Importance Of Governance In Assessing Audit Client’s Business Risk

Potential Audit Risk Areas and Impact on Year-End Audit Testing

Question:

Explain why an understanding of the governance of an audit client is important in assessing the client’s business risk.Explain why the auditors’ understanding of business risk is relevant to public expectations of the audit process.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.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.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. 

Principles and recommendations

Corporate governance has set some principles. These principles are made after making recommendations. Companies that were listed on the Australian stock exchange and which were on the way to get listed on the stock exchange gave their view, feedback and recommendations. After considering the views of al such companies the Board made certain rules and regulations which were to be compulsorily followed by all the companies that want to be listed on the Australian Stock Exchange. These recommendations were made after considering the recommendations of the investors also.

The company has to compulsorily disclose the following

1. The members present in the Board
2. Duties, responsibilities and authority of each member
3. The powers, functions and other matters that delegated to other managers

It is the overall responsibility of the Board that to select the principles from the list of corporate governances framed by the Board. The directors are free to select any of them and implement the same. But this is the most relevant and significant concern for the members of the Board. The Board holds a fiduciary position. They are the trustees of the assets of the company so they should use the resources and their powers are diligent manner as it is in overall benefit of the company. It us the duty of the Board to conduct the business of the company in a fair manner by utilizing the resources of the company in optimum manner

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”.

1. All the stakeholders like creditors, shareholders, debenture holders, government, etc. must communicate with the management of the company over the matters of governance.
2. Based on the above principles the investor can decide their vote regarding in the favor or against of a particular resolution

• The basic decision can be taken by the investor of future investors regarding whether to invest in the company or not

Hence the “if not, why not” method is vital to the operation of the Principles and Recommendations.

There are certain rules to be followed for getting the company to be listed over the Australian Stock Exchange.

The company has to include the corporate governance principles that it follows in its annual reports and the same should be verified by the auditor. In many cases the Board of corporate governance made some recommendations to the company regarding following certain principles and not certain others, the company should state in the annual report the extent to which it agrees and implement not only the recommendations but also other principles. The company further has to show in the annual report the reasons that it feel for not accepting the recommendations of the Board

Internal Controls and 7 Major Objectives

This auditing standard is made and issued by ASA. This imposes certain mandatory duties over the auditor by assigning him or her responsibility to compulsorily communicate with Those Charged With Governance which conducting an audit of financial statements of such company.

This auditing standard focuses mainly on the communication between two persons. One is the auditor and the other is Those Charged With Governance (TCWG). Certain recommendations are as follows

1. Both the parties should be involved in conducting the audit of financial statement for a particular year. This requires an auditor to be independent while conducting the audit and he should follow integrity principles while conducting the audit
2. It is the duty of Those Charged With Governance (TCWG) to provide required information to the auditor that will helps him to conduct the audit in a timely manner
3. Provide the auditor with a platform where he can identify the errors or fraud conducted by the management of a company and can report to Those Charged With Governance (TCWG).

It is left at the discretion of the auditor to select the person with whom he will communicate while conducting the audit. The auditor will communicate the findings to such person. He will also communicate the weaknesses in the internal control system with the auditor. The person may be head of the audit committee or any independent director. They both will determine what aspects to be communicated with the other members and what not. In some cases where the business is small and the owner is himself involved in all the activities then the standard requires communication with such person Such matter is been noted in paragraph 16(c) of this Standard of auditing.

ASA 315 Identifying and Assessing the Risk of Material Misstatement through understanding the entity and its environment.

This standard compulsorily requires the auditor to conduct a risk assessment in order to satisfy himself that the financial statements of the company are free from frauds or any other material misstatements and such should be conducted at all levels of audit. These procedures are as follows

• Analysis to satisfy the auditor that the financial statements are free from material misstatements
• Analytical procedures. (Para. A14-A17)
• Observation and inspection. (Para. A18)

In large businesses the company has a separate audit department which regularly performs audit functions and does the risk analysis. This department is in direct touch with the Board of Directors. This department ensures that the reporting is transparent, the internal controls are effective and the committee is independent.

The auditor faces certain limitations while conducting an audit of an organization. These are

1. Lack of time to conduct 100% audit
2. He has to depend on sample which may be such that does not represent total population
3. Crucially made frauds and misstatements cannot be discovered by the auditor
4. There is a huge time gap between the recording of a transaction and auditing the same
5. Auditor is not a blood hound. He is just a watch dog

All these limitations posses risk of giving incorrect opinion on the financial statements based on which the shareholders take decision to invest or not. This is called audit risk. There are certain tools which will help the auditor to reduce the risk up to an acceptable level. The level after which the risk cannot be reduced is called residual risk. The audit risk ha two parts

1. Incorrect evaluation of financial statements. Placing over reliance on some aspects and under reliance on other aspects
2. Risk of affirmations which was created due to evaluation of financial documents.

The very basic purpose of the audit is to check out any material inconsistency termed as misstatement and to communicate the same to the stakeholders in the form of audit report. Audit report is the tool through which the auditor communicates with the stakeholders.

