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According to ASA315.6 (ISA 315.6), the auditor is required to apply analytical procedures which can assist the auditor to obtain knowledge of the entity and industry at the planning stage as part of the risk-assessment procedures and analysis the data in order to give a result for investment.
There are two types of analytical procedures, simple analytical procedures and complex analytical procedures may be used at various stages of the audit. In this case, simple analytical procedures should be used because this procedure includes simple comparisons, ratio analysis, common-size statements, trend statements and time series analysis. We need to select some analytical procedures which are commonly chosen by auditors to do analysis.
1. Three simple comparisons contain current year with previous year's financial report, financial with budgeted information, and relationship of individual items yearly totals.
Take draft statement of financial report for example, from 2009 to 2010, the number of current assets increases from $69,394 to $102,230 while the number of non-current assets grows from $512,700 to $531,884. There is a rise in current liability of $9,580; however, there is a fall in non current-liability drop of $21,132 due to the provisions. Total shareholders' entity increases greatly from $141,300 to $204,862 because of the decrease of accumulated losses.
2. Calculating common liquidity, activity, profitability and solvency ratios to gain a better understanding of the entity. For instant, gross profit ratio is 0.46 in 2010 while the ratio is 0.48 in 2009. This ratio is smaller than in previous year so we may consider that whether the entity has omitted goods from the ending inventory or not record sales. Current ratio is 0.28 in 2010 and the number is 0.19 in 2009. The commonly used benchmark is 2 to 1 or better and the acceptable ratio may vary for different industries. This company who works on manufacture and supplying cooking ingredients to home kitchen and small restaurant markets will require smaller levels of assets to generate a given level of cash and can exist with a lower current ratio. Generally speaking, a high current ratio indicates the ability to pay current obligations.
3. Common-size statements express statement of financial position components as a percentage of total assets and income statement items as a percentage of total revenue.
4. Trend statements are similar with common-size statements but each number is expressed as a percentage of its own level calculated from some base year.
5. Time series analysis predicts a trend what the current level of various financial report items should be in accordance with past values financial information.
Appropriate planning is essential for the audit to be completed in an effective and efficient manner. For the reason that Gourmet Pty Ltd extended its product range and installed a new computer system experienced no major problems, our firm has acted as the entity's auditor for many years and the entity has an internal audit group, we should set materiality and assess acceptable audit risk and inherent risk.
(a) There are a number of factors that would affect the assessment of inherent risk associated with the audit of Gourmet Pty Ltd including integrity management, management experience and knowledge and changes during the period, unusual pressure on management, nature of the entity's business, results of previous audits and actors affecting the industry in which the entity operates.
(b) (i) Gourmet Pty Ltd has extended its product range, opened many small cafes and had 25 outlets of varying sizes, a focused marketing, promotion strategy and acquisition of a number of smaller competitors decrease inherent risk. It increases inherent risk because the company may underestimate the cost and it is difficult to control such a large size business.
Experienced company's management team and all managers worked here for many years decrease inherent risk because less risk results from enough management experience and knowledge. However, a new finance director increases the inherent risk for the reason that the director, to some extent, is not familiar with the practical situation of this company.
A new computer system installed to process its own stocktaking results, accounts payable invoices and payments increases the inherent risk because of the potential high independence. Nevertheless, new and old system were run parallel for three months decreases inherent risk because the entity can be influenced largely by using the new system to make faster and better decisions while the company using old system to compare the result.
(ii) Inherent risk must be assessed both at the financial report level and at the assertion level. These inherent risks affect our audit procedures and lead us to understand internal control, assess control risk, and gather information to assess fraud risk.
(c) The higher the audit risk, the lower the materiality level. The new lower materiality level will affect the nature and extent of audit procedures plan and need us to have regard to the reliability of management information, factors which may indicate deviations from normal activities and qualitative factors.
(a) The overall objectives and scope of the work of the external auditor and the internal audit are to report on the truth and fairness of the financial report and on whether proper accounting records and registers have been kept, and be of assistance management to make their decision by means of examining, evaluating and reporting the sufficiency of internal control.
(b) The external auditors can share some information with internal auditors that may be of benefit to the client. In this case, if the payment terms, supplier lists and supply agreements are not recorded clearly, completely and timely, the external auditors can share the information with the internal auditors so that IAG could check and update these records and then the external auditors could develop overall audit plan and audit program preferably.
(c) It would be possible to rely on their testing because there is a good working relationship between the audit committee and the IAG. The recommendations of IAG are usually accepted and a follow-up report on implementation of recommendations is required by the committee. However, 'ASA 610.11 (ISA 610.11) requires that an external auditor who relies on specific internal audit work to support a preliminary assessment of control risk must evaluate and test that work to ensure that it is adequate for external audit purposes. This testing may encompass items already examined by internal audit, testing of similar items and observation of internal audit procedures.'
(d) As an external auditor, I should examine existing relationships with creditors, supply agreements as well as longer payment terms in order to make sure whether there is misstatement for nonexistent customers and records are complete.
