The Unusual Relationships that Happen Across the Financial Statements - Case Study Example

Audit Approach Name Institution Audit Approach QUESTION ONE: Ratios are used by auditors to identify when a company is facing a sufficient danger of being bankrupt or even experiencing financial distress. Financial statements give auditors the insight of the possibility of the organization collapsing after 12 months. That can only be effective if auditors use ratios. These ratios are used to link information from the balance sheet to any fishy activity in the income statement in a bid to identify the unusual relationships that happen across the financial statements (Vasarhelyiet al, 2012). Quick and Current Ratio lie in liquidity ratio. Current Ratio is gained by dividing current assets with current liabilities. Current assets are normally used by an organization to pay the current liabilities. All the ratios of the two years are greater than 1. A current ratio that is not less than one is not alarming and should not worry the organization. However, before making conclusions, the type of the business must be put into consideration. Nirvana Produce Pty Ltd (NP) is a large wholesale fruit and vegetable supplier. The company operates out of a warehouse and office near the fruit and vegetable markets and also sources product directly from organic growers. This implies that the inventory will probably turn into cash in a manner that is predictable and stable. The supply of cash available is enough to pay liabilities. Days in receivables also known as day’s sales outstanding (DSO) is used by a company to calculate the estimate of the average collection period of products. This financial ratio illustrates the accounts receivables of a company and how they are managed. It represents the ratio of the outstanding receivables and credit account sales that the company has achieved over a given period. DSO is calculated monthly and it represents the number of days the customers or suppliers take to pay invoices. The days in receivables of Nirvana Produce Pty Ltd (NP) is rising every year. This ratio is indicating that the customer base is having credit problems and/or the company has been having deficiency in the activity of collections. However, if the ratio is too low, it is an indication that the credit policy of the firm is too rigorous and that may hamper sales. Auditors use DSO to measure liquidity and tend to increase as the firm becomesless risk averse. The increasing the number of DSO value can result into cash flow problems and the directors may decide to increase the creditor company's bad debt reserve. It can also indicate inadequate analysis of the applicants for open account credit terms (Lobo & Zhao, 2013). DSO ratio = accounts receivable / average sales per day Nirvana Produce Pty Ltd (NP) experiences a seasonal business cycle. Since the number is increasing, customers and suppliers are satisfied by the products and the firm is paying debts in time. Inventory turnover ratio compares the cost of goods that the firm has sold with the average inventory for a given period. It is a good show of how the firm is effectively managed. If the company does not have greater amounts of inventory, it will incur costs in storing products and other holding costs. The sales and purchasing departments must be tuned with each other. The cost of the goods sold is reported on the income statement. This company is having a constant inventory of 3 days. This implies that the company does not have wasted resources in purchasing and storing non-salable inventory. This also implies that it can effectively sell the inventory that it has bought. Debt to equity ratio measures the financial leverage of a company and is obtained by dividing total liabilities by the stockholders’ equity. This ratio shows the debt that a firm may be using to finance its assets compared to the value that is represented in the shareholders’ equity (Pizzini, Lin, &Ziegenfuss, 2014). This value represents the financing that comes from creditors and investors. If the value is high, it implies that the company is being financed by creditors more compared to the finances form the investors or shareholders. The value of .50 shows implies that there is half as many liabilitiesthan there is equity. The assets of the firm are funded 2-to-1 by investors to creditors (Pizzini, Lin, &Ziegenfuss, 2014). Audit risk happens when the auditor expresses misstated financial statements. If the expenditure is not correctly classified for instance, the net profit figure may be under or overstated. The auditor may not visit the warehouse and also the risk of opening balances being misstated and inappropriately transferred from the old system to the current system.The receivables may be overvalued and the customers may refuse to make payments in full due leading to a damaged inventory.To respond to the risks above in auditing, a further testing should be undertaken to classify the financial statements as correct. The breakdown of the costs incurred should also be reviewed to ascertain the split of capital and revenue expenditure. The opening balances should be correctly recorded in the new general ledger system. The new system is then documented and tested. The post year-end cash receipts should be tested and the aged receivables ledger reviewed in a bid to assess the evaluation as well as assessing any need for an allowance for receivables (Lobo & Zhao, 2013). QUESTION TWO: Internal audit control system is commonly used by forms to safeguard business operations from the risks of