MP221 AUDITING AND ASSURANCE SEMESTER2,2022

ASSIGNMENT 2

This assignment consists of two questions which are to be answered separately .The normal requirements for assignments exist with respect to referencing are expected .

QUESTION 1

JS Business operates a group of business colleges and it offers a range of different professional courses to its potential customers both in providing undergraduate accounting, business and IT courses as well as professional knowledge update courses to existing professionals so they can maintain their professional accreditation as well as generic courses in supervisory skills and professional writing .

JS Business has just invested a significant amount in a new integrated IT system which is to be used by the staff for operations within the business for customer bookings , as well as inventory management ,purchasing and sales recording and payroll and HR all linked around a nominal ledger  and management reporting module . The company providing the new IT system , ZEERO , is providing two days of training for staff as part of its service in supplying the new IT system . As this is only one staff has had previous experience with the software and only one IT lecturer and one Accounting lecturer have had some brief exposure to the software it is expected that the training will be very well  attended by staff and lecturers .

To purchase the IT systems JS Business has had to borrow extensively from the bank and needs to ensure it operates very full classes so it can cover the costs of the loan and meet the requirements of the bank loan to maintain its interest coverage and gearing ratios . The colleges have been having classrooms full of students and have a significant number of people in their buildings and it is subject to strong health and safety rules and fire protection legislation as well as the need to meet the requirements of the tertiary regulator with regards to the courses and student welfare .

One of JS Business’ main costs relates to property rental and so it tries to maximise its student numbers by employing lecturers with good reputations who will generally have the ability to draw students to their colleges which will generally lead to higher class sizes . JS Business seeks to create its salary packages to staff which provide higher monetary rewards for those providing higher class sizes .

REQUIRED

(a) Identify and explain the business risks and the audit risks in the above situation .
(b) Outline the impact of these risks on the audit approach    


QUESTION 2

The Green company supplies a wide range of garden and agricultural products to trade and domestic customers . The company has 9 divisions with each division specialising in the sale of specific products , for example seeds ,garden furniture and agricultural fertilisers .The internal audit department which provides audit reports to the audit committee on each division on a rotational basis . Products in the seed division are offered for sale to domestic customers via an Internet site . Customers review the product list on the site and place orders for packets of seeds using specific product codes along with their credit card details onto Greens’ secure server . Order details are then manually transferred onto the company’s internal inventory control and sales system . A two part packing list is printed in the seed warehouse . Each order and packing list is given a random alphabetical code based on the name of the employee who input the order , the date and products being ordered .
In the seed warehouse , the seed packets for each order are taken from specific bins and despatched to the customer with one copy of the packing list . The second copy of the packing list is sent to the accounts department where the accounts clerk updates the inventory and sales computer to show that the order has been despatched .The accounts clerk then charges the customer’s credit card .

REQUIRED
(a)Make an assessment of the above system identifying internal control weaknesses .  
(b) Make an assessment of the internal control weaknesses identified in part (a) for potential
       material misstatement/fraud and the effect this will have on the audit and the audit approach.

QUESTION 3

The following are individual situations faced by an auditor when carrying out an audit of the respective company financial statements .All items mentioned are considered material .  
(a) The auditor is appointed as auditor of the client after the client’s annual physical inventory count has been conducted . The year end balances are not sufficiently reliable to enable the auditor to become satisfied as the year end inventory balance .
(b) A client holds a note receivable consisting of principal and accrued interest receivable . The note’s maker recently a voluntary bankruptcy petition , but the client failed to reduce the recorded value of the note to its net realisable value which is approximately 15 per cent of the recorded amount . No other current assets appear to be incorrectly valued .
(c) A client receives the majority of its revenue(approximately 60 per cent) in cash with some account customers and it only banks its cash once per week .The accounts clerk writes up details of all cash received at the time and then proceeds to bank the cash .        (d) Due to significant losses and adverse key financial ratios, the auditor has substantial doubt about a client’s ability to continue as a going concern for a reasonable period of time . The client has adequately disclosed its financial difficulties in aa note to its financial report , which do not include any adjustments that might result from the outcome of the uncertainty .
(e) A client has just started converted its operations from being a private company to a publicly listed company during the current period. It has never undergone an audit until the current year although it has prepared financial statements each year for the five years of its existence as a private company prior to the current year .

