Part A
Australian auditing standard relating to the risk of material misstatement
ASA 315, the specified Australian Auditing Standard deals with the duties of Auditor relating to ascertainment and assessment of the risk of material misstatement in the financial report through analyzing the environment of an organization comprising entity’s internal control.
ASA 240 deals with the responsibility of auditor relating to fraud in an audit of the financial report. Further, the standard expands to the manner in which ASA 315 and ASA 330 are to be followed in order to ascertain the risk of material misstatement due to fraud. The first objective of this standard is to recognize the risk of material misstatement of the financial report due to deception (Mangala and Kumari (2017). Further, the second objective is to acquire appropriate audit proof related to evaluated risks of material misstatement because of deception, by designing and executing suitable responses. The last objective is to react appropriately to scam or suspected fraud which is identified during the inspection.
The risk material misstatement for PPE account
In the present scenario, the construction company provided Unifactor to order to capitalize all repair cost relating to PPE, i.e. Property, Plant and Equipment so that it could have minimized the impact of same on expenses. In accordance with Abu-Ras (2015), the risk of material misstatement relates to the risk that financial statements are materially misstated. Australian Accounting Standard 315which is related to identifying and evaluating the risks of material misstatement, signifies that the auditor should evaluate the specified risk at two levels. The first is at the financial statement level and second is at the assertion level. The first level of risks of material statement relates pervasively to the financial statements as a whole and probably influences various assertions. Moreover, particularly it might be related to the auditor’s deliberation of the risk of material misstatement because of scam. In the present case, risk relating to a material misstatement in PPE account could be an inappropriate valuation of PPE in case expenses which required to be charged from profit and loss are capitalized. Further, it will also have an impact on depreciation expenses which is a deductible expenditure expense. In case expense which is required to be charged from P&L are capitalized in appropriate asset that same will lead to the presentation of overrated profits.
The manner in which assessed Risks of Material Misstatement of PPE account could be reduced by the auditor
The reasons due to which major accounting repairs as a capital expense could be a risk of misstatement
PPE account is one of the crucial as well as important parts of the financial statement. In case, the specified account has not been accounted with appropriate treatment; the same could lead to the risk of misstatement. While ascertaining and evaluating the risks of material misstatement due to deception, auditor should, based on assumption that there is specified risk in income recognition, assess which kind of income, revenue assertions give rise to such type of risks (Hentati-Klila, Dammak-Barkallah and Affes, 2017) Paragraph 47 of ASA 315 implies that the documentation is needed where auditor concludes that assumption is not suitable in conditions of engagement and therefore has not ascertained income recognition like a risk of material misstatement due to fraud.
Thus, in the present case, the repairs are treated to be relating to expenses which should be charged to P&L, as no particular specification have been provided that it relates to capital expenditure. In case the company capitalizes the expenditure it would misinterpret profit which has been provided in the P&L account. Further, it will also state the statement of affairs in an inappropriate manner because it will not present actual fair position of assets of the organization.
The manner in which same is likely to be misstated
As per Para 25 of ASA 315 the auditor is responsible for recognizing and evaluating the risks of material misstatement which takes place because of deception in financial statements. At the assertion level for classes of business operations, closing balance of different accounts and disclosures relating to same. In context with above specification as repairs are relating to the nature of expenses which are required to be charged to Profit and loss account. A repair expense can be capitalized only in the case when it enhances the performance of asset in comparison to the results which were attained prior to repairs. In the present case, if Unifactor, capitalizes specified repair expenditure than the following misstatement will be presented in financial statements:
It can be accessed from above specified likely misstatement that in the case specified treatment of repair and maintenance, i.e. capitalization and adding the same to the existing value of PPE is applied the same will affect financial statement in a significant manner. Moreover, due to the same financial statement of Unifactor will not provide a true and fair view.
Part a
Inherent Risk
According to Griffiths, (2016), the inherent risk is a significant factor which is utilized by auditor along with control risk to evaluate the risk of material misstatement related with specific financial statement line item or audit area. Further, the inherent risk is utilized to evaluate the level of specified risk in order to plan audit process applied to the related accounts. Moreover, the inherent risk is also considered to be the level of vulnerability related to the material misstatement that would subsist where no controls in place. It is evaluated mainly by the auditor’s knowledge and judgment regarding the diligence, various types of business operations taking place at a specific organization as well as assets that the company owns. Generally, an auditor evaluates every audit area whether low, medium or high inherent risk. In the present case, Karl’s computer is doing auditing of their product.
The inherent risk in the inventory refers to a possibility of the loss of inventory due to the failure of inventory planning as well as control failure. Since the inventory represents the major portion of current assets, different valuation method and valuation of a method directly affects the cost of goods sold therefore auditor has to consider the various factors for evaluating the risk due to inventory on the financial statement.
