Inherent Risks In MaxSecurity Limited And Factors Affecting The Determination Of Preliminary Materiality | Strengths And Limitations Of Debtor’s Confirmation As An Audit Evidence

Inherent Risks in MaxSecurity Limited

Parat (A) Inherent Risks in MaxSecurity Limited:

Audit risk is the risk of provision of inappropriate audit opinion by the auditor in the situation where financial statements of the company are materially misstated. There can be various reasons due to which audit risk arises (Bell, Landsman & Shackelford, 2001). The process of audit suffers from some inherent limitations which imposes the various kinds of risks on it. Inherent risk is one of the major element of audit risk that is imposed on the entity due its inherent nature. It is the risk of occurrence of material misstatements in financial reports due to errors and omissions other than control failures. This type of risk exists irrespective of the audit of the financial statements (Cassell, Drake & Rasmussen, 2011). Therefore, it is impracticable to avoid such risk even with the help of creation of adequate controls in audit procedures and enhanced audit training.  In the present case inherent risk is particularly high because of the fact that company belongs to the industry where the product designs are considered to be quite sensitive. These designs of vehicles of every carrier manufacturing company generally requires to be maintained confidentially due to high competiveness in the market place. Since, the company has adopted a new system of costing to replace the old system which was not compatible with the needs of the company. The first audit engagement is inherently risky because the auditor has no enough knowledge of entity’s new manufacturing costing system. Also, the complex nature of the manufacturing costing system may lead to misstated costing records which could finally lead to misstatement financial statements of the company. Further, the product designs are also cost sensitive so there is higher inherent risk due to this factor as incorrect determination of cost may cause incorrect cost records (Houston, Peters & Pratt, 1999). Inherent risk is also higher in the situations where there is an involvement of more judgements and financial estimations. In the current case, the company is indulged in filing tenders to win contracts it might be using the estimated prices giving rise to higher inherent risk (Rittenberg, Johnstone & Gramling, 2010).

Part (B) Factors Affecting the Determination of Preliminary Materiality:

Determination of audit materiality is the matter of auditor’s professional judgement. Materiality is the degree of significance of any audit matter or item to influence the decision of users of audit report. Materiality of an item can be judged on the basis of quantity as well as the quality. It must not be seen only from the point of view of its individual effect rather while deciding the materiality of a transaction its overall impact on the financial statement must be considered. Factors determining the audit materiality in the present case MaxSecurity are as follows:

Determination of materiality of an item majorly depends upon the professional judgment of the auditor and is entirely based on perception of auditor about the financial information requirements of the intended users of financial reports of the company. As there are various users of the financial reports such as investors, shareholders, government etc. and the auditor has to carry out extensive audit procedures in the areas from where more relevant information can be obtained by the users (Eilifsen & Messier, 2014).

Factors Affecting the Determination of Preliminary Materiality

Moreover, the degree of internal controls in the particular area also affects the materiality of that item. Since, if internal controls are weak in a specific area, there arises higher risks of misstatements therefore, an auditor is required to apply more audit procedures in those areas. Higher risk of misstatement increases the audit materiality of an item (Akresh, 2010).

Complexity of financial reports may require the auditor to carry audit procedures in details therefore higher materiality level must be set in those situations. Even uniformity homogeneous nature transactions affects the level of audit materiality (Joldo?, Stanciu & Grejdan, 2010). 

The possibility of risk of frauds in particular areas also increases the audit materiality. In cases where auditors has found greater degree of risk of fraud on part of management, the auditor has to carry detailed audit procedures in those areas and ignorance of such areas may result in incorrect or inappropriate opinion by the auditor (Keune & Johnstone, 2012).

Even in the areas where there are stringent rules and regulations to be complied, the auditor has to set higher audit materiality benchmarks for those items (Zhou, 2012). As misstatement in those areas may lead to provision or supply of incorrect or untrue information to regulatory bodies. Here, the participation in the government contracts may require the auditor to set higher materiality level in the areas which are directly associated with the government (Legoria, Melendrez & Reynolds, 2013).

The framework of financial reporting also affects the materiality level of the transactions. As general purpose financial statements may not require consideration of certain transactions whereas specific purpose financial statements may require auditor to carry detailed audit procedures in the special areas so that proper checking and verification of those areas could to form an appropriate opinion (Aqel, 2011). In the current case the company is participating in the government contracts so it might require preparation of special purpose financial statements to fill the tenders for governmental contracts.

The previous year audit results may also affect the audit materiality level in the current period as the adverse or qualified opinion on certain matters in the earlier years may require the auditor to carry out additional audit procedures in the current year so that any misstatements in the financial statements do not remain uncorrected (Houghton, Jubb & Kend, 2011). 

