Key Audit Matters, Financial Report Assertions and Substantive Audit Procedures-Solution 3
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 30 June 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
Approved by KOI Academic Board for T2 2019 ACC707
(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
ASA 701 is one of the well-known auditing standards on which this report is based by considering how auditors can report the key audit matters. Two different situations are given in the case study, which has been evaluated in this report. These scenarios are based on two different companies. The scenarios and case studies are based on certain key matters which have been evaluated in the report by first assertion identification regarding the KAM (key audit matters), and then the identification of a substantive audit procedure has been performed in the report for minimizing the risks. This report also included the provision of a full rationale for determining the key audit matters and their required disclosure.
QUESTION 1
a-Two Key Assertions
Two key assertions considered regarding the scenario of this section of the report are Existence and valuation concerning inventory.
Existence
Existence deals with the occurrence and existence of auditing assets such as inventory of an entity at a given data. The assertion of existence also deals with the occurrence of transactions related to inventory during a specific period. According to the definition of this assertion of existence provided by Statement of Accountant, Standard (SAS) number31, it is an assertion with the help of which auditors can check whether the inventory of Computing Solutions Limited exists or whether the recorded transaction regarding inventory has occurred during a specific period. In case of Computing Solutions Limited, this assertion of existence will help in checking the inventory amounts in six new regional warehouses which were considered by Computing Solutions Limited in March 2019 in respect of moving its inventory from a central warehouse.
Valuation
Valuation is the second key assertion in this case, and according to the definition provided by SAS 31, valuation is an assertion with the help of which an auditor can evaluate and asses that whether all the values regarding elements like liabilities, expense, revenue, and assets are accurate and correct. This valuation assertion helps in identifying the appropriateness of the values. This valuation assertion in the given case will help the auditors to check the valuation of inventory at the period end 2018 and 2019. It will help in identifying whether the inventory had been undervalued or overvalued or it had correctly represented the values of 19% of sales in 2018 and 26% of sales in 2019 (Cohen et al., 2017).
b-Two Substantive Audit Procedures
The auditor in response to the identified risks could consider a couple of audit procedures such as auditor can consider observing the inventory physically present and second audit procedure that would be considered by the auditor is matching concept under which auditor can assess the record made by management regarding the purchase by matching with the record made by management regarding inventory in the warehouse.
The first substantive procedure that should be adopted by the auditor is to personally go to the new warehouses of the company to make an assessment and the counting of the inventory present in these warehouses. The auditor at a visit should count the amounts of inventory present or existed in the warehouses and ask the management concerning finding any deficiency in the recorded inventory and inventory in warehouses.
The second substantive procedure that should be considered by the auditor is crosschecking of the record of purchases made by the management of Computing Solutions regarding inventory with the inventory existed or present in the company’s warehouses or even with the inventory sold by management during the year. In this way, the sales record of inventory of Computing Solutions Limited could be checked by an auditor with the purchase record, which will confirm the accuracy of the valuation of inventory. The physical count could be made by the auditor with the help of which auditor will be able to ensure the inventory presence or existence in warehouses (Carson et al., 2016).
c-Requirement of ASA701
ASA 102
ASA 102 was established for creating requirements for auditors to comply with and considered all the ethical requirements pertaining to assurance engagements, reviews, audits, and independence. In the case of Computing Solutions Limited, the auditors are responsible for meeting the requirements of ASA 102, in the context of which they must have to follow fundamental principles of professional ethics established by APES 110.
The accountability and responsibility of an auditor have been described in ASA 701 in the context of reporting KAMs on the auditor’s report. The scope of this standard is based on realizing the importance of communicating these important matters recognized by the auditor during an audit to help the users to understand these important matters within the organization. There are various rationales and requirements for fulfilling and implementing ASA 701 by the auditor. Some of the key requirements of ASA 701 are given below in respect of placing these significant matters in the report.
The first requirement is to determine KAMs, and in the context of this requirement, the auditor has the responsibility to identify and find those matters which are very important to be discussed and informed of those charged with governance. This requirement of ASA 701 is also based on the need of proper and valid concentration given by an auditor to the significant risks identified.
According to the requirements of ASA701, communication of KAMs is the obligation of the auditor to inform the company’s management. So, the auditors need to state all significant matters and required disclosure of these matters. For this key requirement of ASA701 is to create a separate section for placing the opinion of the auditor regarding KAMs for giving valid importance of that specific information about KAMs. Separate KAMs section in the report can increase the easy understanding of the current condition of the company.