There are various types of audit risk. The major ones are as follows

1. Inherent Risk: It assumes that there are no internal controls in the entity’s environment. This will help the auditor to know those material areas which are prone to misstatements
2. Control Risk: This assumes that in spite of having strong control the misstatement would be such that it will not be controlled by the entity’s internal controls. It may be detected but will not be controlled
3. Detection risk: This means the misstatement may not be detected by the internal controls of the company

After conducting an analysis of the ratios provided in the question, the potential risk that prevails in the current structure of the company is as follows:

1. Net Profit Ratio: it is a ratio of net profit to sales. We can see that in the year 2013, the company earned profit. Profit was less i.e. 3% of sales but in the current year we see that the company has incurred loss. This is 1% of sales. Normally we see a positive relationship between the advertising expenditure and the turnover of a company. As the advertising expenditure increases the turnover also increases as the product becomes more popular. But in the case of this company we see that the ratio has fallen down in spite of a rise in the expenditure on advertising.

   Each product has its life cycle. The product of the company may at declining stage because only at this stage we notice that even though after incurring huge expenditure on advertising the company is still incurring losses. Or it might be so that a new competitor has entered the market. Whatsoever may be the reason, it is posing a big risk to the company.

2. D/E ratio (Debt Equity Ratio)

Possible Audit Procedures to Test Client’s Sales Software Application

Having leverage in the capital structure is advantageous to the company. The interest that it pays to the lenders provides benefit in the form of tax savings. So a levered firm is better than an unlevered firm. But the company should ensure that it has a liquidity ratio of more than 2 because payment of interest is revenue expenditure so the company has to regularly pay interest on monies borrowed. In our case the current ratio is more than 2 so it is good for the company. But what we have noticed is that the D/E ratio has increased from 3.25 times to 5 times. The company has to pay huge interest to the money lenders. Though there is a tax saving but there won’t be anything left for the shareholders or for transferring into reserves. So there is a risk that as the company will pay less dividends the market price of shares may fall. The company is incurring loss so it may happen that in the coming years it won’t be able to pay interest or any principal installment. This may reduce the credit worthiness of the company

1. Return on Assets

This has fallen down from 0.04% to -0.10%. The resources of the company like fixed assets, etc. are over utilized or underutilized. This represent opportunity loss to the company

The management in order to comply with corporate governance requirements must establish procedures for year-end and the ensure 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

Internal controls help the entity in laying down the procedure of preventing and detecting any fraud or error. The very purpose of internal control is segregation of duty. It ensures that the work done by one person is checked by other.

The following are some transactions that would occur at the Fitness for Life Company

1. Payment and receipt of cash: This area is the most critical area. Cash is the area which more prone to fraud. Especially the payment part is prone to fraud. In big companies the petty expenses are overlooked by the managers which are loopholes for conducting fraud. The cashier can embezzle cash unless and until proper internal controls are not there for authorizing the payment of cash
2. Since, the entire responsibility of recruiting the staff for the company and allocating the salary to them is delegated by the top management to the 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.
3. The manager can use his position in an unfair manner. For example in many cases the relative of a manager is provided more privileges than the normal customers. Especially in cases of gyms, the manager may allow his relatives to use the facilities of gym free of cost

The question deals with testing the internal controls at the client’s sales software application. Let us first understand where it is compulsory on the part of the auditor to perform tests

1. After knowing the business and the industry in which it operates the auditor has included in the audit plan to conduct the test of controls as it will be necessary to know the effectiveness of the same
2. Analytical procedures and test of Balance Sheet items are themselves not well enough to make an opinion regarding the assessment of financial statements

Tests are conducted for two main reasons

1. Whether the internal controls present in the entity’s organization are effective i.e. they are doing what they are required to do and they are not doing what they should not. 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 utilizing the substantive testing procedures.

Consider the amount of receivables in the SOFP. There are many ways in which the same can be manipulated. There are certain customers who are very irregular in paying the debts owed to the company. Such can be easily manipulated by the company’s employees like cashier, etc

The controls that can be used to prevent such fraud

1. Segregation of duties and ensuring that work done by one person is checked by the other
2. Not to allow any one single person to complete the full transaction
3. Rotate the job position of employees, this will not give time to the employees to make a group and then commit fraud
4. Take up the references of credit on the new customers.

1. Establish a limit of credit.
2. Developing the analyses for aged receivables.
3. The follow up of the amounts which are not paid timely.

References

Accounting Web, ND Test of Controls

Open tuition, 2015 Test of Controls

Western Economic Diversification Canada, 2011, “Year End Audit Procedures” .

Enel, ND, “Principles of Corporate Governance”

University of Tasmania, 2014, “Audit and Risk Committee”

HM Revenue and Customs, ND, “Audit and Risk Committee”

Thrivent Financial, 2014, “Year End Audit Procedures”Monica Zorn, 2014, “Year End Audit Procedures”

Proformative, 2014, “Year End Audit Procedures”

Accounting Tools, 2015, “Test of Controls”

Cram.com, 2015, “Test of Controls”

Accounting Concern, ND, “Test of Controls”

PCAOB, 2015, “Identifying and Assessing risk of material misstatement”