Key Audit Matters, Financial Report Assertions and Substantive Audit Procedures-Solution 2
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
ACC707 AUDITING AND ASSURANCE T219 21/06/2019 16:43 PAGE 9 OF 14 *AUSTRALIAN INSTITUTE OF BUSINESS AND MANAGEMENT PTY LTD © ABN: 72 132 629 979 CRICOS 03171A
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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 assignment discusses the matters to be disclosed under ASA 701 as per the case studies provided. It is important under this standard that key & significant audit matters should be included in the company’s financial statements, and the audit report is formulated with a foundation on the identified key & significant audit matters. The assignment has identified that ownership and accuracy are the two most important aspects in relation to assertions. The study also identified valuation and existence of ascertaining in case of inventory management.
Question 1)
a- Risky Two Key Assertion
During the risk management with computing solutions, it is important that auditors should associate himself with the company and environment prevailing in the company in order to have the proper results for the audit assessment (Eddy, 2017). The first factor identified in this case is valuation. From this case study, one may suggest the inventory valuation at the end of the year and it should be properly investigated. It is important to understand how the management is calculating the realizable value and the value of the damaged items and scrap items at the end of the year.
It might be possible that an increase in return for the package of computing solutions might be because of the problems and defects in the software provided by the company to their customers. It is important to gather appropriate evidence in order to investigate valuation related to the closing inventory and recording of the closing inventory in the company’s financial statements. It is important to identify the location of relevant cost and irrelevant overhead cost with inventory in the calculation of the value for closing inventory.
Valuation:
The case study suggests that inventory turnover had been around 5.2 times for the year 2017 2017 which dropped to approximately 3.8 times in the year 2018 suggesting a significant decrease in sales. Closing inventory for 2018 was approximately 22% of the total sales while it was only 18% in 2017. This suggests that there might be problems with the valuation of closing inventory due to which the company is experiencing variability in closing inventory amounts.
Company has recently accepted one government tender in which they will be providing software at 10% lower than their cost price which is only because of the fact that management is providing impairment of the inventory in order to decrease their overall losses if the inventory is not sold on time.
Existence of Assertion:
Another identified factor is the existence of assertion. Existence of assertion may arise in any company if the inventory may or may not be present with the process of shifting the warehouse. It might be possible that inventory shifted to the new warehouse is overstated by including the relevant transactions with the cost of the inventory in the new warehouse. It is important to formulate appropriate cut off procedures for the inventory purchase in order to make sure that it is recorded according to the current year sales to make sure that the accounting principles are properly applicable along with management’s steps and actions towards financial management formulation.
b- Description of Two Substantive Audit Procedures
Procedures related to substantive auditing in relation to the identified best matters in this case study will help to resolve the issues related to material misstatement. It is significantly important to include appropriate test control as well as procedures of substantive audit in order to analyze the financial statements in detail to identify appropriate and relevant material misstatement. It will also help to improve the standard of Audit and substances auditing during the overall audit procedures.
Regarding Valuation:
First identified risk was related to the valuation of the inventory at the end of the year. It is important for the management to make sure that they implement AASB 102 on the inventory available to the company in order to make sure that the valuation of the inventory is made at low cost or market value (whichever is lower). It might be possible that some cost related to production has been included in the inventory and such cost should not be included in the valuation of the inventory as it is not inventory and is related to the production only (Heng & Haines, 2018). It is also important to identify the cost related to whichever technique is applied in selling the inventory whether it is a FIFO or LIFO.
The case study clearly suggests that management was not able to implement consistent treatment-related to overhead cost because management was not comparing the overhead cost with the market prices in relation to the recording of the overhead cost. It is important to compare such costs with market prices in order to identify the relevant and appropriate cost of the inventory.
Regarding the Existence of Assertion:
As far as existence and cutoff are concerned, it is important to appropriately track the receiving of the goods and dispatching of the goods in the invoices in order to record them appropriately in the financial statements. Another significant aspect for the auditors in this case study relates to taking the inventory from central warehouse to 6 other regional warehouses. It is important for the auditors have appropriate receiving of the inventory in new warehouses at the time of physical count of the inventory. In order to achieve this objective, a test of Sampling could have been implemented on receiving the goods in new warehouses and after counting the inventory one by one and physically in the new warehouses. This will help to support the cut off procedures which were identified as a significant risk for the management associated with reporting of inventory and miss-statement on the company’s financial statements.
C- ASA 701 Requirement for Audit Matters Communication
According to the auditing requirement under auditing standard 701 while relating with communicating key & significant matters related with audit, it is essential for the auditor to properly describe every related key audit matter by using appropriate related subheading and improper separate section while formulating the audit report (IFAC, 2017). The auditor should use the proper heading key& significant audit matters in order to disclose the related information. It should be disclosed in paragraph 14 or 15 according to the accounting standards. The following should be the terminology which should be utilized by the auditors while formulating the introduction paragraph of the report developed by auditor:
(a) Key & significant matters for audit are considered to be those matters which are investigated by using the professional judgment of the auditor, and they are considered to be significant for financial statement audit for the client for the related financial year.