The KAMs identified in Computing Solutions Limited are the following:
- It might be possible that revenues and sales of the company would be affected because of the reason that scenario revealed that software problems could be present in the best-selling computer presentation package.
- Another significant matter in case of Computing Solutions Limited is its agreement to sell the products below 10% of costs, and this is a key matter because it could have a direct impact on the sustainability and profitability of Computing Solutions Limited. Therefore, the auditor needs to ensure that tender of supplying products below 10% of costs has been accepted properly. This step of the auditor will help investors decide on their investment, according to the given situation and condition.
- A turnover ratio of inventory revealed that an increase in maintaining the level of inventory occurred with a significant percentage which indicates the difficulty of the entity in maintaining adequate liquidity. This situation may result in a blockage of funds.
The disclosures required are given below:
- In the context of decentralizing the operations in respect of the management of inventory, a decision has been taken by the management of the company to move inventory from the central warehouse to the regional warehouses which are six in numbers.
- The proposal of supplying the products at 10% lower than cost has been accepted by the company to win the tender of supplying the products to the government department. This step was taken by the management to gain sustainability on a longer-term basis and to prevent other competitors from taking a high position in the public sector market. But it is important to note that profitability could be affected by this step.
- A high level of returns has been experienced by package linked with the best-selling computer presentation owing to alleged software problems (Simnett & Trotman, 2018).
QUESTION 2
a-Two Key Assertions
In this case, concerning intellectual property, intangible assets, the auditor can consider the rights and obligations as audit assertion and auditor can also focus on considering valuation as an assertion in this perspective.
Rights and obligations
In the context of the recognized and identified assets of the organization, the auditor can consider the obligations and rights as the first assertion. For example, in the case of Beautiful Hair Ltd, Shimmer Pty Ltd has been acquired by Beautiful Hair Ltd, but the most important aspect in this context is the formula for creating products is only known to the owner of a small manufacturing firm. The intangible asset of the company could be represented by the secret ingredients associated with the formula. However, a risk in respect of rights associated with the use of the products would be created in the context of ingredients recognition in the company’s financial statement. There might be a risk in the context of identification of an asset’s value of the company (Lima & Santos, 2018).
Valuation
The valuation is the second assertion as the risk associated with it is based on the context of valuing the property (intangible asset) that has been acquired by the assessee and which considered and created a right in respect of the intellectual property. In this case, the formula in respect of products manufacturing is the intellectual property right as these products are contrived by Shimmer Pty Ltd. The key aspects that will be considered by the auditor are to assess and identify all those risks that are linked to the valuation of intangible assets based on consideration of relative rules and provisions in the context of asset valuation. Consideration of AASB would be made in this case of Beautiful Hair Ltd.
b-Two Substantive Audit Procedures
AASB 138
The accounting treatment of intangible assets have covered by AASB 138, and according to AASB 138, an intangible asset is only recognized if specified criteria are met. The requirements under this AASB 138 also include the requirement of specified disclosures of intangible assets and method of measuring the carrying amount of intangible assets also covered by this standard.
A couple of the important substantive audit procedures are given below that would be considered by the auditor concerning the risk identified above:
- Identification of terms and conditions based on which the acquisition has performed, and investigation of an acquisition agreement is one of the Substantive Audit Procedures which could be considered for minimizing the risks associated with the rights and obligations assertion. The right of using the intellectual property should be ensured by the auditor in case of Beautiful Hair Ltd, and further form of a substantive audit procedure is to ensure that disclosures regarding the right of using the asset have been properly presented in the company’s financial statement.
- Obtaining schedule is another good procedure considered by the auditor, and it would be helpful in risk management which could be created in the context of valuation of intellectual property. The correctness of amortization of the company’s intangible assets should be properly assessed by the auditor. For this, the approach of foot and trace ending balances should be applied by the auditor during the time of performing audit work on these company’s intangible assets. This Substantive Audit Procedure should include discussion of the policies developed regarding the amortization and capitalization with the client, and critical evaluation of the acceptability of policies should be performed by the auditor concerning different procedures and policies (Ackerman, 2018).
c-Requirement of ASA701
The key requirements of ASA701 include the need for communicating with the KAMsby the auditor to ensure that significant and relative information that is important for the users has been provided. According to the standard, it is the auditor’s responsibility to include noteworthy information in their audit report. The first important area of the requirement for the auditor under ASA701 is the identification of the significant type of information that could impact the decision making. The identification of KAMsis based on the auditor’s verdict of the importance of those matters which could be a certain level of impact on the decisions of users.