REQUIRED
For each of the above situations identify the type of auditors opinion that would be given and provide an explanation of the reasons for the opinion .          

Solution

Question 1

A.

Business Risks:

  • Financial Risk: JS Business has borrowed extensively from the bank to purchase the new IT system (Pinjisakikool, 2018). This creates a financial risk as the company needs to generate sufficient revenue to cover the costs of the loan, maintain interest coverage, and meet the requirements of the bank loan in terms of interest payments and debt ratios.
  • Operational Risk: The implementation of the new integrated IT system is a significant investment for JS Business (Van Greuning, & Bratanovic, 2020). There is a risk associated with the successful integration and adoption of the system by the staff. If the system fails to function properly or if the staff faces difficulties in using it effectively, it could impact the operations of the business, including customer bookings, inventory management, purchasing, sales recording, payroll, and HR processes.
  • Compliance Risk: JS Business operates in a regulated industry, subject to health and safety rules, fire protection legislation, and requirements from tertiary regulators. The organization has an obligation to adhere to these norms, both to assure the well-being of pupils, personnel, and the facility and to satisfy the tertiary regulator’s stipulations concerning the standard of the curriculum and student well-being. Neglecting to meet these regulations could beget punitive actions, legal disputes, harm to reputation, or even the revocation of accreditation.
  • Market and Competitive Risk: JS Business aims to maximize student numbers to cover its property rental costs. The company relies on employing lecturers with good reputations who can attract students and increase class sizes (Davis, Karim, & Noel, 2020). However, if the lecturers fail to meet the student’s expectations or if competitors offer more attractive courses or pricing, it could impact student enrollment, leading to lower class sizes and potentially affecting the financial viability of the business.

Audit Risks:

  • IT System Implementation Risk: The new integrated IT system is critical to JS Business’s operations. There is a risk that the system implementation may face challenges, such as data migration issues, integration problems, or staff resistance to change (Zamboni, & Litschig, 2018). These risks could impact the accuracy and reliability of financial data, internal controls, and operational efficiency. The audit risk lies in ensuring that the IT system has been implemented effectively, and controls are in place to mitigate potential risks and ensure data integrity.
  • Financial Reporting Risk: Due to the extensive borrowing and the need to generate sufficient revenue, there is a risk of financial misstatement or fraud. This hazard could spring from inaccuracies while logging revenue, costs, or dealings related to loans, or even deliberate doctoring of financial accounts (Zhang, 2018). The task of audit risk involves corroborating the precision and thoroughness of financial data, evaluating the efficiency of internal safeguards, and uncovering any plausible distortions or anomalies.
  • Compliance and Regulatory Risk: JS Business operates in a regulated industry and is subject to various rules and regulations. The threat lurks of non-adherence to health and safety norms, fire prevention laws, or demands of the tertiary regulator. Such discrepancies could culminate in punitive repercussions, legal implications, or a dent in reputation. The audit risk rests in gauging the firm’s conformity to relevant rules, appraising the potency of compliance-related internal checks, and pinpointing any compliance deviances that need rectification.

B. Impact on Audit Approach:

The identified business risks and audit risks in the given situation have several implications for the audit approach. Here are some key considerations:

IT System Audit: Given the significance of the new integrated IT system and its impact on operations, the auditor needs to focus on assessing the system’s implementation, functionality, and controls (Manita, et.al 2020). This involves understanding the system’s design, testing controls, and verifying the accuracy The thoroughness of the data migration process is assessed by the auditor may also need to assess the IT system vendor’s reliability, support, and training provided to the staff.

Risk-Based Audit Planning: The financial risks, including loan obligations and revenue generation, require the auditor to conduct a thorough risk assessment and develop a risk-based audit plan. This plan should address the areas of highest risk, such as financial reporting, revenue recognition, and compliance with loan covenants. The auditor needs to allocate resources and design procedures to address these high-risk areas effectively.

Internal Control Evaluation: Given the operational and financial risks, the auditor needs to assess the efficiency of internal safeguards, specifically pertaining to the newly implemented IT system, revenue recognition, payroll, and compliance (Reid, et.al 2019). This involves understanding the control environment, performing walkthroughs, and testing key controls to ensure they are operating effectively. The auditor’s evaluation should also encompass the adequacy of controls related to health and safety, fire protection, and regulatory compliance.

