The performance of the audit provides valuable insight into the organization. It provides robustness in terms of internal control and process. To conduct this study, medium-sized firm and Face paint Ltd has been considered for the study. The study provides an insight into the audit standards and mechanism. Various analytical procedures have been conducted and ways of using analytical procedures as a substantive test have been suggested. On the other hand, the second part of the result deals with the audit risk and the impact of the risk on the financial statements.
Possible sources of information that would help gather sufficient knowledge of the business to perform the audit of Telechubbies Ltd.
Preliminary analytical procedures using the information provided.
Analytical procedures performed could be extended using the information collected in (a).
Ways in which analytical procedures used as a substantive test during the audit of Telechubbies Ltd.
Minimizing the business risks of the organization.
Describe the auditor’s responsibility with regard to business risks.
Consider the extent to which these risks can have an impact on the financial statements.
Audit is an important as it helps in evaluation of the operations of the organization and maintenance of internal control. It helps in detecting the weakness or forms of fraud and other forms of irregularities (Livne 2015). Without a proper audit system, the organization will fail to create a reliable financial report whether for internal or external purpose. The aim of the report is to assess the principles relating to the audit standards, process and techniques followed by the implication of the same for different stakeholders. For this purpose two case studies has been selected and the same is analyzed in the light of the auditing environment.
Telechubbies Limited is a toy manufacturer and a public limited company. As this is the first year of audit, the knowledge of the business is a requirement before the commencement of the audit. The letter of engagement has to be received from the company which has been approved using a resolution passed by the majority at the company’s general meeting. In addition to this, the letter of no objection has to be received from the previous auditor to ensure that there are no uncleared dues or unresolved matters that could have n impact on the audit for the current year. The financial statements for the previous years’, the audit working papers, and the notes to the financial statements could give an idea about the business. Apart from this, using communication with the directors and stakeholders the auditor can obtain information to identify such events, practices, or transactions that might not be recorded in the financial statements but are having a significant impact on the financial statements (Hoffelder 2012).
The preliminary analytical procedures would be the verification of the revenues and expenses of the company and the assets and liabilities of the company (AUASB 2019). Since each item of expenses, incomes, assets, or liability has a significance attached to it, the analytical procedures to be carried out for each item are to be modified accordingly. Based on the points given by the Finance Controller, the below areas have been identified as the key audit areas requiring special attention while carrying out the audit for the year ended 31 December 2021:
The Debt equity ratio of the company should not be more than 2:1 at any point in time but there seems to be an issue with this, hence the same requires a special audit focus.
The management policy states that there has to be an inventory write-down by 10% every year owing to obsolescence. But in reality, the same has not been followed and there have been variations to it that need to be further audited and addressed as a key audit area.
The long term loan receivable is the next audit focus area as it is extended to a company owned by one of the directors of Telechubbies Limited. The said company is involved in the production and development of software for Telechubbies Limited and this clearly falls in the net of a related party transaction and hence needs to be included under the key audit area.
Apart from these three areas, the other major areas of the audit would be sales, expenses, and profit of the company. It has been observed that the sales of the company have been falling year after year and this decrease needs to be audited. The expenses are also increasing which has ultimately led to a decline in the net profit of the company. The loan term loans which represent the non-current liabilities of the company are increasing year after year and this suggests the difficulty the company is facing in meeting its operating expenses. The reasons for the company's performance become a key audit area due to these factors.
Analytical procedures are usually performed by the auditor to obtain audit evidence. It can be either a single procedure or a combination of procedures like inquiry, inspection, observation, external confirmation, recalculation, etc. Analytical procedures refer to the test and checks applied by the auditor to verify the accuracy of the transactions and figures and the information provided in the financial statements (Livne 2015). Analytical procedures can be carried out by the auditor as below:
Set up an expectation. N this step, the auditor defines the purpose of the audit and what does the auditor expects to achieve based on the tests and verifications carried out.
Definition of a significant threshold. The next step is to define the level of misstatement that is acceptable or the range of differences between the expected result and the audited results that can be considered as acceptable given the size of the entity and the nature of transactions.
Compute differences. The third step is the actual calculation of the differences between the actual and the expected.
Investigation and reporting. The last step is the investigation of the significant differences and concluding the same to help in the evaluation of the audited results.
Thus carrying out the analytical procedures is a step by step activity to be done by the auditor with audit working papers documenting the results and actions carried out by the auditor. Analytical procedures thus aim at drawing plausible relationships between the financial and non-financial data by the carrying out of relevant tests and checks (Manoharan 2011). The purpose of these procedures is to obtain assurance about the information that is provided in the financial statements. It also aims to test the assertions that have been made in the preparation and presentation of the financial statements.
At Telechubbies Limited the analytical procedures can be used to clear the areas of concern as follows:
With respect to the declining sales, the quarterly, monthly and weekly break-up of the sales has to be compared with the similar das of the prior year to investigate into the reasons for the difference.
Debt equity ratio, in this case as it has exceeded the limit of 2:1, the audit procedures should be carried out to find out whether the same has been reported to the bank that extends the loans or not. If not, then the immediate measures must be taken to ensure that the management communicated the same to the bank and the financial report should also mention this fact. Failing which, the auditor should consider the inclusion of a qualification in the audit report (Niemi & Sundgren 2012).
Inventory write down. As the management has provided only for 5% write down in contrast to the required write down of 10% it becomes a significant reporting issue. The management has to state the reasons for the same in its disclosures in the financial statements and the auditor should also consider qualifying the audit report to ensure this matter is reported to the stakeholders (Livne 2015).