termination. This entails internal audits and internal controls. The business owners and employees provide insights or information on internal operations for internal auditors. On the other hand, internal controls entail the specific policies that the owners and the employees must follow. However, the internal audit control systems have some weaknessesthat must be addressed to prevent any instances of the company collapsing (Boritz, Hayes & Lim, 2013). NP uses basic accounting software which can import a bank statement but has no facility for generating a file of creditor payments to be uploaded into the NP bank account. The software, which comprises order/sales, purchases/creditors and payroll modules, is on a server that is accessed through a number of networked computers in the office. Passwords are required to access various modules and authorization levels of the system. There are two sales’ clerks who take phone and email orders and generate packing/buying slips through the sales order module of the accounting software. These slips are used by warehouse and buying staff to purchase produce on the following morning and pack the produce into boxes. The debtors’ clerk uses the completed packing/buying slips to generate invoices which are attached to the boxes to be collected by the purchaser or a courier later that morning. Often when the customer arrives to collect their order they identify other produce that they want and take that with their order. These goods are then added to the original invoice in the system and the revised invoice is emailed to the customer. Payments on sales invoices are due within seven days of invoice date and are generally paid by electronic funds transfer (EFT). A brief review of debtors identified that there were a significant number of short payments on the invoices. The debtors’ clerk matches the EFT payments to the invoices and chases up outstanding payments.  George and his sons do the buying in the morning on the basis of the information on the buying slips. Purchases are often made in cash at the market and the details noted on slips of paper which are passed to the bookkeeper when all the purchasing for the day has been concluded. Purchases direct from contracted growers are paid for through EFT on receipt of the goods and the purchase invoice.  Warehouse staffs agree the goods to the invoice and pass the signed purchase invoice to the bookkeeper. The bookkeeper maintains and reconciles the cash purchase float daily. The bookkeeper also maintains the creditors’ ledger, approves and makes payments to creditors and reconciles the bank account monthly. Payments to creditors are made within 7 days of the date of the invoice through the bank’s online payment system and then entered into the accounting software. The invoice is then stamped as paid and the date of payment and the bookkeeper’s initials are entered on the invoice. A brief review of the creditors’ ledger revealed that there were a number of duplicate payments to creditors which were being resolved. The payroll is completed by the bookkeeper on the basis of normal hours worked though George must authorize any holiday pay, paid sick leave and overtime. All holiday, sick pay and overtime authorization is completed online. The internal audit control system that NP has adopted does not cover broad application and hence does not create a weaker internal audit control system. NP managers have attempted to develop a system that focuses on specific business issues. The firm’s control system does not cover too many business departments, implying that not so many functions are being included and hence maximum benefits for the company are being produced. Each department has few well developed policies helping the owners of the business to have a greater focus on proper application of the policies of the internal control systems (Boritz, Hayes & Lim, 2013). The basic accounting software used by NP is time consuming as the clerks of the company must generate a file of creditor payments to be uploaded into the NP bank account. The owners of the business may also face a challenge in learning about the system while most of their time is dedicated to other critical business operations. It is actually a pain in the neck for the managers of a company to dedicate their time in reviewing the extensive internal audit control systems and maintaining proper business practices (Budescu, Peecher& Solomon, 2012). The strength of the internal control system is usually reflected on the external audit process. The system that NP uses must report any weaknesses to the owner of the business but that is not put into place. The purpose of the external audit in any firm is determining with a reasonable degree that assures the involved auditors that the financial statements reflect the current financial condition of the firm in accurate and fair basis. A professional audit firm is necessary for an organization to detect the weaknesses in the internal control system that could not have been detected by an in-house audit personality. They achieve this by controlling the context of the risk degree towards the business success and also fine-tune the integrity of the financial statements provided by the organization. After completing the audit process, the responsible firm should give the owners or managers of the business under audit an audit opinion report that without reasonable doubt that the financial statements were free from material misstatement (Budescu, Peecher& Solomon, 2012). A weak audit firm uses audit trials and physical inventory to uncover the