Substantive Testing: The auditor needs to design substantive procedures to mitigate the financial risks that have been identified. This includes verifying the accuracy of financial data, performing analytical procedures and carrying out substantive tests on transactions and balances. The focus should be on areas such as revenue recognition, expense recording, loan obligations, and compliance with loan covenants.

Compliance Audit: To address compliance risks, the auditor needs to evaluate the company’s adherence to health and safety rules, fire protection legislation, and requirements from the tertiary regulator. This involves reviewing documentation, performing site visits, and assessing the effectiveness of controls in place to ensure compliance. Non-compliance issues should be identified and reported.

Fraud Detection: The auditor needs to be vigilant for any indications of potential fraud, given the financial risks involved. This includes assessing the company’s fraud risk management, performing fraud risk assessments, and implementing appropriate fraud detection procedures. Unusual or unexpected transactions should be investigated, and any potential fraud should be reported.

Overall, the audit approach should be tailored to address the specific business risks and audit risks identified in the situation. The auditor must collect adequate evidence to establish an assessment regarding the accuracy of the financial statements, adherence to regulations, and efficiency of internal controls. This should involve particular attention to high-risk and material areas.

Question 2

(a) Assessment of Internal Control Weaknesses:

  • Manual Transfer of Order Details: The manual transfer of order information from the Internet platform to the internal inventory control and sales system poses a potential data vulnerability. entry errors or omissions (Donelson, Ege, & McInnis, 2017). This manual process increases the likelihood of mistakes, such as incorrect product codes or missing orders, which can lead to inventory and sales inaccuracies.
  • Absence of Automated Data Verification: The system seemingly lacks automated data verification routines when dealing with the transfer of order specifics. In the void of such safeguard checks, there’s a lurking hazard of embracing flawed or imprecise data, such as wrong credit card particulars or product identifiers, thereby potentially causing issues in payment procedures or paving the way for fraudulent activities.
  • Inadequate Segregation of Duties: The process of updating the inventory and sales system and charging customers’ credit cards is performed by the same accounts clerk (Lisic, et.al 2019). This lack of segregation of duties creates a risk of fraudulent activities, as the clerk has the ability to manipulate inventory records or misuse credit card information without detection.
  • Absence of Reconciliation Procedures: There is no mention of reconciliation procedures between the seed warehouse and the accounts department. Reconciliation between the physical seed inventory and the recorded sales and inventory levels is crucial to ensure accuracy and detect any discrepancies or theft.
  • Reliance on Random Alphabetical Codes: The use of random alphabetical codes based on employee names, dates, and products for order identification lacks proper control. These codes can be easily manipulated or guessed, potentially leading to unauthorized access or tampering with orders and packing lists.
  • Reliance on Manual Controls: The overall reliance on manual processes and controls within the system increases the risk of errors, inconsistencies, and potential fraud. Manual controls are more prone to human error, lack of standardization, and limited visibility, making it easier for unauthorized activities to go undetected.
  • Lack of Security Measures: The absence of mention regarding security measures for the Internet site and the secure server raises concerns about the protection of customer data. In the absence of stalwart security protocols, like encryption methods, firewalls, and access restrictions, there’s an escalated threat of unauthorized entry, data leaks, and possible exploitation of credit card details.
  • Insufficient Documentation and Record Maintenance: The system’s description fails to allude to any particular documentation or record management practices. Inadequate documentation and record-keeping procedures can hinder traceability, audibility, and the ability to reconstruct activities or resolve discrepancies effectively.
  • Inadequate Training and Oversight: The lack of information regarding training and oversight of employees involved in the order processing and inventory management processes is a potential weakness. Without proper training, employees may not fully understand their responsibilities or the importance of following internal control procedures. Insufficient oversight increases the risk of non-compliance and errors going unnoticed.

