An Investigation of Auditors Judgments - Essay Example

PART A: As an auditor, before getting into the technical aspects of auditing procedures, we generally use the attest function to assess whether the information presented provides assurance of its fairness, reliability, credibility, dependability, and whether it is presented according to the GAAP or some other appropriate basis of accounting. A quick glance at the financial statement, the company is financially healthy but there are some weaknesses even the financial statement presentation has departure from GAAP in certain areas. In addition, in order to identify these weaknesses or considered as risks associated with these financial statements, we perform comparative year-on-year and ratio analyses which may be effective for us to identify possible problem areas for additional analysis and audit testing and for which we can provide other assistance. Among other: The company’s short-term debt paying ability. We analyse the company’s liquidity status, such as its current ratio is 1.28 (lower than 1.31 in 2004) but it indicates that the company should have sufficient fund to pay its short-term debts. Our calculation also indicates that the company will be able collect the amount owed by its customers, except the average day of collecting payment of 82 days (15 days longer than the previous year). This may have an affect on negative cash flow. Since the company does not have sufficient cash to meet its short-term obligations, the company may consider lengthening the time it takes to convert less liquid assets into cash. Short-term liquidity. The company’s balance sheet shows that it has negative cash balance. It is likely that the company or that the record shows that the company cannot meet its obligation. Therefore, its debt-paying ability would be the length of time it takes the company to convert its current assets into cash. The company’s balance sheet indicates a huge amount of bank overdraft. In case of necessary, the company has 2.5 times cash turnover rate (down by .89), 4.36 times of receivables turnover rate (down by .94), can recover the value of its fixed assets 51.17 (down from 56.93), and over all, 2.5 times (down from 3.2) chance to convert its assets into cash to cover bank over draft. With the absence of inventory, it may be possible that the company is having inventory obsolescence problem. Ability to meet long-term debt obligations. The company’s debt-to-equity ratio is 3.35, down from 3.97 in 2004. There is a possibility that the company would be able to raise fund through borrowing. Times interest coverage is 59.22 which indicates that the company generates positive cash flows from operations in the short run and over time. Therefore, the company would be able to meet its interest payment assuming earnings are stable. Although the collection period is too long, high sales value, high profit margin, 2.3 times chance of assets utilization, greater indication of liquidity, the company long-term ratio of solvency has been greatly reduced. For example, total-debt-to equity is 3.35, down from 3.97, long-term debt to equity and long-term-debt to asset are 16% and 4% respectively, down from 53% and 10%. Operating and performance ratios. Improve operations may remedy financial ill. We evaluate company’s performance or profitability and trace it to the balance sheet account. Performance wise, the company’s ROE is 94% (80% higher than in 2004), ROA is 21% (18% higher), GP margin increased by 5% from 30% (increased by 5%), operating profit margin and pretax margin are 9% (8% increase from 2004), and net profit margin is 7% (6% higher than that in 2004). Basic earning power is 83%, a little lower that in 2004 (96%) 16% ROA – increased from 1%, and 70% ROE, which is 60% higher than in 2004. As the case indicates that the system is reliable, the ratios indicates that the company generates sufficient revenue to justify the assets employed or that it has sufficient earnings relative to the assets base. Using both operating and performance and operating ratios, and determine the return on each source of capital, we are able to assist the company with different assistance such as the suggestion to raise additional capital. At the same time, the use of operating and performance ratios bring about some accounting inconsistencies and make comparisons over time for certain accounts such as operating versus non-operating items, inventory methods, amortization methods and off-balance-sheet financing. Based upon these key areas, we make preliminary decision concerning materiality at the planning stage of the engagements by conducting comparative financial analysis and ratio analysis. The qualitative factors, such as information given in the case and the undisclosed information, such as ownership versus long-term liability, will affect materiality of the financial statements. We gather evidence to ensure that the financial statement is fairly presented and reliable from the management’s assertion by examining the financial statement, financial information, its compliance with agreements and regulations. Examination allows us to select samples to lower the level of risk if there is no material misstatement and we have better understanding of the Useful Product Unlimited’s internal control. We learn the Useful Product Unlimited’s internal control by collecting evidence, making inquiries, inspecting internally or externally, and by performing other audit procedures. The reasons for understanding the company’s internal control is that we would be able to evaluate whether the company’s financial statements are in accordance with GAAP; we can identify risks that may affect our assessment of acceptable audit risk; and that we would be