Key Audit Matters, Financial Report Assertions and Substantive Audit Procedures-Solution 1
Task details:
Question 1
While assessing the risk of material misstatement and determining the appropriate response with regard to the inventory of Computing Solutions Limited (Computing Solutions) for the 30June 2019 audit, you become aware of the following information:
(i) The best-selling computer presentation package has been experiencing a high level of returns owing to suspected software problems
(ii) Based on closing inventory, inventory turned over an average of 5.2 times in 2018 and 3.8 times in 2019
(iii) Computing Solutions moved its inventory from a central warehouse to six new regional warehouses in March 2019
(iv) Inventory on hand at end of year represented 26 per cent of sales in 2019 and 19 per cent of sales in 2018
(v) Computing Solutions has recently won a tender to supply a large government department with various products. In order to win the tender and prevent competitors from gaining a foothold in the public sector market, Computing Solutions agreed to supply the items at 10 per cent below their cost price. The first shipment is due to be delivered to the government department in the middle of July 2019.
Required
(a) Identify and explain the two key assertions at risk in relation to inventory
(b) Identify and describe two substantive audit procedures that you could perform in response to each risk identified above
(c) Explain the requirement of ASA 701 Communicating Key Audit Matters in the Auditor’s Report and the rationale for this auditing standard. Determine if each of the above matters are key audit matters, providing full rationale for the determination. If it is determined that they are Key Audit Matters, provide the disclosures which are required in Key Audit Matters Section of the Auditor’s report as required under ASA 701.
Question 2
You are the audit senior with Howard & Associates and have been assigned to the audit of Beautiful Hair Ltd (Beautiful Hair).
In early 2019, Beautiful Hair acquired a small manufacturer of high-quality organic hair-styling products, Shimmer Pty Ltd (Shimmer). Beautiful Hair’s management had identified that Shimmer’s line of products would fit extremely well with the Beautiful Hair business, and organized funding for the acquisition from Regional Bank.
Shimmer uses special formulas to create its product. Only the owner of Shimmer knows the
secret ingredients for the formulas. These secret ingredients are apparently documented and held by Shimmer’s solicitors.
Beautiful Hair’s management has been advised that the intellectual property related to the formulas has the potential to be both a material and valuable asset and has been recognized as an intangible asset arising from the acquisition in accordance with accounting standard AASB 3.
Required
(a) Identify and explain the two key assertions most at risk in relation to the intellectual property intangible asset
(b) Identify and describe a substantive audit procedure that you could perform in response to each risk identified above
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(c) Explain the requirement of ASA 701 Communicating Key Audit Matters in the Auditor’s Report and the rationale for this auditing standard. Determine if each of the above matters are key audit matters, providing full rationale for the determination. If it is determined that they are Key Audit Matters, provide the disclosures which are required in Key Audit Matters Section of the Auditor’s report as required under ASA 701.
Executive Summary
The following paper is assembled for the purpose of developing an understanding of the concepts of auditing process and assurance service as provided to the companies by the auditors. The two case studies that have been studied in the report show the answers to the various questions in detail. The descriptions regarding the key audit matters, and a key assertion along with their evidence have been shown in detail as well. The report also includes the explanation related to the substantive procedures which can be used for implementation concerning the identified risks. The standard of the ASA 701 and its application is also shown in detail with its application to the specific case studies in order of the identified risks. All necessary recommendations as per the case studies are also made.
Answer 1: Computing Solutions Limited
A-Inventory of the company in terms of Two Key Assertions
Audit Assertions are an integral element of the auditing process of the financial statements of any organization. Any auditor uses the element of the audit assertions and its procedures in order to perform the tests on the policies of the company. It also examines the internal control systems of the company and its guidelines and its processes that it follows for financial reporting purposes. In terms of the financial statements and its auditing, the assertion is usually about the identification, measurement, disclosure and presentation of the company’s financial information.
All the important key assertions as identified for the inventory of Computing Solutions Limited for the first case study are explained as follows.