Inherent risks for inventory for Karl’s Computers
Generally, auditor has to focus on the identifying the risk which is associated with the inventory management process and internal control system established in the company for compensating those risk. In the present study, Karl’s computer has many branches in several country however inventory is received at the central warehouse and after that distributed in each branch after the inventory transfer request which is authorized by the branch manager. With this regards, auditor has to check whether the branch manager request for the inventory is reasonable as there are chances of the excess inventory in a branch due to lack of planning by the branch manager. In addition with this, it is asserted by Hay, Knehcel and Willekens, (2014), that auditor should also assess after the distribution of the inventory to the branch whether it is directly used in the branch since it may be possible that branch manager uses the inventory for the personal purpose. As per assertions of Ghosh and Tang (2015), by assessing the internal control system for purchasing, issuing, receiving, supplies auditor can check the risk of material misstatement due to inventory in the financial statement.
Another inherent risk for the auditor is too complicated year-end inventory procedure which affects the value of the inventory. It may lead to overvaluation and undervaluation of the inventory. Moreover, it is asserted by Euchner, and Ganguly, (2014), that misstatement from the earlier year also the big issue with the valuation of the inventory. Undervaluation and overvaluation of the inventory might lead to a material misstatement in the financial statement since it is a significant portion of the current asset of the entity which affects the profit of the organization.
According to Oringel (2012), in an organization, the strength and weakness of the inventory control are depends on the type of control which is put in place for managing the inventory. Inventory control is defined as the observing the movement of the inventory from the receiving in the warehouse to the issue of inventory to the branches or to the customer. If the inventory control system is not proper, then it may lead to the loss of the inventory which affects the profitability of the company.
Strength
In the present study inventory is received at the centralized warehouse, and on the request by the branch manager, it is dispatched to the respective branch. Due to centralized system proper record of the number of items purchased and distributed to each branch can be measured by the head office by which manager can get to know about the inventory utilization by the branches and review whether the effective internal control in the branches is established. Moreover the company also provide the training to the casual and permanent employee of the branches by which the employees can get to know about the material requirement of the product and the knowledge regarding the inventory handling requirement so that there is no under stock or the overstock of the inventory in the company which may save the direct cost of the company.
Weakness
Since the company is large in size and having many branch offices in the several different countries, therefore there should be a proper inventory control system in the whole organization. In the present study the company received inventory directly to the warehouse, and after that issue, to the respective branches, it may sometimes lead to delay in receiving the inventory by branch by which product can be finished on time. The company should establish the centralized computer software program in the head office by which the number of items purchased by each branch, quantities, description, cost and selling price record can be maintained. And on the basis of this surprise visit by the officer can assist whether the physical inventory stock and the computerized stock calculation is same or not. Moreover, there will be saving in the cost of transportation as well as the time as the inventory will be directly dispatched from the supplier to the branches.
Materiality for inventory at Karl’s computers
Inventory of Karl’s organization is material because it forms a significant part of the financial statement. It has been provided in the present case that value of inventory varies from cents to thousand’s dollar. This fact signifies that Karl’s organization is having significantly expensive inventory as well as inventory which cost mere cents. Materially concept is based on the concept of the judgment of auditor. Thus, according to paragraph 4 of ASA 501, in case of inventory is material to the financial report, then the auditor is require to attain adequate, appropriate audit evidence related to the subsistence and situation of inventory. This can be through taking attendance att physical inventory counting and it same in not possible, than as per Para A1-A3of ASA 501. As per the facts provided relating to Karl’s Computer, it has been provided that there is a tough competition and new products are continuously coming to the market. The company is having a main business of import and export of computer hardware accessories and is having a branch in every capital city. This fact asserts that a company must have a significant inventory balance as its main business in relating to computer hardware accessories and parts. As inventory is part of P&L as well as Statement of Affairs, it is a material item; however audit of inventory of all the items will not be done in the same manner.
The manner of an audit of inventory of Karl’s Computer
Inventory of Karl’s computer requires special consideration as it requires both expensive as well as immaterial inventory. The inventory of the materiality of Karl’s Computers should be audited through the procedure according to ASA 501 which is discussed below:
In order to audit material as well as expensive inventory, it is necessary to assess directions given by executives and process related to recording and managing of outcomes of entity’s physical inventory counting as same has been specified in Para A4 of ASA 501. After this, the inspection of the performance of administration count’s process should be done as per Para A5 of ASA 501. As per provision of Para A6 of ASA 501 auditing of inventory is a must. After the inspection, test counts should be done. With accordance to Para A7-A8 of ASA 501 carrying out of audit process through assessing the entity’s inventory records in order to ascertain whether if reflects real inventory count or not. In case physical inventory has been done on other date than date of the financial report, then the auditor is required to follow provision of paragraph 4 of Australian Auditing Standard, Compiled Auditing Standard ASA 501. In case auditor is not able of attending physical inventory due to unavoidable reason than in that case auditor should create or assess few physical counts on other date and carry out audit process on prevailing business operations. Above specification should be considered while auditing material inventory.
A random check is sufficient for immaterial inventory which is not significant for making opinion relating to financial statements. However, the same cannot be neglected as it is part of the financial statement. Sample auditing technique can be applied for auditing of same.
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