2014. The details of inventory, stock report, and stock take report; income statement and balance sheet are provided in the report. It also includes relevant information and accounting practices of the company for the current financial year. Management’s responsibility The management of Farhan Muscat is responsible for the true and fair presentation of the financial statements that conform to the financial reporting standards. It should try and reduce the deficiencies in the internal control system that will ensure fair financial statements that are free from any kind of material misstatements, suppression of facts, accounting errors of omission and commission. Auditor’s responsibility The audit report put forth an opinion that is based on the audit of the financial statements and the stock reports. The audit report requires that the audit should be performed in conformity to the international financial reporting standards. The international reporting standards require the audit report to be ethical and the financial statements to be free from any kind of material misstatements and suppression. The audit ensures appropriateness of accounting procedures used by the management in producing the financial statements. It is aimed at finding out material evidences in regard to amounts disclosed in the financial statements and reports. It is also incumbent on the judgement and ethical procedures that are used to assess the risk measure of the material misstatements. The audit procedures used to assess the financial statements are adequate in forming the basis for the opinion (Knapp, 2010) Audit opinion After the audit of the financial statements of Farhan Muscat SAOG for financial year 2014, it is opined that the accounting practices of the company are in conformity with the financial reporting standard except for its stock take report. The internal control system is subject to a few deficiencies that have resulted in the current financial position. Following the audit procedures the stock take and inventory report have been assessed based on detection and control risk. The details of the desired practices and procedures are opined in the management weakness letter. The deficiencies in the internal control system of the management have led to the current financial distress. Such shortfalls in accounting practices of inventory valuation have witnessed same results from FY 2011. The effective practices in the management weakness letter will improve the company’s current financial position leading to a stronger management-shareholder relationship. Report on regulatory requirements Relevant information and necessary supply of various documents that were necessary for the audit process were procured. After the completion of the audit process, it can be said that all the books of accounts have been in accordance with the regulatory procedures and the chairman’s statement. It has performed annual verification of stock in accordance with the accounting procedures. The chairman’s statement which highlights the financial information conforms to the amount reported in the books of accounts. Under the given circumstances the company was not found to vitiate any of the UAE Federal Laws, which would affect its financial position, for the year ended 31st December, 2014, materially to its best interest (Bragg, 2011). References Bragg, M.S., 2011. Inventory best practices. USA: John Wiley & Sons. Knapp, C.M., 2010. Contemporary auditing: real issues and cases. USA: Cengage Learning. Read More