Part (A) Strengths and limitations of debtor’s confirmation as an audit evidence

The basic objective of an audit engagement is to enable the auditor to provide an opinion on the truth and fairness of the financial statements of the client entity. The audit opinion is expressed in the written form through the audit report prepared by the auditor of the organisation. Audit report offers the most effective way of communication between the company and its stakeholders specially the shareholders and investors, regarding the financial performance of the company. An auditor’s report helps the external parties such as shareholders and investors in their decision making process regarding the investments made or to be made in the company. Therefore, such reports must be prepared only after carrying out the necessary and appropriate audit procedures. One of those necessary audit procedures entails the collection of sufficient and reliable audit evidences and evaluation of those evidences. Audit evidences can be in any form whether verbal or written, externally or internally generated (Elder, Beasley & Arens, 2011). These evidences helps the auditor’s to draw the conclusions based on which audit opinion is formed on the integrity and authenticity of financial statements. An audit evidence can be generated from various sources like invoices and bills, inventory reports, debtor’s or creditor’s confirmation, bank statements etc. All the types of sources of collection of audit evidences have some strengths and limitations.  

Strengths and Limitations of Debtor’s Confirmation as an Audit Evidence

Debtor’s confirmation is of the type of external evidences. This sort of evidences is not necessarily required to be generated at the conclusion date of the financial year rather they should be collected on any date during the year under audit. The strengths and limitations of collecting audit evidences through debtor’s confirmation are discussed as below:

Since external parties like debtors are generally not intended to manipulate the accounting and financial information of the auditor’s client, the external evidences are generally considered to be more reliable than those collected from the internal sources. In the present case, the trade receivables of MSHG covers the debtors having large outstanding balances as well as the debtors with smaller outstanding balances. The auditing firm can therefore opt debtor confirmation as a source of collecting the required evidences for the audit engagement. These debtors of MSHG will help the auditor by providing the reliable information based on which audit opinion can be formed. As the debtors do not involve in the earnings management practices of the client company (Piercey, 2011).

However, when the external parties such as debtors have spoiled relations with the auditor’s client, collection of audit evidences from the debtors by making confirmations about transactions in which they are associated with the company would not help the auditor in gathering the reliable audit evidences.  In special circumstances, management of the client might have special relationships with their debtors and therefore they may involve those external debtors in their earnings management practices. In order to obtain confirmation from debtors, the auditor must have direct communication with the debtors without any interference of the client which generally does not happen which helps the auditors to manipulate the debtor’s responses before they finally reach the auditors.

In the present case, if auditor comes to know or finds something unusual which indicates that the MSHG (the auditor’s client entity) has spoiled its business relationships with its debtors, it must not consider the option of collecting the required audit evidences from the debtors of the company as they may provide them the misleading information.

It is provided in the present case that the auditor’s client organisation has directly taken the allowances for doubtful debts to the trade receivables account rather than showing them separately. This practice may provide the intended users of financial reports with the misleading information about financial position of the entity. Therefore, the firm of the auditors in the present case must perform necessary and appropriate substantive audit procedures to gather the audit evidences in relation to the trade receivables of the firm so that they can provide an audit opinion on the authenticity of financial information contained in the reports of the company.

Part (B) Possibility of using only Debtor’s Confirmation as Audit Evidence

It is not possible for the auditor to form an audit opinion based on the audit evidences in the form of debtor’s confirmation only. Debtor’s confirmation only provides the supportive audit evidence and not the conclusive audit evidence. To form an opinion on the true and fair view of the financial information contained in the financial statements an auditor however requires to obtain some conclusive evidences. Conclusive evidences are those evidences based on which auditor draws conclusion to form an audit opinion whereas supportive evidences merely provides the additional information to the auditor and supports the previous information available with the auditor. Therefore, the auditor must, in addition, check the sales registers maintained by the company and the invoices issued to the trade debtors of the company to verify the correction of amount. Also, the internal controls in the areas of accounting of trade receivables must also be checked by the auditor by applying the essential compliance procedures in this regards. These are the internal sources from where the evidences could be obtained to ensure the authenticity of records maintained by the company for its trade receivables (Sarens & Abdolmohammadi, 2011).