(b) Assessment of Impact on the Audit and Audit Approach:

The identified internal control weaknesses have several implications for the audit and the audit approach:

  • Elevated susceptibility to significant misrepresentation and fraudulent activities: The manual transfer of order details and lack of automated data validation increase the risk of errors and fraudulent activities (Muda, et.al 2018). These weaknesses can lead to inaccurate recording of sales and inventory levels, misallocation of revenue, or fraudulent transactions. As a consequence, there is an elevated risk of significant misrepresentation and fraudulent activities in the financial statements.
  • Reliance on Manual Controls: The absence of automated controls and reliance on manual processes make the system more susceptible to errors and fraud. Manual controls are inherently weaker compared to automated controls due to the potential for human error, lack of consistency, and increased susceptibility to manipulation. The risk of material misstatement and fraud is further amplified by these control weaknesses.
  • Impact on Substantive Testing: The audit approach needs to be adapted to address the identified control weaknesses (Rose, et.al 2017). Due to the increased risk of material misstatement and fraud, the auditor should focus on performing more extensive substantive testing. This may involve testing a larger sample of sales transactions, reconciling physical inventory counts with recorded levels, and verifying the accuracy of credit card charges and inventory updates.
  • Segregation of Duties Testing: Given the inadequate segregation of duties, the auditor should pay special attention to testing the effectiveness of compensating controls. This may involve reviewing management oversight procedures, examining access controls and restrictions, and testing the accuracy and completeness of the accounts clerk’s activities through independent verification.
  • Testing of Controls: While the system has control weaknesses, the auditor should still perform testing of controls to identify any compensating controls or areas where controls are operating effectively. This includes testing the controls over data transfer, order processing, inventory management, and credit card authorization and charging. The purpose is to assess the design and operating effectiveness of these controls and determine if reliance can be placed on them to reduce substantive testing.
  • Increased Professional Skepticism: The identified internal control weaknesses highlight the importance of exercising professional scepticism throughout the audit process. The auditor should approach the engagement with a questioning mindset, critically assessing the effectiveness of controls and searching for potential misstatements or fraud indicators. This includes considering the risk of management override of controls and assessing the integrity and ethical conduct of key personnel involved in the process.

In summary, The presence of deficiencies in the internal control system amplifies the likelihood of significant misrepresentation and fraudulent activities. Consequently, the auditor should modify the audit methodology by emphasizing substantive testing, assessing alternative controls, verifying the operational efficacy of controls, and upholding a rigorous level of professional scepticism throughout the engagement.

Question 3

(a) Situation:

The auditor assumes the role of the client’s auditor following the completion of the client’s annual physical inventory count. The year-end inventory balances lack adequate reliability, preventing the auditor from achieving confidence in the accuracy of the year-end inventory balance.

Type of Auditor’s Opinion: Qualified Opinion

Explanation: In this situation, The auditor faces challenges in obtaining satisfactory and relevant audit evidence regarding the year-end inventory balance. Consequently, the auditor’s opinion will be qualified due to a significant limitation in the audit scope, specifically pertaining to the inventory balance. The auditor will issue a qualified opinion, outlining the limitation and incorporating an explanatory paragraph in the audit report. The qualified opinion indicates that the financial statements are reasonably presented except for the inventory balance, which has not undergone sufficient audit procedures to meet the auditor’s standards.

(b) Situation:

The client possesses a note receivable that encompasses both principal and accrued interest receivable. The note issuer has recently initiated a voluntary bankruptcy proceeding. However, the client neglected to adjust the recorded value of the note to its estimated realizable value, which is roughly 15 per cent of the recorded amount. No other current assets seem to be inaccurately valued.

Type of Auditor’s Opinion: Qualified Opinion

Explanation: In this situation, the client’s failure to adjust the note receivable’s recorded value to its net realizable value constitutes a significant misstatement. Consequently, the auditor’s opinion will be qualified due to the financial statements’ lack of fair presentation in accordance with the relevant financial reporting standards. The qualification will specifically pertain to the valuation and presentation of the note receivable. In the audit report, the auditor will provide an explanatory paragraph detailing the misstatement and its repercussions on the financial statements.

(c) Situation:

The client receives the majority of its revenue (approximately 60 per cent) in cash, with some account customers, and it only banks its cash once per week. The accounts clerk writes up details of all cash received at the time and then proceeds to bank the cash.

Type of Auditor’s Opinion: An unqualified opinion will be provided, with an inclusion of an emphasis on the matter.(Key Audit Matter)

Explanation: In this situation, the client’s practice of banking cash once per week poses a risk of misappropriation or loss of cash. However, The auditor has gathered enough relevant and reliable evidence concerning revenue recognition and has determined that the financial statements are accurately presented in accordance with the relevant financial reporting standards. The auditor will issue an unqualified opinion, but the audit report will contain an emphasis on the matter paragraph. This paragraph will highlight the substantial risk related to the client’s cash handling procedures, underscoring that it does not impact the fairness of the financial statements.

