Audit Risk Analysis For Electric Wholesale Company

Liquidity ratios

Question 1 :

Understanding the structure and composition of the board of directors and its sub-committees assists the auditor in documenting and evaluating the governance structure and in identifying potential risks within that structure.

a) Explain why an understanding of the governance of an audit client is important in assessing the client’s business risk.

b) Explain why the auditors’ understanding of business risk is relevant to public expectations of the audit process.

c) Access copies of the 2013 annual report for Namoi Cotton Co-operative Ltd, namoicotton.com.au/reports/financial-reports.aspx (https://namoicotton.com.au/reports/financial-reports.aspx). Examine the annual report for information about the governance structure of this co-operative and evaluate whether this co-operative follows the ASX Corporate Governance Principles and Recommendations.

d) Evaluate the impact that the existence or nonexistence of an audit and a risk committee may have on the external audit function.

Case Scenario

You are commencing the audit of an electric wholesale company and undertaking a preliminary analytical review in order to assist you in identifying potential audit risk areas. These calculations are based on the audited accounts from last year and the unaudited figures for this year.

Liquidity ratios		2014	2013
Current ratio	Current Assets/Current Liabilities	2.1	2.7
Quick ratio	Liquid assets/Current Liabilities	.9	1.4
Inventory Turnover	Cost of Goods Sold/Average inventory	2.9	2.5
Accounts receivable	Credit Sales/Average receivables	3.5	5.5
Solvency ratios
Debt to equity	Liabilities /equity	5	3.25
Times interest earned	Operating profit before interest and taxes/interest expense	1	2.9
Profitability ratios
Gross Profit ratio	Gross profit/sales	.5	.55
Net profit ratio	Net profit/sales	-.01	.03
Return on assets	Net Profit/average total assets	-0.10	.04
Return on Shareholders’ funds	Net profit/average common shareholders’ equity	-0.5	.20

In addition you have the following information:

• The remuneration contracts of the Financial Controller and Business Systems Manager include stock options if revenue targets are met.
• In order to finance a new warehousing facility the company doubled its bank loan.
• The company has spent significantly on marketing to build their brand through sponsorship of a popular football team. The marketing activities include team based television advertising as well as advertising on team clothing and at the home team stadium.

Required:

Identify the three potential audit risk areas and evaluate the implications of your analysis on the year-end audit testing. Identify the accounts likely to be affected, the impact of the

affect and the assertion that is at risk.

Question 3 :

 

Case Scenario

Rachel Powers runs Fit for Life, a women only gymnasium, providing use of a range of exercise equipment, exercise classes, personal trainers, dietary advice and dietary supplements. She has just opened another branch of the business in a town 100 kilometres away and there are plans for a third branch to be opened next year. Rachel has been very busy establishing the new branch and relies on the staff at that branch to run the day to day operations, including ordering supplies and banking receipts. In addition the branch manager organises the staff rosters and authorises the time sheets. Rachel makes the payments for rent, power, salaries and large items of expenditure such as the exercise machines.

Required:

Give examples of at least 3 types of transactions that would occur at Fitness for Life.

Explain what could go wrong with these transactions if the system of internal controls could not meet any of the seven generally accepted objectives of internal controls.

Question 4:

Case Scenario

The sales transactions for Shepparton Brothers, a new audit client, are handled by a software application that is not supported by very detailed documentation. The audit partner request the team to perform some tests of controls to ensure that the software application controls are working as described by Shepparton Brothers management. The audit software used by the audit team can access the data on the client’s files, allowing the use of standard audit procedures.

Required:

Generate a list of possible audit procedures that could be used by the audit team to test the controls in the client’s sales software application. 

Solvency ratios

Principles and Recommendations

As per the recommendation which was been set out by the corporate governance and its principle also been set out by them for those companies who are listed on the exchange of Australia i.e. ASX and they have to follow them compulsorily and we expect that they would come out as per the requirement of us and as per the expectation of their investors in most likely situation. (ASX, 2014) & (Newstatement, 2015)

Company disclosed:

(a) Board of directors and the management their respective functions and responsibilities; (b) matters which are allotted to other managers.

Principles and Recommendations – the “if not, why not” approach

The listed company must select the well performed governance practices to select a good governance practice is the main concern for the board and the top most managers of it which would have all the responsibility for creating such things. They are responsible for conducting their business and must conduct it with due care and by using proper way so that is why they have to place a good governance policy in the company.