Existence and Occurrence:
The key assertion regarding the inventory of the organization makes sure that the inventory disclosed by the company for the period also exists in tangible form and has been therefore correctly reported by the company for the relevant period. For assuring of the existence of the inventory would need adequate number of invoices for purchase of that number of the inventory and its amount of the records and all other transactions pertaining to it. The Auditor has the requirement to check each and every transaction and its occurrence related to inventory and then reconciles it with the evidence available in the form of invoices or other documents (Mock & Fukukawa, 2015).
Completeness of Records:
Another important key assertion linked to the inventory records of the company of Computing Solutions Ltd is that of the completeness of the records and the accounts. This dealt with the fact that the data and information gathered related to the inventory was considered to be identified in the financial statements of the company, was in fact included or is else missing. For the purpose of supporting this assertion, the auditor requires it to obtain all the evidence needed related to the transactions and records of the inventory of the company. The concept of materiality is going to be crucial for this part of the assertion. All the material transactions of the company regarding the inventory need to be reported in the company’s financial statements. Therefore, the completeness of records in terms of the presentation and its reporting against all the information and documents related to the inventory is needed to be evaluated (Knechel & Salterio, 2016).
B-Audit Procedures for Identified Risks:
It is evident from the given records of the company of computing solutions Pvt. Limited that the company has witnessed a substantial raise in the closing inventory in its last year. Furthermore, the mean inventory of the organization has also increased in 2019 as compared to 2018. The substantive Audit procedures regarding the existence of the inventory of the firm would need the auditor to take confirmations of the inventory records from the outside suppliers and third parties involved in the transactions. For instance, the closing inventory as recorded by Computing Solutions can be confirmed in terms of its amount by the suppliers for the Purchases made from the supplier in terms of its exact amount. The auditor is needed to make an effort to confirm the records and the reported financial information by looking outside the books as those are reported by the company itself. Only just reconciling the information in terms of the debits and credit of the company would not suffice the process of auditing for the existence of the inventory. The company internal control process is needed to be examined and analyzed to make sure the proper maintenance of accounts and records under supervision and ensured that there is no chances of any ambiguity in terms of the recording and maintenance of the inventory records.
In terms of the completeness of the physical inventory of Computing Solutions, the substantive audit procedure would need the Auditor to conduct physical examination of the inventory at its six regional sites. The process needs the auditor to identify and reconcile the amounts of the inventory that is recorded by the company in the books against its physical presence in the stores. The case study shows that the company has been witnessing a high level of inventory for the last year, this can be assured by regularly inspecting the level of inventory of the company at the warehouse of the company. The vouching of the transaction also needed to be applied for testing the transaction’s accuracy and its completeness. This is another important Audit procedure which will help in assuring the completeness of the records of inventory. The purchases and supplies records will be reconciled with the company records for the inventory for the period in order to conduct vouching. The amount of the utilized inventory in the activities of production is needed to be equal to the amount of the purchases made by the company from the suppliers.
C-ASA 701 | Key Audit Matters:
The requirement of the ASA 701 for the Communicating of the Key Audit Matters in the Report of the Auditor is related to the accountability and the responsibility of the auditor in terms of the reporting of the key audit matters in the report delivered by him or her to the company. This auditing standard has a scope which includes all the factors regarding communicating of the key audit items and matters identified during the process of the audit is needed to be done for the purpose of aiding the users of the financial reports in examining and evaluating the company current situation. This is also similarly needed by the auditor in order to consider the several rationales and requirements linked with the fulfillment of these rationales. The conveying of the reports and all the key audit items is expected to aid the financial reports used in their financial decision making. The requirements according to the standards require.
Determination of the KAMs (Key Audit Matters):
The requirement asks for determination of the items or matters which are needed to be communicated to the stakeholders of the company responsible for its governance. It needs the stakeholders of the company to initiate the process of safe consideration in terms of the identified risks as determined during the process of auditing. It also asks for identification of the risks, challenged and any other types of expected situations linked with it for any kind of modifications (AICPA, 2018).