(a) Accounting estimates almost invariably create a risk of misapplication of accounting policies. Generally, processing of accounts payable is influenced more by cash management concerns. An entity can only encourage prompt collections, but, within limits, it can control precisely the timing of disbursements. The risk of material misstatement for accounts payable is one of understatement because of the improvement in financial performance and position that can be achieved by omitting liabilities and the associated expenses.
In this case, the internal auditor notes some errors such as payments were not matched to an approved purchase order, not made to an approved supplier, no supporting documentation attached and not bear evidence that computation on creditors' invoices had been checked. They implicate the possible problems that whether material procurement of goods is reasonable, whether settlement and procedures of accounts payable in accordance with the bank settlement account processing, credit and financial management system requirements, and maybe there is an existence of false statement of accounts payable. Because accounts payable has a normal credit balance and often there are many individual customer accounts. And this is one of the reasons that audit procedures and control activities emphasize ensuring the existence of recorded accounts payable.
(b) Due to these errors, the additional work should now be performed. For instance, we should review the procurement contracts, purchase orders as well as acceptance to check the merchandise, raw materials procurement are reasonable, and by undertaking external confirmation procedures, examining the specific content of the accounts payable, certificate, vouching and the corresponding account relationships.
Tests of controls evaluate the reliance to be placed on the internal system and do not directly measure monetary error in accounting record. So we should use substantive tests of transactions to obtain reasonable assurance to detect material misstatements in the financial report assertions.
(a) An essential feature of substantive tests of balances for accounts payable is emphasis on the specific audit objective related to completeness. This is a reflection of the fact that the auditor's major risk is in understatement of this account. The completeness objective is achieved primarily by a search for unrecorded payables, a review for any goods received but not taken up as a liability, and analytical tests of related expense account balances. The understanding of liabilities can also be achieved by including the liability on the list of payable at year end but at an amount below the appropriate value, and thus the valuation and allocation assertion is also of interest to the auditor.
There is an increase in the balance of accounts payable (about 4%). Total revenue increases by 7.5% and total cost of sales increases by 11%. Current ratio is 0.28 in 2010 and the number is 0.19 in 2009. However inventory increases by 50.68%. We should consider whether the new stock in this year are paid by cash or it is corrupt or the wrong behavior. Hence, there is a risk that some accounts payable amounts may be not complete and unrecorded at the balance date at the correct amount.
(b) The main audit procedures to address the risk areas identified include:
i) Completeness: Confirm with suppliers; undertake out-of-period liability search; review for any unmatched receiving reports and suppliers' invoices; undertake analytical procedures; and undertake general procedures.
ii) Valuation and allocation: Agree dollar value of accounts payable to supporting documents (e.g. suppliers' invoices); and undertake analytical procedures.
(a) It is necessary to collect and evaluate sufficient and appropriate audit evidence on the basis of ASA 500 (ISA 500) by three methods, 100 per cent examination, selecting specific items, and audit sampling. 100 per cent examination means examining the entire population of items that make up an account balance or class of transactions. Under selecting specific items method, the auditor may use professional knowledge and judgment to decide and select specific items within a population because of high value or some other characteristic of interest. Audit sampling is the common evidence-gathering technique and can involve a statistical or a non-statistical approach. The sample size the auditor considers is determined by whether sampling risk will be reduced to an acceptably low level (ASA 530.07/ISA 530.07). It is affected by the degree of sampling risk that the auditor is willing to accept and can be determined by the application of a statistical formula or professional judgment.
In this case, audit assistant used selecting specific items method to select all balances over $2,000,000 and vouched these to supporting invoices and found one invoice for $1,827,400 had been incorrectly recorded on the accounts payable listing because the goods belonged to next year. The assistant also applied audit sampling method to select sample comprised $45,585,000 of total accounts payable of $111,680,000. For the reason that the error relates to only 4% of accounts payable tested, and a total error of $4,476,994 of the overall accounts payable is a little greater than $4,467,200 ($111,680,000 - 4%) for $9,794. Therefore, it is not material and no future work should be performed on accounts payable.
(b) The maximum rate of deviation that would support the auditor's planned assessed level of control risk is tolerable deviation rate. Generally speaking, a lower reliance on internal controls will result in an increase in the tolerable deviation rate and a decrease in the sample size.
In this case, a tolerable error of 5 per cent had been established in the planning of the test which usually means a low level of control risk and high reliance on the control. The assistant undertook a test of controls for 50 sales transactions with 4 errors. None of the errors found were material in the assistant's working paper.
Calculate 1: sample deviation rate = 4/50 = 8% > 5% = tolerable deviation rate
The sample deviation rate is the auditor's best estimate of the population deviation rate. If the sample deviation rate is greater than the tolerable deviation rate, the auditor can not rely on the internal control being assessed.
Calculate 2: sample size (n) = R/TDR → 50=R/0.05 → R=2.5
This means that the reliability factor for desired level of assurance is 2.5 and the desired level of assurance is between 90% and 95%.
(c) The auditor's evaluation of sample results is not limited to quantitative analysis. The auditor also needs to consider other factor, such as the nature and cause of the deviations. If the deviations analyses indicate that prescribed internal control policies or procedures have been intentionally circumvented, the auditor should consider the possibility of material fraud.