Your firm has been engaged to do the current year’s audit of Dawood Ltd., a medium sized business involved in manufacturing television screens and monitors. Dawood is privately owned and its two shareholders have requested that the annual financial statements be audited for the first time this year. One of the shareholders manages the business; the other is not involved. You are now reviewing Dawood’s preliminary general ledger trial balance, shown below, to begin the audit planning.
ACCOUNT …………………………………………………………. BALANCE DR/(CR)
Cash …………………………………………………………………. $10,009
Accounts receivable ……………………………………………………… 167,090
Allowance for bad debts …………………………………………………… (25,000)
Inventory, finished goods ………………………………………………… 200,550
Inventory, work-in-progress ………………………………………………… 94,601
Inventory, purchased components ………………………………………. 199,800
Inventory, parts ………………………………………………………. 34,400
Property, plant, and equipment ……………………………………………… 9,700,100
Accumulated amortization, PPE ………………………………………. (3,607,597)
Accounts payable ………………………………………………………. (222,400)
Warranty provision ………………………………………………………. (87,000)
Bank loan, long-term ………………………………………………………. (1,000,000)
Share capital, common shares …………………………………………………. (1,500,000)
Retained earnings ………………………………………………………. (1,738,442)
Revenue ………………………………………………………………... (9,005,800)
Cost of goods sold ……………………………………………………………. 4,696,600
General and administration expenses ……………………………………….. 1,902,500
Other expenses ………………………………………………………………. 180,589
Required:
a. When planning this audit, explain why it is important for Dawood’s auditor to understand its business, its environment, and its risks.
b. Determine an appropriate materiality level for preliminary audit planning purposes. Explain your reasons for selecting this materiality level.
c. List two analytical procedures you could perform using the trial balance data above. Explain what each procedure can tell you about the risks in Dawood’s financial statements and what further investigation the analytical results may suggest.
d. Identify two accounts that you feel would have the high risk of material misstatement, and two that you think would have the lowest. Explain the reasons for your risk assessments.
e. Assume you have determined that Dawood’s inventory account is a high risk item. Assess the risk of material misstatement for the inventory account, using the five principle assertions as the basis for your assessment. (You will probably have to make some assumptions since little information is available in the case. In a real audit, these assumptions are points you would want to enquire to obtain the information needed.) Give the reasons supporting your assessment.
SOLUTION
To assess the risk of material misstatement, the auditor must understand the nature of the business on what needs to be accounted for, because it will affect what inherent risks exist in the business and thus its accounts. This illustrates the importance to the auditor of understanding how a business creates value and earns profits. The case requires one to apply one’s knowledge of the business, given the facts provided in the case and other reasonable assumptions, to judge the relevant inherent risks for different financial statement components in relation to the five principle assertions: existence, completeness, ownership, valuation and presentation [ECOVP]
To make a decision on materiality, we first identify the main users of financial statements – these are the minority shareholders who have asked for an audit for the first time this year. Also, the bank holding the long term loan shown in the trial balance likely will use the f/s to evaluate the risk of the company not paying back its loan. Other qualitative factors could be relevant, like contracts or covenants based on f/s balances, transaction volumes, indicators of fraud, etc. For quantitative assessment, apply appropriate benchmarks, e.g. 5-10% pre-tax normal income, 0.5-1% revenues or assets, and then also consider qualitative factors, to generate reasonable range. Select one level from range and justify the quantitative choice based on qualitative factors.
Two possible ratios that could be calculated for analysis are:
Current ratio/quick ratio
May indicate liquidity problem, financial condition is poor, risk of business failure.
Gross margin percent
May suggest performance of operation is inefficient, or price competition affecting viability
For more meaningful ratios and analysis, further information is needed, e.g. past periods to compute turnover, efficiency ratios, industry average, to allow for more different comparisons.
Other valid ratios, implications, and related further investigation are also acceptable if clearly explained and supported
Assessment of the risk of material misstatement (RMM) takes into consideration both the inherent and control risks, at the assertion level. The inherent risk assessments are based on the nature of the item and the risk that an error can have occurred in accounting for that item in the first place, regardless of controls. The general tendency is for high value items that are attractive to steal, like TVs, to have higher inherent risks related to the existence assertion. For Dawood, it is manufacturing the TV and monitors, so the valuation may be subject to errors in complex cost allocations, and the net realizable value may fall due to technological obsolescence, so the valuation assertion has high risk of misstatement. Several other accounts could also be noted as high risk, such as warranty provision (high valuation assertion risk as this is an estimate) or PPE because it is highly material and may become obsolete or inefficient over time, affecting its valuation. Another item that may have high inherent risk in Dawood is the accounts receivable balance if there is a concern about collectibility, as the valuation assertion would have a high risk of misstatement.
Two items that may have low inherent risk assessments are the bank loan - it is straightforward to value it and confirm its existence and completeness. Share capital might also be noted as a low risk account, since its ownership is well documented and since it is not complex to account for, its existence, valuation and completeness would not have high inherent risk.
Generally, assessing high inherent risk leads the auditor to expect management to have strong risk assessment processes, and strong controls in place to offset/reduce these risks. If this is the case, when inherent risk and control risk are combined as RMM, the assessed risk could be lower than the inherent risk alone. However, to rely on this assessment the auditor must test the relevant controls. In Dawood’s case it may be feasible and efficient for the auditor to test these controls and get some assurance from them, and that will lower the amount of assurance required from substantive tests. On the other hand, if the controls are not very strong the RMM will be very high for high inherent risk items and the auditor will need a lot of substantive evidence to be able to get reasonable assurance to form an opinion about whether the f/ss are fairly stated.
Inventory in manufacturing business will have raw material, WIP and finished goods
Assertions:
Existence: moderate
The question is whether all the TVs and monitors recorded really are on hand. Since these items could be easily stolen, the risk is raised, but verification by physical inspection can provide very reliable evidence. Further, if controls in place appear strong over recording the purchases, it would be difficult to make an entry for an inventory purchase that doesn’t exist. Thus the risk is moderated.
Completeness: moderate
The question is whether all the inventory the company actually owns has been recorded. This depends on good controls over recording all purchases, and moving costs of WIP through the production accounting process properly. Since it is possible to miss recording unless controls are good, and inventory is key to the company’s success, we can assume the controls over this are good and the risk is moderated.
Valuation: high
The question is whether the dollar amount allocated to the finished goods is correctly calculated and complies with GAAP (i.e., the financial reporting framework selected by management, including the relevant inventory valuation policies and methods). There are a number of factors that can lead to risk of misstatement of the valuation assertions, such as: the TVs might not be able to be sold at expected prices; the raw materials and componement used may not be of suitable quality; the costs of the components may not be correctly recorded; all production costs incurred in the process may not be captured accurately such overhead allocations.
Ownership: low
The question is whether Dawood has proper title to the inventory. The risk is assessed as low since it is unlikely that Dawood will record inventory that is has not purchased and taken title to upon delivery, or will include inventory once it is sold (under an assumption that the terms of sale for this type of business are not complex to follow, and title transfers when goods are delivered with little uncertainty about completing the sale )
Presentation: low
The question is whether the inventory is properly classified in the financial statements and all disclosures required by GAAP are complied with. This is assessed as a low risk assertion since the classification not complex (as long as there are reasonable systems controls in place to measure the different classes of inventory: RM, WIP and FG), accounting policies for inventory valuation & disclosure are clear to apply, management is assume to have the required accounting skills.
Other valid risk assessments could be made based on different assumptions, or on different interpretations of the facts provided since these are fairly limited in the case.