Communicating of the KAMs (Key Audit Matters):
Similarly, the auditor is responsible for communicating all the important and key audit matters as well to he is also responsible for the governance of the company. Thus, the Audit Report needs to state the items which are crucial for the judgment of the financial condition of the company and needs to make the appropriate disclosures as per the requirements.
The rationale behind the stating and reporting of the Key Audit Matters is to present the analysts with accurate and authentic information which is crucial for the decision making of the company analysts and governance stakeholders, and to give more value to the company financial reports.
As per the Case study of the Computing Solutions Pvt Ltd, the Key Audit Matters and the disclosures in the Key Audit Matters will be.
| Key Audit Matters | Disclosures |
| The software for the best-selling computer package is often supposed to be facing different glitches in the proper functioning which is expected to impact the future revenues of the company in terms of this specific product.
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The company has been experiencing returns of a high level due to the presentation of best-selling computers and all the other problems are associated with its software.
If the software is needed to be written-off, then the company needs to record the impairment loss for this amount.
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| The company inventory levels have increased substantially showing the blockage of the funds which is expected to be resolved for maintain an adequate level of liquidity.
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The variation of location for the inventory from central to regional warehouses is conducted in order to decentralize the inventory management system.
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| The company profitability is expected to be impacted by the decision of selling below the 10% cost of the products.
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The company has accepted the tender at a 10% lower than cost in order to win it. It is also necessary to prevent other competitors from getting the most desirable market share in the public sector. However, even though it will ensure sustainability of the company’s future, it will substantially affect profitability. |
| The company also needs to record the impairment for the software program package, if it is going to be written off. Furthermore, the company has been receiving back its products back which are also needed to be written off and recorded as impairment loss.
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The company has received back some packages from the customers which are not written off. The company needs to record the impairment loss for this specific amount.
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Answer 2:
A-Key Assertions Pertaining to the Intellectual Property/Intangible Assets:
There are mainly two different types of key assertions that pertain to the intangible assets or intellectual property of Beautiful Hair Ltd for the formula of Shimmer Pty Ltd are identified and explained as follows.
Rights and Obligations:
The main assertion as made in the present case regarding intellectual property for the formula is related to the right to possession of the use of the recognized and recognized asset (Groot et al., 2014). The case of Beautiful Hair Ltd who is going to acquire the company of Shimmer Pty Limited shows that the formula is only known by the shimmer company owner for creating the product. This secret knowledge of the company is recognized as the intangible asset of the company. However, if it is characterized in the company’s financial statement as an intangible asset, then it is going to impose significant risk associated with all the rights to use the particular product. This whole is associated will value of assets of Beautiful Hair Ltd.
Valuation:
The assertion of the valuation is relevant for this case as the risk associated with the valuation of the intangible asset identified in the company records as intellectual property as acquired by the company is substantial. The auditor is needed to assess the risk linked with the valuation of the intangible asset, i.e. the secret of the formula of creating the shimmer product. The auditor needs to consider the needed provisions and rules linked to the valuation of the assets. The auditor would need to consider the AASB 3 in this regard (Louwers et al., 2015).
B-Audit Procedures for Risks Identified:
As per the identified risks and assertions above, the audit procedures needed include.
- When considering assertion of rights and obligations, the risk accompanying with assertion can be reduced by examining and analyzing the agreement of acquisition and evaluating the terms of the acquisition contract. It is the responsibility of the auditor to make sure that the acquisition agreement has clearly transferred the rights to use the property to the acquirer. The rights and obligations of the asset considered in this case lie with the Beautiful hair Limited and the financial statement of the company disclosed all this.
- In terms of the valuation of the company intellectual property, the needed audit procedure would include the gathering of the data related to the intangible assets held by the acquiring company i.e. Beautiful Hair Limited. The correction of the process used for the amortization of the intangible assets is needed to be ensured by the Auditor. The foot and trace ending balance is needed to be applied by auditor for the intangible assets required by the company. All the governing rules regarding amortization and capitalization is needed to be evaluated and understood by discussing with the client (Carson et al., 2014).