discrepancies or misstatements indicating fraud and corruption at the end. There may be cases of honest mistakes and instances of fraud at the same time. Internal auditors often locate which is which by separating duties or a lax computer password policy that grants the staff authority of accessing accounting data.The auditor must select an approach of designing a substantive framework of reconciling the relevant assertions that relate to each transaction class materials and account balances. Internal controls do not eliminate the risk of material misstatement and tests of controls just reduce the need of such substantive procedures. Since the final year has not been audited, the auditor may be forced to perform substantive procedures ahead of just analytical procedures such as examining the cash collections that the firm has had in subsequent years. Otherwise, there stands a management risk overriding the subjectivity of the account balance. Evidence may be obtained from electronic files such as approved invoices to provide substantive evidence of a transaction. Financial misstatements are examples of materials that indicate weaknesses in internal control system (Boritz, Hayes & Lim, 2013). QUESTION THREE: Computer assisted audit technique is an audit software that I can use to interrogate the system of the client. The audit approach that I would take with the networked personal computer based accounting software in this audit engagement will be tailored to fit a business that is seasonal and is run from the warehouse that fits the scenario of NP. This approach will be effective in scrutinizing large volumes of data that could otherwise be tedious to do using manual approach (Vasarhelyiet al, 2012).The results that CAATs present can be used further for investigation. CAATs apply specific procedures to extract samples of data according to specified criteria such as random, at certain dates or over or under certain amount. It will enable me to calculate ratios and select indicators that have failed to meet a given threshold such as industry benchmark. It is effective in checking arithmetic accuracies and preparing reports. It well represents stratification of data such as invoices and produces automatic mails or letters to customers and suppliers. It is easy to track the transactions that have been done over a given time (Lowe et al, 2014). I will adhere to auditing procedures that any other effective auditor must follow. Instead of selecting samples from financial statements for testing and selecting risk areas to perform certain substantive procedures, I will replace that with the system that does away with such procedures. I will submit dummy data into the system of the firm (NP) to get the assurance that the system can process the data and protect any acceptance of any misstatements, instead correct them. I will use two types of data, one with errors and another without any built in errors. Such errors may be non-existent customers or suppliers, transactions that are above pre-determined limits such as salaries that are above the amounts that have been contracted, invoices with arithmetical errors and also feeding the system with incorrect batch control totals data (Lowe et al, 2014). CAATs are cost effective and accurate in testing the reliability of the client’s software. I will train the audit team and the staff of the firm to understand the results of the CAAT. The CAATs that I will use are: Integrated test facilities – where I will create dummy ledgers and records to send test data to. This approach will enable me perform more frequent and efficient test data procedures live (Vasarhelyiet al, 2012).The client can also ignore the information when printing out the internal records. I will also use embedded audit software that will entail embedding a purpose written audit program into the accounting system of the client. This type of CAAT can be switched on and off depending on the operational season within the year. It can be tuned to perform specific tasks that the auditor may request. This will indeed help me to gather information regarding some transactions in materials to be used for later testing and also in identifying the peculiars that may demand attention during the final audit (Vasarhelyiet al, 2012). References Bierstaker, J., Janvrin, D., & Lowe, D. J. (2014). What factors influence auditors' use of computer-assisted audit techniques? Advances in Accounting, 30(1), 67-74. Boritz, J. E., Hayes, L., & Lim, J. H. (2013). A content analysis of auditors' reports on IT internal control weaknesses: The comparative advantages of an automated approach to control weakness identification. International Journal of Accounting Information Systems, 14(2), 138-163. Budescu, D. V., Peecher, M. E., & Solomon, I. (2012). The joint influence of the extent and nature of audit evidence, materiality thresholds, and misstatement type on achieved audit risk. Auditing: A Journal of Practice & Theory, 31(2), 19-41. Lobo, G. J., & Zhao, Y. (2013). Relation between audit effort and financial report misstatements: Evidence from quarterly and annual restatements. The Accounting Review, 88(4), 1385-1412. Pizzini, M., Lin, S., &Ziegenfuss, D. E. (2014). The impact of internal audit function quality and contribution on audit delay. Auditing: A Journal of Practice & Theory, 34(1), 25-58. Vasarhelyi, M. A., Alles, M., Kuenkaikaew, S., &Littley, J. (2012). The acceptance and adoption of continuous auditing by internal auditors: A micro analysis. International Journal of Accounting Information Systems, 13(3), 267-281. Read More