Related party transactions are to be carried out at arm’s length prices. It is necessary that the rate at which the loan is extended to the company owned by one of the directors is audited and whether it corresponds to the market lending rate (Livne 2015). Also the reason for extending such loans needs to be audited as the figure of loan is increasing every year. The possibility of the director trying to withdraw funds from the company needs to be investigated. The repayment terms and the interest payment are also covered in the audit area.
Examination of the increasing trend of the non-current liabilities in the form of bank loans needs to be audited. By getting the management reasons for the same.
Risks in the business refer to such situations against which the business can guard itself or take adequate safety measures. On the other hand, uncertainties are situations that are not planned by the management and the company doesn’t have a safeguard (Matthew 2015). It is the responsibility of the management and those charged with governance to analyze the market and economic conditions within which the business is operating. There are different types of risks that a business could face a few of which are as below:
Establishing a proper risk management plan can save the company from many losses in times of difficulty and crisis. The management is wholly responsible to devise the adequate plans and policies for risk assessment and risk mitigation. The management can also consider availing the services of a risk management consultant to ensure a professional approach to risk management. A company without a risk mitigation plan is like a ship without an anchor. A risk committee is usually formed by companies to effectively address this issue (Manoharan 2011). The risk charter should be made public and the employees should be made aware of the same. Specific risks have to be addressed with specific options to ensure the smooth functioning of the company. Thus it is the responsibility of the management to carry out this entire process.
The auditor is presented with the financial statements and the notes. The management discussion and analysis provides an insight into the functioning of the company. The major risk identified by the company and the possible measures taken by the company for its mitigation is provided by the management.
The auditor has to carry out an assessment of the significant risks and whether the company is having adequate safeguards to eliminate the same. The role of the auditor about risk management is outlined below:
Assessment of internal controls
Improving risk management
The first step is to carry out an audit of the internal controls in the company. This is to ensure that the controls are in place; they are operating at all times and can detect the mistakes and frauds. This effective working and functioning of the internal controls can be tested by passing in a random or dummy transaction and test whether the same is accepted or not (Hoffelder 2012). If it gets accepted, it implies that the system is flawed and if it prevents or highlights the dummy transaction, then the internal controls are functioning appropriately.
The next step is risk assessment. This involves auditing whether all the significant business risks have been covered by the management or not. If any risk is missed out but the auditor finds it significant to the working and functioning of the business, then the same should be brought to the knowledge of the management, and emphasis should be laid to address the same (Livne 2015).
The last step is risk management which involves an audit into the measures taken by the company to fight against the risk. In case these measures are found to be inadequate, then it is the duty of the auditor to highlight the fact to the management and recommend measures in the light of the changing business environment.
In the current scenario of Face Paint Limited, the company has been recently listed on the stock exchange. So the information about the company becomes more public attracting newer business risks. The major risks are explained and discussed below:
Due to advancements in technology, the physical sales are deteriorating and online sales are increasing. The evolution of the internet has made the world a small village to trade-in. As this is beneficial, it also comes with its own set of risks.
As Face Paint Ltd pays its suppliers in advance, there is a possibility it can run into a cash crunch. The payments to the suppliers have to be made according to the terms of payment stated in the invoices and Face Paint Ltd is being overly courteous by making advance payments that are not required.
As Face Paint Ltd claims that its products are totally eco friendly and have neither been tested on animals not have harmed any animals, it comes under an environmentally responsible net. It is possible that a small lapse in compliance with any environmental regulation can have a great and damaging impact (ASIC 2020). Hence this also becomes a significant risk for Face Paint Limited.
The impact of these risks on the financial statements can be discussed as under:
As computerization has become the way of the world, with everything going online, if Face Paint Ltd fails to improve its online business, it is likely to suffer from falling revenues and its competitors will be able to take a step ahead of it. Thus Face Paint Ltd must offer its products for sale on major websites like Amazon, etc and it is also essential that it offers a wide product range and makes an attempt to include all its products for its online sale. On one hand, as customers are loyal to a specific brand in this industry, on theater hand, it is still not impossible for the customer to change preferences and move on to another brand due to the non-availability of some items online. Thus this business risk impacts the revenues of the company to a significant extent.
As Face Paint Limited pays its suppliers even before the orders have been placed and received, it is unnecessarily blocking its funds and the cash balance on the statement of the financial position deteriorates to that extent. Where such an action is not required, it can postpone the payments to the suppliers and avoid making advance payments. The quick ratio and the current ratio of the company are affected by such actions and hence the financial impact can be understood by the excess payment made by Face Paint Limited.
This risk will not have a direct impact on the financial statements but the reputational damage caused to the company due to non-compliance or fighting out litigation can have a lasting impression on the minds of the consumers. The implied effect of this can be seen in the form of decreasing sales and the deterioration of the financial position in the long term. Also if any fines or penalties are to be paid by the company, then it can lead to a loss and have a financial implication.
Thus these are the significant risks Face Paint Ltd could face and its possible financial implications.
The assessment of the business risks is to be carried out by the auditor by obtaining knowledge of the industry and economy in which the company is operating. More specific knowledge is obtained by the analysis of the internal audit reports of the company, publication relating to the company, discussions with a related and knowledgeable person outside the entity, and by visits to the factory or plant of the company. All the documents produced by the company have to be studied by the auditor to obtain knowledge about the legislation and regulations applicable to the company
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