(d) Situation:

Given significant deficits and negative vital financial metrics, the auditor carries considerable scepticism regarding the client’s capability to sustain operations for a foreseeable duration. The client has duly made known its financial tribulations in an annexure to its financial dossier, which refrains from incorporating any alterations that could emerge from the resolution of the uncertainty.

Type of Auditor’s Opinion: Opinion of disclaimer or unfavourable opinion.

Explanation: Under these circumstances, the auditor harbours considerable apprehension concerning the client’s potential to persist as a viable entity. Should the client’s financial records fall short of suitably revealing the financial hardships and the probable consequences. The auditor is prepared to render an unfavourable judgment. An adverse opinion signifies that the financial statements are not fairly presented in alignment with the applicable financial reporting framework. However, if the financial statements adequately disclose financial challenges and potential outcomes, but uncertainties exist regarding the outcome, the auditor will issue a disclaimer of opinion. A disclaimer of opinion indicates that the auditor cannot provide an assessment of the financial statements due to notable uncertainties. The audit report will incorporate a descriptive paragraph explaining the uncertainties and the rationale behind the opinion.

(e) Situation:

The client has recently transformed its operational stature, shifting from a privately held firm to a publicly traded entity within the current cycle. Despite producing financial statements annually throughout its five-year tenure as a private corporation, the client is undergoing its inaugural audit only this year.

Type of Auditor’s Opinion: Unqualified Opinion with an Emphasis on Matter (First-Time Audit)

Clarification: In the present scenario, the client is experiencing its inaugural audit as a public corporation. The auditor has amassed enough relevant evidence and beliefs. The audit report will include an emphasis on matter paragraph to highlight the change in circumstances and the unique nature of the audit while ensuring the financial statements adhere to the relevant financial reporting standards with accuracy. This section will underscore that it’s the company’s first audit post-public listing and there is an absence of comparative financial data from the prior year.

Ultimately, the auditor’s opinion in each instance is formulated considering the magnitude, character of the discrepancy or restriction, and its effect on the fairness of the financial reports. This opinion is shared in the audit report, imparting clarity and valuable information to those using the financial statements.

References

Davis, E. P., Karim, D., & Noel, D. (2020). The bank capital-competition-risk nexus–A global perspective. Journal of International Financial Markets, Institutions and Money, 65, 101169.

Donelson, D. C., Ege, M. S., & McInnis, J. M. (2017). Internal control weaknesses and financial reporting fraud. Auditing: A Journal of Practice & Theory, 36(3), 45-69.

Lisic, L. L., Myers, L. A., Seidel, T. A., & Zhou, J. (2019). Does audit committee accounting expertise help to promote audit quality? Evidence from auditor reporting of internal control weaknesses. Contemporary Accounting Research, 36(4), 2521-2553.

Manita, R., Elommal, N., Baudier, P., & Hikkerova, L. (2020). The digital transformation of external audit and its impact on corporate governance. Technological Forecasting and Social Change, 150, 119751.

Muda, I., Maulana, W., Sakti Siregar, H., & Indra, N. (2018). The analysis of effects of good corporate governance on earnings management in Indonesia with panel data approach. Iranian Economic Review, 22(2), 599-625.

Pinjisakikool, T. (2018). The influence of personality traits on households’ financial risk tolerance and financial behaviour. Journal of Interdisciplinary Economics, 30(1), 32-54.

Reid, L. C., Carcello, J. V., Li, C., Neal, T. L., & Francis, J. R. (2019). Impact of auditor report changes on financial reporting quality and audit costs: Evidence from the United Kingdom. Contemporary Accounting Research, 36(3), 1501-1539.

Rose, A. M., Rose, J. M., Sanderson, K. A., & Thibodeau, J. C. (2017). When should audit firms introduce analyses of Big Data into the audit process?. Journal of Information Systems, 31(3), 81-99.

Van Greuning, H., & Bratanovic, S. B. (2020). Analyzing banking risk: a framework for assessing corporate governance and risk management. World Bank Publications.

Zamboni, Y., & Litschig, S. (2018). Audit risk and rent extraction: Evidence from a randomized evaluation in Brazil. Journal of Development Economics, 134, 133-149.

Zhang, J. H. (2018). Accounting comparability, audit effort, and audit outcomes. Contemporary Accounting Research, 35(1), 245-276.









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