As per the Principles and Recommendations, when the board of directors came to know that the company and its council recommendation is not proper for the above circumstances which are shown in the company and they recommend that not to adopt such policy. If the company is adopting that than it has to give the reason that why it has not accepted the recommendation which was provided to them by using the approach of “if not, why not”. (ASX, 2014)

• The investors and the other stake holder must have the proper communication with the company management on governance matters;
• The investor can use the information about the use of their vote and decision on it for the particular resolution; and
• They also take the decision to how to take the information about the decision as to whether to invest in their shares or not.

The “if not, why not” approach is fundamental to the operation of the Principles and Recommendations.

The corporate governance statement has to show the extent of which they need to followed the suggestion given by ASX and set by the Council at the time of reporting period. If they are not following the suggestion or any part of them of the reporting period, then they must have to separately identify or disclosed its corporate governance statement and the suggestion and that period which needs to be followed and state its reasons why they are not following the suggestion and any other governance practices.

By requiring listed entities to compare their corporate governance practices with the Council’s recommendations and, where they do not conform, to disclose that fact and the reasons why, Listing Rule 4.10.3 acts to encourage listed entities to adopt the governance practices suggested in the Council’s recommendations but does not force them to do so. It leaves a listed entity with the flexibility to adopt alternative governance practices, if its board considers those to be more suitable to its particular circumstances, subject to the requirement for the board to explain its reasons for adopting those alternative practices instead of the Council’s recommendations.

Scope

The standards which was been issued by ASA is used and it deals with the auditor’s responsibility to make a communication with TCWG during the conduct of audit of the financial report. Apart from any discussion it applies to the company governance and its structure and its particular size and it also applies to all the things where the Those Charged with governance are been involved. As per this standard it does not establish any communication with the management of the company unless they are been those charged with governance.

Profitability ratios

The Role of Communication

The main objective of this Auditing Standard is to focuses on communications between the auditors to those charged with governance. The two way communication is always affected when:

(a) Both of them are involved in making a proper pattern to work the things. Such type of relationship can be maintained only when there is a integrity and independence in the auditors work;

(b) The auditor must obtain the necessary data to carry the audit from those charged with governance. To illustrate, they provide and help auditor in understanding the entity and its environment which helps to obtain the audit evidence; and

(c) It also helps to fulfil the responsibility to check the process of reporting and to find the fraud and reduce the risk in them.

The auditor has to decide that to whom they will communicate for any particular work in the company.

Communication with a person of Those Charged with Governance

The auditor finds any material items it must communicate with the person in the company for example, head of audit committee or an individual. They also determine to communicate with the management also.

When All of Those Charged with Governance Are Involved in Managing the Entity

In most of the case those charged with governance are taking part in managing the organisation, for example, a small businessman who is a single owner manages the organisation and has no other person having a governance role. As per such case if matters required for such standard is to make a communication with the person who is responsible for all work. Such matter is been noted in paragraph 16(c) of this Standard of auditing.

The auditor must do the risk assessment procedures to obtain the information and material misstatement in the financial report at the various level of audit. The auditor conducting the Risk assessment procedures by themselves would not provide the acceptable audit evidence so that audit opinion can be given on such.

The risk assessment procedures shall include the following:

(a) The auditor must make the enquiries of the entire individual in the organisation. So that fraud and error of the organisation can be obtained.

(b) Analytical procedures. (Para. A14-A17)

(c) Observation and inspection. (Para. A18)

The auditor shall consider whether information obtained from the auditor’s client acceptance or continuance process is relevant to identifying risks of material misstatement.

If other partner of the firm i.e. the engagement partner who has conducted the other work for the organisation whether such information obtained is sufficient and appropriate to identifying risks of material misstatement. (PCAOB, 2015)

• The process of financial reporting in order to ensure the integrity and transparency of the financial reports;
• The effectiveness of the internal control of the University’s and its environment of risk management;
• The Enterprise Framework for Risk Management;
• The independent process of audit, which includes the recommendations of the assessment and appointment of the performance of external auditor;
• The internal audit function and its effectiveness;
• The compliance of University with the, statutory, legal and the regulatory requirements, regarding the safety and health of the employees. (University of Tasmania, 2014)

The Committee also has an authority of requesting the investigation of appropriate to fulfil its responsibilities.