(b) These matters are disclosed around the background of the audit related to the prepared financial statements of the client in general form. They are not specific to any financial matter made apparent in financial statements, but they are disclosed on a general basis by considering the overall analysis of client’s financial statements for the relevant financial year. They are utilized by the auditor in order to formulate the auditor’s opinion at the end of the audit report. It is important to disclose here that the auditor is not required to formulate a separate opinion for the disclosed key & significant audit matters which are relevant with client’s financial statements. They are just used as a base in order to formulate the views and opinions of the final audit of client’s financial statements for the relevant fiscal year.
The following are some key audit matters, which must be highlighted and made openly available in formulation of audit reports:
| Key Audit Matter | Reason |
| Significant events and transactions | Significant events and transactions must be disclosed as key audit matter considering them material for investor decision-making process. |
| Areas with a higher level of risks of material misstatement | Areas with a higher level of risks of material misstatement should also be disclosed because material misstatement can influence the decision-making process of the investor. |
| Key maters of the audit and Communication | According to IFRS, it is obligatory for important matters about audit for audit report users. |
| Inventory Shifting | It is important because valuation of inventory in new warehouses is an important factor for financial reporting |
Question 2)
a- Two Key Assertion at Risk
Two key assertions in this case study linked with the concept of intellectual property associated with intangible assets can be ownership of the intangible-asset and accuracy of the intangible-asset value disclosed in the balance sheet of the company. As far as ownership of the intangible-asset is concerned, it is important for the beautiful hair management to analyze the available lawful claims about intellectual property (IP) associated with the intangible-asset and secret formula to ensure that the management can easily recognize the intellectual property (IP) on the company’s balance sheet.
Ownership:
Another significant aspect of this case study is the accuracy assertion. According to the accuracy assertion, it is important for the management of beautiful hair to make sure that they identify the accurate and correct value of the intellectual property (IP) for the intangible-asset, including the secret formula show that the intellectual property (IP) could be easily recognized on the balance sheet of the company without any mistake or error. This is a significantly important aspect related to the acquisition of intellectual property (IP) because it can create issues in future audits. It is also important from the financial perspective as the value for intellectual property (IP) will be disclosed in the balance sheet of the company. It is vital for management to acknowledge and know the right and suitable classification and entertainment in relation to the impairment regarding the intellectual property (IP) of intangible-asset with secret formula. It is important to identify appropriate impairment because the intangible-asset will start decreasing the revenue with the passage of time and it will be required to appropriately adjust the carrying value of the intangible asset in company’s balance sheet.
Accuracy:
With the passage of time, intangible-asset will be appropriately charged with the impairment loss as the revenue-generating capacity of the intangible-asset will decrease. It is important to make sure that the value of the intangible-asset should be reduced to zero as it will start becoming obsolete with the passage of time (Audit IT, 2014). This is not only important from the financial-statements perspective, but it is also important for the auditors of the company to investigate the intellectual property (IP) related to intangible-asset from this accuracy perspective.
b- Important Audit Procedures
It is important that the appropriate test of control should be applied in order to investigate the operating performance related to specific controls at different levels in the organization (PCAOB , 2019). It is also important to acquire detailed information regarding the performed test of controls. It will help to validate the expectations of the auditor related to the operating performance for specific controls.
Ownership:
As far as ownership perspective is concerned, it is important that substances audit procedures should be applied in such a manner that proper examination related to the title of the documents should be implemented. Substances audit procedures should make sure that all the available documents should validate the proof of ownership. It will help to validate the ownership of intellectual property (IP) for the management of beautiful hair. It is important to do a review related to the agreements signed between both the parties for modifying and getting correct valuation for assets and the needed one. This review is important because it will make sure that the valuation of the asset is appropriate in the agreements and some valuation should be disclosed in the balance sheet of the company as well. It will validate intellectual property (IP) on the balance sheet of the company.
Accuracy:
The first step associated with accuracy is that it is significantly important for the auditor to verify the accusation related transaction which took place in recent years between both parties involved. It is also important to investigate the and what documents at the time of acquisition and appropriate adjustment should be applied in relation to the cost associated with acquisition in order to make sure that all accounting procedures and policies have been applied during the acquisition transaction and related aspects. It is also important that the accounting policy of the client should be appropriately determined, and necessary recommendations should be implemented if required.
It is also important to determine the recorded transaction related with intellectual property (IP) in the balance sheet and verification of the transaction is also important to make sure that the value recorded in the balance sheet is correct and is relevant with revenue and other related expenses in order to make sure that revenues and expenses of the same financial year are disclosed in same financial statements. In order to further investigate the correctness of intellectual property (IP), it is useful to apply to test of the continued asset, and their suitability is also important.
c- ASA 701 Requirement for Audit Matters Communicating
Important audit matters are the matters which are according to the wisdom of the auditor, and they are considered to be most significant aspects of audit related to the financial statements of the client (Arnold, 2017). According to the international standards of accounting 701, it is important for the auditors to appropriately disclose key & significant audit matters which are mainly associated with specified decision framework for auditors in formulating the audit reports. These key & significant matters for audit are used by auditors in order to formulate their audit report related to the audit. Most of the metals are considered to be significant in relation to the audit, and they are also important for a company’s financial statements.