able to identify any inherent risks within the company. More specific, the items we look for in a financial statement are the assets listed in the balance sheet are really exist or does the company own those assets and if the valuation of the assets is established according to GAAP. In addition, we examine whether the company’s balance sheet contains all the liabilities of the company. If, for example, any of the important liabilities or assets are accidentally omitted or misrepresented, the balance sheet has been grossly misleading – such as the omission of inventory. It appears that the Useful Product Unlimited has poor internal control. As the company does not have formal system for recording receipt of goods but uses only the supplier’s undated delivery note. The case does indicate that this procedure may increase the risk of purchase cut-off errors but the likelihood of risk is further than simply purchase errors. It affects accounts payable and cash management or control risk. For example, goods purchased may be returned but payment has been issued. The risk associated with this practice (control risk) may explain the huge amount of bank overdraft. This may also include fraudulent management practices because the company’s accounting system has departed from GAAP, which involves risks or uncertainties such as inadequate disclosure and the materiality of the financial information. The departures from GAAP involve inappropriate accounting principles. The accounting principles used may cause the financial statement to be materially misstated such as fixed assets classification and ownership versus long-term liabilities, which are indicated differently in the case than in the financial statement. Another assumption, as part of management practices, is that cash payment may have been issued to pay for goods returned and thereby, it affects the overdraft account. PART B: Based upon the test assessment, as the auditor, we are not only test the ending balances, but also the propriety and classification of activity in the accounts during the periods presented. The testing is not limited to merely determining if the liability is understated, but rather whether it is properly stated such that the financial statements are fairly presented in all material respects. Also based upon the above analysis, including comparative financial statement and the ratio analysis, we find that the company’s inherent risks may also be impacted by internal and external factors and the system, oversight threats, quality, and quantity. From the company’s financial statements and the ratio analysis, we have identified several areas of or factors that indicate the company’s inherent risks, such as: 1. Nature of the business. The nature of the business determines the company to name its receivables as trade debtors or it determines how it prepares its financial statements. It should not have affect on inherent risk for current assets such as cash, notes receivable, and long-term debt. However, the omission of inventory for the Useful Product Limited or classifying ownership as liability represents issues to the business. At the same time, the ratio of liquidity indicates the company’s financial health but the financial statement indicates no interest payment and bank overdraft. 2. Nature of data processing systems for the purchases account. For example, there is no record of payment received or purchases received, thus increasing the likelihood of material error or fraud. The case indicates the company is having a potential risk in purchase cut-off errors. On the other hand, with the omission of several accounts from the company’s financial record, or bank overdraft, it is likely that the company’s financial statement is misleading. As previously mentioned, it is likely purchases were paid but without record or returned but payment was made. This may indicate a concern of improper management practices. 3. Integrity of management – when management is dominated by one or two individuals, the likelihood of financial misstatement increases. For example, the company states that Mr. Shaw is one of the owners (20%) but he is recorded as a long-term creditor in the balance sheet. The owners are Mr. and Mr. Taylor (80%), which increases the likelihood of the financial statement to be misrepresented. Additionally, the company has 94% return on equity and 59.22 times its capability to cover interest payment but with huge amount of bank overdraft, management integrity is questionable. The company has 4.36 receivables turnover rate of its 700 active receivables but has overdraft bank account; again, there is a possibility of inappropriate management practices. 4. Company’s motivation. It could be that the management believes that it would be advantageous to misstate the financial statements. For example, if management receives bonus for higher performance, there is likelihood he will make certain that the company’s profit margin is higher. The ratio shows that the company’s 2005 profit margin is increased by 5% - from 30% in 2004 to 35% in 2005. Or if management wants to keep the amount of income tax is at a certain threshold, he would likely encourage the company to underestimate net income and increase the return ratios by increasing sales and expenses such as purchases and claim the purchases as cash payment. Similarly, the owners (Mr. & Mrs. Taylor) may not want to pay interest to Mr. Shaw by stating that the company’s bank account is in red position. 