C-ASA 701| Key Audit Matters:
As explained earlier in the first case study, the ASA 701 requirement need the auditor to include all the substantial and relevant information regarding the company financials which can be instrumental in the decision making of the user of the report of the Auditor. The standards need the Auditor to report the important disclosures which are needed to be exported to the audit reports and to the financial reports of the company. The rationale of the reporting of the Key Audit Matters is that these key matters are important in the assessment of the value of the company financials and are instrumental in the assessing the situation of the company making it more reliable (Carson et al., 2016).
As per the requirement of AASB3, the company of Beautiful Hair has acquired the intellectual property rights from Shimmer Pty Ltd and thus represents that Beautiful Hair have complete acquisition of the valuable asset. The company is expected to undergo substantial capital structure changes as the assets and liabilities of the balance sheet of the company will change after this acquisition. Another important Key Audit Matter is regarding the amortization and valuation of the intellectual property acquired. The provisions and governing rules for the amortization and valuation of intellectual property is mainly required to be considered in the report in the Key Audit Matters. This also needed to be reported in the financial reports of the company as there are expected changes in the balance sheet items of the acquiring company. The ASA315 is also needed to be considered as per this requirement which calls for assessment as well as identification of any of the substantial material risks in terms of the valuation and reporting of the intangible assets. Below is given complete details of the disclosure about Key Audit Matter,
| Key Audit Matters | Disclosure |
| -Residual Value of Intellectual Property
-Cost of the Acquisition of Intellectual Property -Amortization Method Employed for the Depreciation of the Intellectual Property Asset -Valuation Method employed for the Intellectual property valuation
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Beautiful Hair Ltd has successfully obtained the company of Shimmer Pty Ltd as a manufacturing firm, it is well known for the high-quality production of organic hair styling products. These products can be used very effectively in the operations of Beautiful Hair Ltd. The ingredients needed for the creation of the product is identified as important and substantial intellectual property for the company. Therefore, it is going to be recognized as same under the requirements of AASB 3 and should be reported as an intellectual property right under the Assets section of the balance sheet (Alles et al., 2018). All the rules and regulations that govern the company valuation and amortization of the assets are needed to be considered. Furthermore, the company also needs to recognize the impairment loss for the intellectual property that it is not going to use or is going to write off. The impairment loss recorded will show the amount of the cost of the intellectual property which is not earning any benefits for the company or was overvalued.
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Conclusion and Recommendations
In a nutshell, the conclusion can be drawn because of present report as importance of the auditing process to become effective includes consideration of the key assertions, the reporting of the key audit matters and the and risks associated with these key audit matters. This report shows two case studies and reported its key assertions, key audit procedures needed to act in response to these assertions, and the Key Audit Matters needed to be revealed by the auditor in the audit report. The report demonstrates the importance of auditor’s liability as well as accountability and how it needs to report the key assertions and audit matters recognized during the process.
References:
AICPA, 2018. Assessing and Responding to Audit Risk in a Financial Statement Audit. John Wiley & Sons.
Alles, M., Brennan, G., Kogan, A. & Vasarhelyi, M.A., 2018. Continuous monitoring of business process controls: A pilot implementation of a continuous auditing system at Siemens. In Continuous Auditing: Theory and Application. pp.219-46.
Carson, E., Fargher, N. & Zhang, Y., 2016. Trends in auditor reporting in Australia: a synthesis and opportunities for research. Australian Accounting Review, 26(3), pp.226-42.
Carson, E., Zhang, Y. & Fargher, N., 2014. Audit reports in Australia 2005-2013: a preliminary analysis.
Groot, T., Quadackers, L. & Wright, A., 2014. Auditors’ professional skepticism: Neutrality versus presumptive doubt. Contemporary accounting research, 31(3), pp.639-57.
Knechel, W.R. & Salterio, S.E., 2016. Auditing: Assurance and risk. Routledge.
Louwers, T.J. et al., 2015. Auditing & Assurance Services. McGraw-Hill Education.
Mock, T.J. & Fukukawa, H., 2015. Auditors’ risk assessments: The effects of elicitation approach and assertion framing. Behavioral Research in Accounting, 28(2), pp.75-84.
