Audit Assertions, Substantive Procedures, And Key Audit Matters

Case Study 1: Computing Solutions Limited

Audit Assertions are those claims by the management of the company with respect to the preparation of the books of accounts and the financial statements which helps to know the basis of preparation of the books of accounts. It can be in the form of internal control, practices or policies and procedures within the company that has been performed and monitored in order to ensure that the books are free from misstatements, errors and frauds. It helps to place the responsibility on the management and directors of the company in case there is any issue with regards to maintenance of books or internal control within the organization (Bae, 2017). The auditor may examine all of these audit assertions and may or may not choose to rely on the same depending on the strength of each of these. In case the audit assertions are weak, the auditor needs to apply substantial as well as analytical audit procedures to examine the books and find out the conclusion before expressing an opinion thereon. On the other hand, if the audit assertions are string, it indicates that the internal control is strong and the auditor would have to apply less audit procedures. Audit assertions mainly have 5 major kinds namely valuation, existence, completeness, rights and obligations w.r.t. asset in hand and the disclosure requirements (Boccia & Leonardi, 2016). Each of these has a separate parameter to check and test. The two given case studies have been solved below and relevant audit assertion, the substantive procedures and the Key Audit Matters to be shown in the balance sheet has been shown below:

Inventory: Audit Assertions

The 1^st case study is on Computing Solutions Limited (Computing Solutions) which is involved in selling of computer presentation packages and related goods. With respect to the audit for the period ended 30^th June 2018, two major audit assertions are being shown below:

1. Valuation: Valuation is one of the most technical aspects in the computer and related industry and sometimes this needs an expertise of valuation experts. As per the relevant AASB standards, the company should be valuing the inventory at cost or net realizable value, whichever is lower. Furthermore, the standard also indicates that the normal losses should be included in the calculation of the inventory values whereas on the other hand, the abnormal losses incurred during production should be ignored form computation. However, in the given case, the Computing Solutions Limited has been valuing the inventory as per the standards but all of a sudden, they want to change the valuation method to NRV less 10%, which is not ideal and may reflect wrong financial position of the entity. It will also affect the stock in hand and lead to losses(Bumgarner & Vasarhelyi, 2018). Besides this, if the inventory is not liquidated in time, it may become obsolete over a period of time. Since valuation has a direct impact on the financial results, it qualifies to be one of significant audit assertion and the management should use the correct practices here.
2. Disclosure Requirements: The other key assertion is disclosures with respect to financial statements. Everything that is material and has the ability to change the economic decision of the user is required to be disclosed in the financial statements via notes on accounts, There are many estimates and judgements made by the management of the company and the same needs to be disclosed along with the rationale to the user group so that they can take informed decision. In the given case, for the accounts to be transparent, the company should be disclosing that the inventory is hand is 22% of sales in 2018 which was 18% of sales in 2014. Furthermore, it should also be disclosing that the inventory average is 3.8 times in 2018 as against 5.2 times in 2017(Das, 2017). All these issues hints towards one thing being inefficient management of the inventory leading to high costs for the company. Off late, the company has not be able to liquidate inventory and that the reason behind increase in these ratios. The company should also be disclosing the method of valuation of inventories in the financial statements. As mentioned above, since the company is in the process of changing inventory valuation method, it should also be disclosing the reason and impact of the same.

The substantive audit procedures are the audit procedures which are being undertaken by the auditors to collect the audit evidences so that they can express an opinion on the financial statements. Some of the substantive procedures includes vouching of income and expenses and verification of the assets and liabilities. In the given case study, the substantive procedures which can be employed are:

1. Valuation: With respect to the valuation of the inventory, the auditor should first be checking on the test of controls within the entity. He should be vouching the purchase bills in order to see if the amount recorded as purchases are the one and same that appears in bills. The auditor should be checking the inventory valuation procedures being employed by the competitors in the same industry and reconcile if Computing Solutions has used the correct procedures as it is one of the areas where management may use assumptions to undervalue or overvalue the closing stock and thereby affecting the profit(DeZoort & Harrison, 2016). The auditor should also be checking if the relevant accounting standard for valuation of inventory has been used. Besides this the auditor should be checking on the ageing of the inventory to assess the value of the write off or provision to be created in books.
2. Disclosure: Here, the auditor should be applying the test of controls to check if the requirements of Australian Accounting Standards and the Corporation Act 2001 has been met for disclosures. For inventory, besides the valuation procedure, the ageing and the risk of obsolete inventory should always be disclosed in the financial statements. If at all there is a change in the valuation procedure or there is a provision to be carried in the books, then the same needs to be disclosed as all these issues are material from perspective of decision making. It should also be disclosing that the company has started moving its inventory from the central warehouse to 6 new regional locations and the impact it is having on financials.

The reporting of the key audit matters in the Independent Auditor Report is being covered in ASA 701 as per which all those issues and matters which are considered to be relevant, critical and significant from the perspective of the company’s financial statements should be disclosed separately. Besides the reason for why the same has been identified as KAM, it should also be mentioned as to how the auditors approached the situation and collected the audit evidences with regards to the same. In the given case, inventory should be considered as key audit matter as it has had a number of changes over the last one year including the movement to 6 locations instead of one, age old inventory, high closing inventory storage issues, lowering of inventory days from 5.2 times to 3.8 times. Considering all these issues, it is justified to be classified as KAM and the disclosures to be given in this regard are as follows:

1. The change in the inventory valuation method from cost to NRV less 10% and what will be the financial impact of the same(DeZoort & Harrison, 2016).
2. Whether or not the completeness aspect and the period accounting aspect for inventory has been verified by auditors. If yes, what were the steps being taken?
3. The ageing of the inventory and if there is any provision which has been taken in the books.
4. The test of controls employed and the efficiency of internal control w.r.t. inventory in the company.
5. If the reporting and other aspects have followed respective accounting standards.
6. Management estimates and judgements, if any, with respect to inventory.

Case Study 2: Beautiful Hair Ltd

All these points would help the stakeholders to be well informed about the changes in the inventory accounting by company as well as the risks w.r.t. to the same.

In the 2^nd case study, the discussion is on the intangible assets in the form of formulas to create the product. Here the Howard & Associates is planning the audit of the entity Beautiful Hair Limited which is acquiring of the companies Shimmer Pty Ltd (Shimmer) which is the manufacturer of the high quality hair styling product. In the given case, only Shimmer’s owner is having the knowledge of the product and the formula and thus Beautiful hair limited is proposing to buy this as an intangible asset (kabir, et al., 2017). Since AASB 3 deals with the intangible asset, all its guidelines with respect to recognition and valuation criteria of intangibles must be met. Intangible assets can be in the form of copyrights, patents and trademarks and is usually the right in an asset to produce, reproduce, share or produce copy of something. It needs to be registered with the Board of Intellectual Property only then can it be preserved. In the given case, the most relevant audit assertions are mentioned below:

1. Valuation: With respect to intangibles, valuation is one of the complex and critical topics. There are many methods of valuation of the intangibles like it ca be valued at cost in case the same has been acquired from another entity and then later on be amortized. Similarly, it can also be valued at market value. It depends upon company to company as to which approach is being used by them and what are the judgements and estimations being involved. In the given case, since this is a formula, assistance from the valuation experts can be taken as it would be complex and the same should be disclosed in the financial statements(Venezia, 2017).
2. Completeness in recording of transaction: Completeness refers to indicating and accounting of all the transactions related to the assets in the books of the accounts. In case the same is not recorded, it would result in giving inaccurate results and wrong indication to the users of financial statements. Suppose in the given case, formula for making the product is being acquired then there would be incidental costs as well which should be included in the working(Solicitors, 2016). Also, this can only be done if the transaction itself has been executed completely and accurately. The auditors should be checking if all the costs relating to the acquisition of technical knowhow has been properly recorded in the books of accounts.

