Auditing and Assurance - Lakeside Company - Case Study Example

Auditing and Assurance Name Institution Date Audit and Assurance Question one: Sources useful for arriving at an expected figure for Cost of Goods Sold The cost of goods sold is the cost of the inventory items sold to customers during the period. If a company uses a perpetual inventory system, it records this amount at the time of each sale and shows the total amount in the cost of goods of goods sold account. The company reports this amount as the cost of goods sold on its income statement. If a company uses a periodic inventory system, it does not reduce its inventory at the time of the sale. Consequently, the company must calculate its cost of goods sold amount based on a physical inventory taken at the end of the period (Hansen, & Mowen, 2006, pp. 213). For the case of Lakeside, it appears that the company uses a perpetual system of inventory where each sale is recorded in relevant cost of goods sold. Therefore, the sources that would be available to the auditor in arriving at an expected figure for Cost of Goods Sold in relation to reported balances include the following; the first one is industry data. This involves for instance industry average financial ratio and to arrive at it the auditor needs to perform financial ratio analysis using the industry data that are mostly available in financial statements reports (Clyde, 2009, pp. 215). For the case of cost of goods sold, this data may be found in the trial balance, general ledger, and monthly journals of cost of goods entries. The second source that the auditor may use is that of similar period data for instance Lakeside Company’s account balances for cost of goods sold in the previous year. According to international auditing standards, the use of previous data for industry in trying to arrive at the actual figure of a particular accounting element is a method with high probability of certainty (IAASB, 2007a). The third source the auditor may use in the case of Lakeside Company is its determined expected results such as budgeted amounts regarding cost of goods sold. This will help the auditor to know the actual budgeted amount in comparison to the balances. The auditor may as well make use of non-financial information such as Lakeside Company’s warehouse space to estimate maximum inventory quantities. Finally the auditor may come up with his/her own determined expected results for instance using estimates from Lakeside’s historical trends in cost of goods sold. Question two; It is obvious that some account balances and transactions are more prone to misstatement than other. In the case of Lakeside Company, several accounts or transactions are more prone to these misstatements leading to inherent risks. This is directly related to its nature of business operations. Based on the case under evaluation, inherent risk is a function of the entity’s business and its environment, integrity and competence of its management, and nature of the account balance or class of transactions. Based on this, the auditors of Abernethy and Chapman would assess the inherent risk by studying the business environment both internal and external and by their past knowledge of the nature of the transaction under the audit. The first account or transaction of Lakeside Company that is associated with high level of inherent risk is the cash account/transaction. Based on the nature of operation of the company, there are instances where cash transaction would need to be undertaken. The large number of cash and bank transactions by the Lakeside Company leads to a considerable point of inherent risk for cash balance disclosures, principally existence or happening and entirety (Iain and Stuart, 2007, pp. 87). Furthermore, the nature of cash balances makes them predisposed to thievery, as several classes of fraudulent methods concerning cash have borne out. In auditing cash transactions and determining transaction risks, the auditors will be guided by the Lakeside Company internal control system regarding cash dealings. Prepaid expenses account is another aspect where inherent risk would be at its highest level in the Lakeside company case. During these disclosures, possibility of misstating transactions is high hence leading to inherent risk for the company. Compared with cash transactions, it is prone to low level of inherent risk (Iain and Stuart, 2007, pp. 103). The third account where inherent risk could be high for Lakeside Company is the inventory account. In disclosing inventory balances in the journals or trial balances, there is high possibility of omitting some data hence leading to inherent risk for the company. Finally the financial statement account is another area where inherent risk could be highest where important information may be overstated or understated for ill motives. Question three: Financial statements audit entails the gathering and assessment of facts to establish whether a company’s financial statements are reasonably stated (Nelson and Tan, 2005, pp. 46) Fundamental to this procedure is how auditors decide on evidence and establish whether the gathered evidence is adequate to make decisive decisions. There are a number of instances that will inform the auditors that the information they have gathered is sufficient to make a decision. The first relates to existence and occurrence. When the auditor has proofs that some accounting aspects exist and some actually occurred then he/she may stop and use the data gathered to make a decision (Nelson and Tan, 2005, pp. 57). These accounting aspects include assets, liabilities and equity interests and also the existence of recorded transactions. This existence assertion relates to whether the recorded amount is bona fide for instance recorded receivables are legitimate. Secondly, when auditors establish that the company under audit holds rights and obligations to the assets and liabilities, they will be certain that the evidence they have gathered concerning these aspects are sufficient to make a decisive decision. The proof of sufficiency of gathered data by the auditors relate to completeness and cutoff. That is, every assets and liabilities, equity interests, and transactions that ought to be recorded have been recorded and every transaction is recorded in the appropriate accounting period (Nelson and Tan, 2005, pp. 61). Completeness addresses the issue of whether all transactions have been recorded for example, are all receivables recorded. Valuation, allocation and accuracy are also another way of informing auditors that the evidence they have gathered is sufficient for the purpose of making a decision. Under this the auditor will be convinced if all transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts (Nelson and Tan, 2005, pp. 65). Auditors will be convinced that the evidence they have collected is sufficient for them to make an audit decision when there are no inconsistencies in several aspects of the audited financial statements. Question Four Price competition exists in virtually every business and it is a major component for businesses that endeavor to enlarge their market base. The same scenario is similar to CPA firms. Previously there used to be very less CPA firms and the demand for audit services were high hence the prices during those times were equally very high. Currently, the field has been flooded by many players and in order for a particular CPA firm to remain relevant to clients, one of the things it must do in addition to offering quality audit is to review it audit fees charged on the clients. Therefore, the current audit world is characterized by price competition among the CPA firms which has seen audit fees drastically go down. However, the trimming down of audit fee has some problems associated with it particularly to the CPA firm involved in such price reduction activity. The first problem is that of time. When firms trim down their audit fees, they also allocate very less time for auditing; that is the time they spend in auditing a particular client company will be very limited. This has the effect of compromising on the quality of audit since the audit will be done in a hurry in order to beat the audit deadlines (Asare, Trompeter, and Wright. 