Hence, it is evident that the existence of Audit and Risk Committee will reduce the Stress on Auditor, since the people those charged with governance will take the responsibility of fair dealings of the company’s state of affairs.

It is also known to be as residual risk and the audit risk means the risk that auditor is facing whether the proper care is taken but still opinion given by him is not correct and the financial statements of a company or an individual would include any fraud and the errors.. The audit risk is generally been divided into two parts:

• Risk of evaluation of financial items and
• Risk of affirmations which was created due to evaluation of financial documents.

Internal controls for Fit for Life

Mainly audit is been conducted to provide that the financial statement is free from material misstatement and give the opinion on it to the investors.

With the aim of insuring against future litigations arising from missed financial improprieties, like material misstatements, auditors will usually transmit malpractice insurance. (Ready Ratios, 2015)

The different types of audit risk include:

Inherent risk-

The Inherent risk is the risk that a there would be risk in the financial statement. This statement is related to the account important notes and other items.

Control risk- Control risk is the risk that how much control is created still there would be material misstatements which will not be created or detected and cannot be prevented from incurring.

Detection risk- Detection risk is the risk that an audit might not be capable of detecting a material misstatement. (Ready Ratios, 2015)

Assessing the audit risk

The inherent risk and control risk is been assessed by the company auditor at all the three levels – high risk, moderate risk, and low risk.

The top most risk of inherent and control risks would arise due to low checking in the company financial statement. So as a result of this the auditor would require to carry more checking and that the financial statement is free from any risk and material misstatements. (Ready Ratios, 2015)

Significance of audit risk

To get the low audit risk it is not at all possible for auditor to conduct and check every transaction. The auditor is generally required to check the following main areas. For example less cost is been shown or more revenue is shown. So it can be possible that there would be where it is possible that errors will lead to material misstatements on the financial statements. However auditor is required to make the proper planning and driven out its work in a way which is best possible for the financial statements being materially misstatement.

Role of CFO

The main role of the CFO as key person for the department of financial management & support for the Head in his duty as “accounting official” is the crucial in the decentralized structure of organization in order to ensure that the financial risks are monitored appropriately and are also mitigated. The current need for the regions for identifying the surpluses which may be early reallocated is also a better step to foster the efficient practices of financial management. It is also important to ensure that the initiatives made by the corporate or the funding commitment that require the regions to make necessary changes to the strategies or budget plans shall be communicated to them in a timely manner.

The Corporate Finance is also responsible for developing the guidelines for the year-end and also the timetable in order to meet the year-end needs of the central agencies. The Regional staff is authorised to apply the guidelines in their particular regions.

Audit Objective

The objective of this engagement was to determine how well the department has designed and implemented controls relating to year-end procedures, particularly as they related to: commitments and budgetary management; payables and accruals; and departmental and public accounts reporting.

Types of transactions for Fit for Life

Key Risks

The Management shall design the controls for managing the risks. The audit shall examine the controls and processes that the management has designed to reduce the following main risks:

• year-end transactions cause the departmental spending to increase the appropriations;
• the appropriations may lapse despite a requirement for funding the projects;
• the errors in the financial information are made due to the misleading application of the miscommunication, policies, huge volume of the transactions and the complexity of requirements of reporting;
• the accruals and payables are not supported properly by the documentation; and
• the central agency needs are also not complied with.

1. Net Profit V/s Advertising Expenditures

It is clearly evident from the given statistics that the Net Profit to Sales ratio is decreasing in the current year as compared to previous year, and the main reason for the same is Huge Expenditure incurred by the Marketing team to promote their team. The Audit risk here is that, despite of incurring heavy expenditure on advertising, there is significant downfall in Profits of the company which is a matter of concern for the near future.

1. Debt to Equity

It is evident from the statistics given that the Debt to Equity ratio has been increased from 3.25 to 5 in the current year, which is not a good sign for the company, since the funds are borrowed at some rate of interest and in return the interest earned by the company is also lower than what was made in prior year i.e. the Time interest earned is only 1 as compared to 2.9 in prior year. Also the company is making a loss since last year it would be difficult to pay off the interest expense on borrowings.