Part (A) Ethical issues Auditor is facing and APES 110

In the present case of Champion Securities (the auditor’s client company) there are conflicts in the opinion about certain accounting treatments, between the auditors and the client company. The accounting treatment given by the management of Champion Securities in relation to financial assets and liabilities was not acceptable to the auditor. As the auditor’s client is an investment company, majority of its assets and liabilities are financial in nature. These financial items thus constitutes significant portion in the financial statements of the company due to which these assets and liabilities are required to be properly valued in accordance with the prescribed accounting standards in this regards. Only appropriate valuation would help in depicting the true position of the company in terms of profitability and solvency. The auditor of the company had suggested the management to write down the values of those financial items but the chairman and CEO of the company were opposed to the auditor’s suggestion. The principle of fair presentation in audit is being affected by the refusal of management to adopt the accounting practices which were in line with the generally accepted accounting principles. It is auditor’s duty to ensure that the financial statements of the company are not materially misstated and they are presented fairly in every sense. But, the pressure from the chairman of the client company on the auditor to either accept the manner adopted for valuation of assets and liabilities of the company or the client would replace the auditor. This situation might have put the auditor in an ethical dilemma that whether she should withdraw from the audit engagement of the Champion’s Security or she must accept the management’s contention (Trotman & Wright, 2012). If the auditor accepts the management’s method of valuation of financial items and other material balance sheet items, the basic principles of auditor’s objectivity, integrity, independence, professional care and behaviour will be adversely affected. Auditors are expected to strictly maintain all the fundamental principles of audit in order to act in the best interest of the profession and stakeholders associated with the company. If auditor departs from what is ethically correct and appropriate for her to fulfil the responsibilities towards the client organisation, it will bring disrepute to the profession of audit. But, at the same time if auditor chooses to act professionally and according to what is ethically correct, it would lead to dissatisfaction to the employing organisation and the client may choose to replace their auditor with a new a new auditor.

In order to comply with APES 110, which primarily talks about the fundamental principles of audit and code of ethics to be followed the auditor in conducting an audit (George, Jones & Harvey, 2014) the auditor must act in the most objective manner where no biasness, undue influence of others and other conflicts of interest are entertained by her. Secondly, the auditor must remain straight forward and honest towards all the professional obligations. Thirdly, the auditor must ensure that she behaves in the well-mannered professional behaviour by applying due diligence and care in the conduct of the audit engagement. Therefore, Meg must provide an independent opinion in the audit report in regards to the areas where the financial statements of the company are misstated and not fairly presented.

As an auditor, it is his statutory duty to report on the fair view of financial statements and to suggest the appropriate course of actions to the management of the company, wherever possible (APESB), 2013). These basic principles requires an auditor to apply his due diligence and skills while performing audit procedures and to behave professionally throughout the audit engagement. As a part of professional behaviour auditors are expected to remain independent while providing the audit opinion on the financial statement’s reliability and fair presentation. If during the audit engagement audit encounters a situation where there is conflict in his opinion and management’s view on certain accounting adjustments, auditor must duly apply the principles of integrity, objectivity and independence in those situation. Auditor should provide an unbiased opinion that is not influenced by the management’s actions so as to raise the credibility of financial statements in the eyes of stakeholders. In the instant case the auditor was not satisfied with the management’s contention that there is no necessity to provide for the write downs in the values of assets and liabilities.

Part (B) Audit report option available with the auditor in the current case:

In the present case the auditor of the company has been unable to convince the management of the company to make necessary adjustments in the accounting treatments given in relation to the valuation of certain financial assets and liabilities. Even after providing the summary of relevant items of the balance sheet with revised values, the auditor’s recommendations were entirely dismissed by the management of the company. This action of management will require the auditor to modify the audit opinion in this regard (Tsipouridou & Spathis, 2014). Since, the management’s accounting treatment in regards to the valuation of assets and liabilities is not in line with generally accepted accounting principles, the auditor shall provide a qualified opinion in the audit report where the reasons for qualification will be stated (Ittonen, 2012).  However, if the incorrect valuation of assets and liabilities and the amounts of retained earnings and income is leading to grossly misstated financial statements then auditor must issue an adverse report (Johl, Jubb & Houghton, 2007).

Part (C) Course of action to be taken by the auditor:

 Meg (the auditor) shall determine the reasonable course of action to be undertaken in the current situation. An appropriate action needs the consideration of all the possible consequences of each alternative course of action. Meg must try to communicate to the management of the client company, the impacts of incorrect accounting practices on the reliability of the financial information. Even after this if the concern remains unresolved the auditor should communicate with other engagement partners of the audit team. Since the conflict herein involved is with the organisation, auditor must consult the matter, along with the necessary recommendations, with those who are charged with governance in the company such as audit committee and others (Tsipouridou & Spathis, 2014). To act in the best interest of the profession auditor must also document the core substance of the entire issue together with the necessary details of discussions that were held by the auditor with management and those charged with governance. Moreover, if the audit matter is material enough to be resolved, auditor can also consult the concerned matter with the professional advisors. If all the possibilities of resolving the conflict exhausts and the conflict remains unsolved the auditor must, wherever possible, make efforts to disassociate with matter involving the conflict (Van Aalst, 2010). The audit engagement partner shall determine whether it is possible to withdraw from the specific audit assignment or from the audit team in the particular circumstance. If he does not take an appropriate course of action according to the situation, the audit principles would not be duly complied.

References:

Accounting Professional and Ethical Standards Board (APESB), 2013. APES 110 Code of Ethics for Professional Accountants.

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