Some of the substantive audit procedures to be employed by the auditor in this regard are as follows:

1. Valuation: The auditor should be taking the help of the valuation experts to check if the assumptions and estimates taken by management while valuation of the intangibles are true and viable in the circumstances of the case. They should also be checking if the correct rate of amortization has been taken and the other variables are not leading to under or over valuation of the intangible assets(Oberoi, 2018). The auditors should also satisfy themselves on the market rates of interest and the terms on which the company acquired it from Shimmer.
2. Completeness: The auditor should vouch and verify for all the documents relating to the acquisition of the intangible assets and should check if all the aspects have been covered while disclosing the assets in the books. The auditor should also be thorough about the provisions of AASB 3 on intangible assets and should be checking if all of them has been adhered to. The auditor should go through the acquisition contract and the other terms and conditions of the contract as well. Also, the life which has been taken for the intangible asset should be checked for basis and validity(Appelbaum, et al., 2018).

Key audit matters are those issues which the auditor finds to be critical and important from the perspective of the financial statements of the company and which may impact the users of the financials big time. As per ASA 701, the same needs to be reported in the separate section of the Auditors Report along with the approach which the auditor used or employed in checking and auditing these areas. In the given case, since Beautiful hair Limited is acquiring intellectual property in the form of technical knowhow (formula for the product) from Shimmer, it needs to highlight all the issues with respect to same like the contracts, the valuation, the completeness in recording the transaction and the estimates and judgement used. Some of the key disclosures in this regard would be:

1. The key assumptions and the estimates used by the management and how the same was being verified for its validity and correctness.
2. If the services of the valuation experts were taken for checking the valuation of intellectual property here(Chaudron, 2018).
3. If the market rates on interest used is in line with valuation done.
4. If all the disclosures requirements for technical knowhow has been correctly done as per relevant accounting standards.
5. What is the useful life being used for intangible asset and whether the same has been checked for impairment at year end(Mun, 2018)?

In case all these points are disclosed, it can be said that the auditor has met the criteria of ASA 701.

References

Appelbaum, D., Kogan, A. & Vasarhelyi, M., 2018. Analytical procedures in external auditing: A comprehensive literature survey and framework for external audit analytics.. Journal of Accounting Literature, 40(1), pp. 83-101.

Bae, S., 2017. The Association Between Corporate Tax Avoidance And Audit Efforts: Evidence From Korea. Journal of Applied Business Research, 33(1), pp. 153-172.

Boccia, F. & Leonardi, R., 2016. The Challenge of the Digital Economy. Markets, Taxation and Appropriate Economic Models, pp. 1-16.

Bumgarner, N. & Vasarhelyi, M., 2018. Continuous auditing—a new view.. Continuous Auditing: Theory and Application, 20(1), pp. 7-51.

Chaudron, R., 2018. Bank’s interest rate risk and profitability in a prolonged environment of low interest rates. Journal of Banking and Finance, Volume 89, pp. 94-104.

Das, P., 2017. Financing Pattern and Utilization of Fixed Assets – A Study. Asian Journal of Social Science Studies, 2(2), pp. 10-17.

DeZoort, F. & Harrison, P., 2016. Understanding Auditors sense of Responsibility for detecting fraud within organization. Journal of Business Ethics, pp. 1-18.

kabir, H., Rahman, A. & Su, L., 2017. The Association between Goodwill Impairment Loss and Goodwill Impairment Test-Related Disclosures in Australia. 8th Conference on Financial Markets and Corporate Governance (FMCG) 2017, pp. 1-32.

Mun, K. a. S. I., 2018. A close look at the role of regulatory fit in consumers’ responses to unethical firms.. s.l.:s.n.

Oberoi, J., 2018. Interest rate risk management and the mix of fixed and floating rate debt. Journal of Banking and Finance, Volume 86, pp. 70-86.

Solicitors, S., 2016. The Principles of Contract. Contract, p. 13.

Venezia, I., 2017. Behavioral Finance: ‘Where Do Investors” Biases Come From?’. Singapore: WORLD SCIENTIFIC.