2000, pp. 541). According to audit standards, an auditor is expected to allocate sufficient time to an audit exercise so that he/she may be able to do thorough investigation and consultation before a decisive audit decision is made. The other problem is in the deployment of audit staffs. The firm may not deploy enough staff to carry out an audit exercise that is bringing low revenue due to low pricing. The few staff assigned to that particular audit exercise may not be able to carry out a comprehensive and convincing audit because of the enormous task needed to be performed. This will further hitch the quality of its audit result. These two problems have very adverse overall effect on the CPA firm in the sense that it may lose some of its clients based on low quality audit. Question five: The relationship between control risk and planned detection risk is inversely proportional. The meaning of the two terms will help in elaborating this relationship. Planned detection risk simply confirms the likelihood that material misstatement that is undetected in the internal control is also undetected in the audit procedure (Asare and Wright. 2004, pp. 327). Control risk confirms that this misstatement is only undetected in the firms internal control system. Therefore, the acceptable level of planned detection risk is inversely related to the firm’s assessment of control risk; that is, if the later is high for a given account then the former will be lower. This relationship implies that the auditor ought to more substantive examination (IAASB, 2007a). As we have seen above, detection risk is a measure of material misstatement that is undetectable by the firm’s internal control as well as by the planned audit procedure. The level of detection risk is what also determines the level of both inherent risk and control risk. Given that the detection risk is low, it implies that the both inherent and control risk are high since they are inversely related. High level of both control and inherent risks is very alarming to a firm and therefore, the auditor must carry out the audit exercise with practical importance in order to establish these material misstatements. The result of this substantive testing is suggestions of efficient and effective internal control for the company by the auditor (Asare and Wright. 2004, pp. 329). Lack of this testing will imply that quality audit has not been undertaken. Question six, Every firm is liable of being defrauded and from the global experience; it is the managers of these firms who notorious of this act, hence, CPA firms mandated to auditing these are expected and or responsible for assessing the risk of frauds. In assessing fraud risks, auditors carryout the following process in an inquisitive model; the first set of assessment model is that related with incentives to estimate the extent of pressure the managements are under that would make pay less focus on the internal control. This is by finding out if the organization is constant financially or whether its profitability is vulnerable to industry conditions (IAASB, 2007a). In assessing fraud of this nature CPAs also try to find out if the management of the firm is under pressure from external parties in order to carry out false financial reporting. CPAs will also attempt to find out if there are impractical or seriously contradictory statistics applied in lieu of genuine results to generate and report financial projection for the company (Srivastava and Shafer, 1992, pp. 267). They also try to find out if the monitoring administration exercises have been unproductive and if there is a possibility for internal control overrule. The fraud risk assessment is very vital since if this is not assessed properly management actions of overriding internal control systems will cement other audit risks such as inherent, control and planned detection risk. as we can see that all these risks revolves around the effectiveness of a firm internal control systems and for fraud to happen, the internal control system must be overridden and it is therefore very detectable through an audit procedure. Question Seven Ratio 2011 2012 Significance of Change Current Ratio 0.9 0.1 Indicates close to stability liquidity position Days to Sell Inventory 2.6 2.8 The rate of movement of liquidity is fair although much of it stays in the store for long Average Collection period 3.9 4.0 Customer Accounts take long to be collected. Debt to Total Asset Ratio 1.0 0.9 Much of company’s asset acquired on credit have been repaid Times Interest Earned 0.9 0.8 The company is capable of meeting interest payment to some degree Profit Margin 0.8 0.9 Profit margin is low compared to the sales volume an indication that expenses are more. Return on Asset 0.7 0.9 Each dollar of assets is generating o.7 cents of and 0.9 cents respectively Return on Equity 1.2 1.1 The owners are realizing return on their equity. References Clyde, P. (2009). Financial Accounting: An Introduction to Concepts, Methods, and Uses. New York: Routledge. Hansen, D.R., & Mowen, M.M. (2006). Managerial Accounting. New Jersey: John Wiley and Sons. Iain Gray, & Stuart Manson. (2007). The Audit Process: Principles, Practice and Cases. New York: Thomson Learning. Nelson, M., & Tan, H.T. (2005). “Judgment and Decision Making Research in Auditing: A Task, Person, and Interpersonal Interaction Perspective.” Auditing: A Journal of Practice & Theory, 24: 41-71. Asare, S. K., & Wright, A.M. (2000). “The Effect of Accountability and Time Budgets on Auditors' Testing Strategies.” Contemporary Accounting Research, 17 (4): 539-560. Asare, S. K., and A. M. Wright. (2004). “The Effectiveness of Alternative Risk Assessment and Program Planning Tools in a Fraud Setting.” Contemporary Accounting Research 21 (2): 325-352. International Auditing and Assurance Standards Board (IAASB). 2007a. International Standard on Auditing (ISA) 200, Objective and General Principles Governing an Audit of Financial Statements. New York. Srivastava, R.P., & Shafer, G.R. (1992). “Belief Function Formula for Audit Risk " Review: Accounting Review, 67 (2): 249–283 Read More