1. Return on Assets

It is evident from the statistics given that the Return on Assets utilised in the company has also decreased from 0.04 to -0.10 in the current year. This may be due to the heavy depreciation and other operating expenditures have been charged to the revenue of current year. (Namoi cotton, 2015)

Summary Conclusions

The management shall establish the reasonable procedures for year-end and the controls over the commitments, payables and the financial reporting. The identification and the accuracy of the PAYEs and the internal communication of the new spending would also further strengthen the practices of financial management.

Audit Area	Audit Assessment
Payables at the Year-End (PAYEs)	Criteria Mostly Met
Commitments and Year-End Budget Management	Criteria Mostly Met
Financial Information Reporting	Criteria Met

(Namoi cotton, 2015)

The Internal control consists all the processes which are designed to give the assurance for the achievement of the objectives of company in following cases: cost-effective utilization of the resources, the efficiency of operations, the financial reporting reliability and the compliance of the regulations and the internal policies.

The general objectives of the internal control are as under: 

• To ensure that thebusiness is conducted efficiently with respect to the systems that is in place and is implemented fully. The Controls shall mean that the processes and transactions of business may take place without any disruption and also with low disturbance or risk and which may, in turn add the value.

• Tosafeguard the business assets. The Assets may include the tangibles as well as the intangibles, and the controls are also necessary in order to ensure that they are been used and protected from any fraud, misuse, theft or misappropriation.

• Todetect and prevent fraud. The Controls are also required to show up any financial or operational disagreements which may be the result of some fraud or theft. This may include the off-balance sheet funds or the utilisation of the unauthorised policies of accounting, or the use of property of company and similar, inventory controls etc.

• To ensure theaccuracy and the completeness of the accounting records. Also ensuring that the transactions of accounting are recorded accurately and fully, and that the assets and liabilities are also identified correctly and are valued, and that all the revenues and costs shall be accounted fully.

• To ensure thepreparation of the financial information that also applies to the reporting and also to management accounts, if necessary, for the facilitation of the effective decision-making of management. (Strategic management accounting knowledge, 2011)

1. Cash Receipts and Payments: This would include the receipts of the Fees from the members of the Fitness Centre, other miscellaneous Processing charges etc. The payments shall include Petty cash expenditures like repairs of some machineries and equipments, tea, food and beverages, etc. The risk here is that the branch manager may diligently misappropriate the cash received by raising the fake bills for expenditures. Hence, it is essential to set proper internal control system to overcome this risk of embezzlement of cash.

1. Incorrect Claims for Salaries of Staff: Since, the entire responsibility of Staffing and their time management is handed over to branch manager, it may be possible that the claims may be wrongly made for the salary not to be payable to the particular staff on occasion of certain leave taken by him during the month.

 

1. Free Entry to Relatives: There are likely chances that the branch manager allows his friends and relatives to enter the Fitness Centre without making any payment of membership fees, hence the CCTV can be placed at the branch premise which is considered to be the better internal control to overcome this kind of risk.

 

 

The Tests of controls may be required, when:

• The auditor has planned a reliance on test results for some low level of risk of control.
• Tests of the balances and the analytical procedures in itself are not at all sufficient in order to evaluate the assertions of the financial statement (such as the completeness for the revenues).
• The observations and Inquiries concerning the key controls in the small entities are required to offset the material weaknesses and significant control deficiencies for a risk assessment of control at some level.
• Where the tests of controls are performed, they can be used for evaluating some of the assertions for the transactions, thus reducing the tests of balances. The Common sizes of sample utilised in the practice are 40 units of sample (with no deviations or errors) or the 60 units of sample (with one deviation or error). (Accounting Concern, ND)

The Tests of controls are generally “dual purpose.” The first purpose is to test the compliance with the entity’s internal controls.  The secondary purpose is to perform various procedures for accounting and internal controls. The auditor must perform the following audit procedures:

1. Assessment of the effectiveness of the system of internal control. This shall mean that investigation shall be conducted on the entities operations and design.

1. Obtain the direct evidence, additional about the amounts that are disclosed in the Financial Statements. This evidence can be obtained by utilising the substantive testing procedures.

Say for example, we may consider the amount of receivables in the SOFP. The one way in which this can be misappropriated may be if it had been valued incorrectly, because the huge amount of balance had been owed by the customer who is not likely to pay back.

The controls which may assist to prevent shall include:

• Take up the references of credit on the new customers.
• Establish a limit of credit.
• Developing the analyses for aged receivables.
• The follow up of the amounts which are not paid timely.
  

References

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