5. Nature of the assets and utilisation that is susceptible to defalcation. For example, a bank overdraft account may indicate that the management converts the company’s assets to personal use. In this case, Mr. and Mrs. Taylor are the owners besides Mr. Shaw and the company has highly marketable stock which is valued at $1,000 without explanation of the market value or the ownership distribution of earning per share. The financial information should include major classes of transactions in the entity operations, how such transactions are initiated, there should be some significant accounting records and supporting documents in the financial statements, and there should be a dependable and reliable accounting and financial reporting process from the initiation of significant transactions (such as the ownership), and other events to be included in the financial recording. This nature, and based on the financial statement, indicates that assets are susceptible to misappropriation – there is a possible risk that management (owner) may convert company’s assets to personal use. In this case, the cash is converted into marketable securities but as the financial statement indicates there is no change in the company’s shares, it is more likely that the cash is converted into personal use. Judging by the company’s financial statement, for example, factors that cause uncertainties may include: Income statement – company’s profitability or performance. Serious deficiencies in the company’s retained profit between 2004 and 2005 but the profit margin for 2005 is higher than that in 2004. Therefore, the operating expenses and retained profit may indicate misallocation or misleading information. The company expenses is understated because overhead cost, which is associated with the cost of sales is accounted for fixed operating cost and it could have been other wise for the fixed operating cost. This causes an overstatement of expenses, which may have caused lower profit. Balance sheet. The company’s fixed assets, often classified following current assets, are including motor vehicles, computer, fixtures & fittings. They are depreciable assets and depreciated under different classification for tax purposes over the course of the years the assets have been used. However, these assets are undisclosed in the balance sheet but simply classified as fixed assets. This may indicate there is a possibility of misstatement or misallocation of fund. The case indicates that the company has three owners – Mr. & Mrs. Taylor (own 80%) and Mr. Shaw (20%). However, the company’s balance sheet indicates that Mr. Shaw is a long-term creditor who wants his loan be repaid in cash or to be allocated shares in repayment. The case indicates that the company has 700 active accounts receivables and 70% are on account while less than 5% represents cash sales. Assume that trade debtors is the company’s account receivables while stock represents cash equivalent or shareholders’ equity and they should be classified properly. The balance sheet indicates, “Called up share capital” of 1,000 without adequate explanation of the shares outstanding and the valuation of the shares. The company’s balance sheet indicates 10% interest on loan but interest expense is not included in the calculation of net income. This has indicates an overstatement of profit. Without the inclusion of the interest in the company’s profit and loss account, there is a possibility of negative outcome from the company’s ability to meet its loan obligation. Due to improper management practices, the company is 3.35 more likely to be in debt than a return in its equity. The calculation shows that the company is 59.22 times capable to pay off the loan while its long-term debt to equity ration is very low. The return on equity investment is 1.86 and 83% earning power even has excellent short-term debt paying ability but the balance sheet shows that the company is having a huge overdraft. The company is in the business of selling electrical goods from a contractor to a wholesaler but undisclosed the materiality of the inventory. Similarly, prepayment from the customers or clients, according to GAAP, is classified as liabilities and not as current assets. Thereby, the company has overstated its assets and understated its liabilities. The ratio of insolvency indicates the company’s ability to meet its obligation but with bank overdraft, there proves that some significant information have been omitted from the company’s financial statement. We assess the inherent risk and consider that the integrity of management affects many or all cycles, account, and audit objective. References Arens, Alvin J.; Loebbeke, James K.; Lemon, W. Moreley & Splettestoesser Ingrid B. (2000). Auditing and Other Assurance Services. Canadian Eight Edition. Scarborough, ON: Prentice Hall Auditing. BeckerConviser. DeVry/Becker Educational Development Inc. Colbert, Janet L. (2002, May 20). Inherent risk: An investigation of auditors judgments Accounting, Organizations and Society Volume 13, (2), 1988, 111-121. Retrieved April 8, 2007 from http://www.sciencedirect.com/science? Gregory Shailer, Margo Wade, Roger Willett, Kim Len Yap (1998, Nov). Inherent risk and indicative factors: senior auditors’ perceptions. Managerial Auditing Journal, Volume 13 (8), 455 – 464. Helliar, Christine; Lyon, Bob; Monroe, Gary S.; Ng, Juliana and Woodliff, David R. (1996, March). UK Auditors Perceptions of Inherent Risk. British Accounting Review, Vol 28, (1), 45-72. Retrieved April 8, 2007 from http://www.sciencedirect.com/science? Office of the Chief Accountant. December 1999 Letter to Auditing Standards Board re: Need for Additional Guidance on Revenue Recognition (Multiple Element Arrangements) and Loss Accruals. A letter to the Chairman of the Auditing Standards Board. Retrieved April 8, 2007 from http://www.sec.gov/info/accountants/staffletters/asb120999.htm Sabanes-Oxley. Financial Information Disclosure: Risk Considerations. Retrieved April8, 2007 from Read More