It is significantly important for the management of the company to conduct a management review at the end of each year of the valuation of the intellectual property (IP) in order to make sure that appropriate amount is carried forward next year according to the revenue generation capacity of the intellectual property (IP) (Mccann, 2018). Determination of this evaluation will be e significantly based upon the judgment with the management, and appropriate application of the formulated assumptions is also required. The following are some of the procedures which can be utilized by the management to implement management review related to intellectual property (IP) at the end of each year.
The following are some matters for key audit activities, which must be made openly available in audit report formulation:
| Key Audit Matter | Reason |
| Valuation of goodwill | Valuation of goodwill is an important matter in the audit as it is material for the decision-making process of the investors. Secret formula cannot be disclosed but details regarding valuation of the goodwill must be disclosed in the audit report. |
| Areas with a higher level of risk towards material misstatement | Areas with a higher level of risk towards material misstatement should also be disclosed because material misstatement can influence the decision-making process of the investor. |
| Financing for Shimmer Pty Ltd acquisition | It is important to mention that the regional bank was used to finance this acquisition as it is material for investors |
Recommendations
- The value of intellectual property (IP) should be reduced on a yearly basis by implementing the concept of impairment. As the life of the intellectual property (IP) is greater than 1 year, percentage application can be applied by the management in order to write down the value of the intellectual property (IP) on an annual basis.
- According to the definition of intellectual property (IP), Trademark, patent, and copyright are categorized under the category of intellectual property (IP). It is also vital for the management to disclose appropriate and correct valuation for intellectual property (IP) in the balance sheet of the company. It is also important to disclose the relevant details in the notes to the account to the general public. At the same time, it is important to mention that details regarding the secret formula cannot be disclosed and it is not required by the international standard of auditing 701 to disclose such information publicly.
- There will be several advantages of disclosing intellectual property (IP) in the balance sheet of the company. It will not only bring improvements and betterments in the company’s financial position, but it will also help to attract different investors in the company positively. It will help to improve a company’s position and standing financially which will further improve the product line of the company, and several banks will be able to provide loans to the company in case of any requirement (Lin, 2018).
- According to ASA 701, having communication for important audit matters with the general public is needed from the audit standards and must be openly available by the auditor. Key & significant audit matters are entirely dependent upon the professional judgment of the auditor, and they are considered to be significantly important in relation with financial statement audit for the client. Disclose key & significant matters for audit in the audit report of the auditor are related with present financial year of the client with is being audited. Auditor formulates the opinion at the end of the audit report based upon these significant and important key & significant matters around audit function have been put on public availability in the audit report for the purpose of auditing.
References
Arnold, C., 2017. Auditor Reporting Standards Implementation: Key Audit Matters. [Online] Available at: https://www.ifac.org/global-knowledge-gateway/audit-assurance/discussion/auditor-reporting-standards-implementation-key [Accessed 13 September 2019].
Audit IT, 2014. IAS 38 – Intangible Assets (detailed review). [Online] Available at: https://www.readyratios.com/articles/ifrs/ias-38-intangible-assets.html [Accessed 13 September 2019].
Eddy, B., 2017. Auditing Standards of the Public Company Accounting Oversight Board. [Online] Available at: https://www.academia.edu/39276880/AUDITING_STANDARDS_OF_THE_PUBLIC_COMPANY_ACCOUNTING_OVERSIGHT_BOARD [Accessed 14 September 2019].
Heng, K. & Haines, K., 2018. New revenue standard AASB 15: Impact on inventory recognition. [Online] Available at: https://home.kpmg/au/en/home/insights/2018/11/aasb-15-revenue-standard-impact-on-inventory-recognition.html [Accessed 13 September 2019].
IFAC, 2017. Proposed International Standard on Auditing (Isa) 701. [Online] Available at: https://www.ifac.org/system/files/publications/files/Proposed%20ISA%20701%20(Revised)-final.pdf [Accessed 14 September 2019].
Lin, M., 2018. Think Twice Before You Speak – Intellectual Property and Public Disclosure. [Online] Available at: https://www.tmtindustryinsider.com/2018/10/think-twice-before-you-speak-intellectual-property-and-public-disclosure/ [Accessed 13 September 2019].
Mccann, C., 2018. IP Audits: What are they? Why are they important? What do they cost? [Online] Available at: https://www.corporatecomplianceinsights.com/ip-audits-what-are-they-why-are-they-important-what-do-they-cost/ [Accessed 13 September 2019].
PCAOB , 2019. Auditing Standard No. 13: The Auditor’s Responses to the Risks of Material Misstatement. [Online] Available at: https://pcaobus.org/Standards/Archived/PreReorgStandards/Pages/Auditing_Standard_13.aspx [Accessed 13 September 2019].