The rationale of providing information regarding the KAMs is to inform the users of the report of the auditor to understand the current and the actual situation of the company in a more reliable way. If the auditor fails to identify key audit matters, then it could reduce the effectiveness and credibility of the decisions of users (Gepp et al., 2018).
In the context of considering the requirement of AASB 3, the acquisition made in the given case has resulted in the transfer or acquisition of intellectual property rights. It will include valuable and material assets acquired by Beautiful Hair Ltd. As the liability and asset position of Beautiful Hair Ltd and its capital structure would face certain changes because of the acquisition of this asset so this should be considered as a key audit matter. Valuation and amortization of assets are another important area of consideration as a key audit matter especially in this type of acquisition. Therefore, reporting of these KAMs in the report created by the auditor is a key requirement of ASA701.
The consideration of ASA 315 is required in respect of providing disclosure of these types of KAMs. The consideration of ASA 315 is important because the criterion of evaluation of recognition and valuation of the intangible asset has been clearly defined in this standard. The disclosures required in the given case are given below:
- Method of valuation
- Method of amortization
- Asset’s residual value
- Cost of acquiring the asset
The disclosure should include the acquisition made by Beautiful Hair Ltd. The disclosure of acquisition is important because high-quality organic hair-styling products are produced by Shimmer Pvt Ltd that has acquired by Beautiful Hair Ltd and it might be possible that the management of Beautiful Hair Ltd would use these products in their operations. The disclosure of ingredients is also very important because of the reason that these ingredients would be considered as a significant asset of Beautiful Hair Ltd.
AASB 3 has been followed for recognizing the ingredients as an intangible asset by Beautiful Hair Ltd and under the section of the asset; these have been reported as an intellectual property right of Beautiful Hair Ltd (Sinclair & Keller, 2014).
Different rules and regulations have been considered for performing amortization and valuation of the above-mentioned intangible assets (Cuozzo et al., 2017).
Conclusion
It is concluded that the appropriateness of audit work is directly linked with the audit procedures implemented for identifying and reporting the KAMs. It is required under ASA701 to consider key assertions and perform certain substantive audit procedures in respect of the company’s assets, liabilities, and other elements of financial statement to identify the risks associated with the KAMs. It is also concluded in the report that the identification of KAMs should is based on the auditor’s verdict regarding the implication of the matters regarding the decisions of users. The main purpose of reporting KAMs is to inform the users of the audit report and financial report regarding the situations and facts that could affect the company.
Recommendations
Based on the conclusion it is recommended to the auditor to strictly adhere to principles of auditing standards such as gathering appropriate and sufficient audit evidence, integrity and honesty, use of due diligence and care, use of professional skepticism, auditor independence, and to identify the key audit matters based on professional judgment. It is also recommended that relative accounting and financial reporting framework should be complied by the auditors along with the consideration of some other, but important regulations and legislations regarding the conduction of audit especially in case of reporting key audit matters.
References
Ackerman, P., 2018. Intellectual Property Audit and Management. Intellectual Property: Valuation, Exploitation, and Infringement Damages, 2(1), pp.352-71.
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.
Cohen, J., Krishnamoorthy, G. & Wright, A., 2017. Enterprise Risk Management and the Financial Reporting Process: The Experiences of Audit Committee Members, CFO s, and External Auditors. Contemporary Accounting Research, 34(2), pp.1178-209.
Cuozzo, B., Dumay, J., Palmaccio, & Lombardi, , 2017. Intellectual capital disclosure: a structured literature review. Journal of Intellectual Capital, 18(1), pp.9-28.
Gepp, A., Linnenluecke, M.K., O’Neill, T.J. & Smith, T., 2018. Big data techniques in auditing research and practice: Current trends and future opportunities. Journal of Accounting Literature, 40(2), pp.102-15.
Lima, F.V.R. & Santos, J.A.B., 2018. Intellectual Property Management in Small and Medium-Sized Enterprises. International Journal of Innovation Education and Research, 6(9), pp.109-27.
Simnett, R. & Trotman, K.T., 2018. Twenty-Five-Year Overview of Experimental Auditing Research: Trends and Links to Audit Quality. Behavioral Research in Accounting, 30(2), pp.55-76.
Sinclair, & Keller, 2014. A case for brands as assets: Acquired and internally developed. Journal of Brand Management, 21(4), pp.286–302.
