Areas of Heightened Audit Risk - Assignment Example

Areas of Heightened Audit Risk PART A: AREAS OF HEIGHTENED AUDIT RISK Trade and other payables These account balances add to an entity’s liability. There is an inherent risk that an entity’s management is more likely to understate liabilities. As stated by McGraw-Hill Higher Education (2006), liabilities are understated with a view to exaggerating the financial strength of an entity just as assets are overstated. It is, therefore, advisable that an auditor approaches his audit assignment with this issue in mind. According to this report, Havelock Europa Company’s trade and other payables in its statement of financial position reduced to £15,969,000 in 2013 from £23,321,000 in 2012. In itself, this reduction of trade payables by £7,352,000 seems material and as such, an area of heightened audit risk. This understatement could be associated with either a complete omission of some liabilities from the financial statements, and/or recorded at a lower amount. This act would portray that Havelock Europa Company as healthier and less risky since the omission of some expenses that are not yet paid lowers the debt and leads to an overstatement of incomes. From the financial statements of the Havelock Europa Company, the understatement could have been caused by the omission of contingent liability because, according to its policy, it considers contingent liabilities only when it becomes probable that it will have to make payments under the guarantee (Havelock Europa Plc., 2013, p. 93). The next probable cause for this fall could be the omission of unearned revenues that arise from prepayments from customers for services and goods not provided. Finally, the understatement could be as a result of Havelock Europa Company’s fraudulent financial reporting scheme. Related party transactions The Public Company Accounting Oversight Board (2014) states that, related party transactions, including those between a company and its executives is a critical area as it has historically been characterised by increased risk of material misstatement. Therefore, this report also considers the transactions between Havelock Europa Company and its executives and related parties risky. These transactions are prone to manipulations and are used to understate liabilities or overstate assets. This report is concerned with the decrease in the amount from transactions with the management and group companies to £877,000 in 2013 from £914,000 in 2012 and £1,377,000 in 2013 from £2,045,000 in 2012 respectively (Havelock Europa Plc, 2013, p. 94). As noted by Colby (2010), these related party transactions could be improper and arise due to sale and purchase transactions between undisclosed affiliates. The danger with these transactions can also arise from purchasing inventory whose prices have been inflated by the affiliates. Improper transactions also arise when liabilities are transferred to a related affiliate. Revenues Financial statement fraud is also done by overstating revenues. The possible means through which Havelock Europa Company could have overstated its revenues is through recording fictitious revenue, understating sales returns, and recognising revenue prematurely (Colby, 2010). Fictitious revenues are recorded when an entity record sales to ghost customers or recording of inflated sales to the actual customers. Through fictitious revenues, the Havelock Europa Company could have recorded sales that never occurred by creating or manipulating transactions to enhance its reported earnings. Phantom customers and sales could have been created, and phony invoices created. The fictitious revenues are also created through the timing differences. The Havelock Europa Company could have recorded revenues in the wrong period. For instance, The Havelock Europa Company could have recognised revenues early before they are actually earned, leading to an increase in its revenues using legitimate sales. Such a move contravenes the requirements of GAAP in regard to revenue recognition. Revenues could also have been overstated by capitalising expenses or deferring them to the next period. Fictitious revenues are examined by verifying that customers exist and also the accounts receivable aging report. To test for the timing difference, unusual transactions during the last few months to the closure of the financial period are audited, and the necessary reconciliations done. PART B: SUBSTANTIVE AUDIT PROCEDURES The substantive procedures are conducted by an auditor in the course of his audit work to gather evidence called substantive evidence. The Public Company Accounting Oversight Board (2015) posit that substantive tests or procedures form part of the audit and is the point at which the auditor collect enough evidence as to whether the client has materially misstated his accounting records or other information. These procedures help in creating conclusive evidence regarding the management’s assertions in regard to the accounts balances and transactions. These assertions are in regard to the existence, completeness, valuation, rights and obligation, completeness, and disclosure. This report suggests some substantive procedures that should be performed on the purchases and accounts payable of the Havelock Europa Company as published in its 2013 financial statements to find out if they are materially misstated. In approaching these tests, this report has professional scepticism. Additionally, it appreciates that for the misstatement to occur, there are three risks surrounding the audit assignment. First, is the inherent risk that is an error and could have occurred. The second is the control risk that could have occurred as a result of Havelock Europa Company's internal controls’ weakness. The third risk is the detection of risk and could have arisen due to an auditor's failure to detect it through his tests and procedures. The available substantive audit procedures that this report would perform to establish whether the purchases and accounts payable of the Havelock Europa Company were misstated include analytical procedures, inspection, enquiries and confirmations, observation, and recalculation and reperformance. Analytical procedures The Public Company Accounting Oversight Board (2015), notes that analytical procedures are an integral part of the audit process. The financial information presented by Havelock Europa Company in its financial statements will be evaluated through a plausible study of the subsisting relationship among financial and non-financial data. The relationship will be established based on the assumption that this relationship is reasonable and is expected to exist and continue in the condition that there are no known conditions to the contrary. Through analytical procedures, the evidential matter in the amount of £15,969,000 disclosed as trade payables will be gained. In addition, these tests will help in ascertaining the correctness of this balance as well as its classification. The recorded amounts will be compared against compared to the expectations of this report given the plausible relationship. When developing these expectations, this report will rely on: the anticipated results from budgets and forecasts; financial information for comparable prior periods through ratio and trend analysis; relationship of financial and non-financial information; the industry information; and the relationships among financial statements’ elements. Inspection Through this substantive procedure, this report will examine the records and documents that were used by Havelock Europa Company in relation to its purchases and their payments. Among these documents include the local purchase orders, goods receipt notes, credit notes and the cash book. According to McGraw-Hill Higher Education, (2006), this inspection will be aimed at finding out the completeness assertion of the recorded amounts. However, the reliance of these documents and records will depend on their nature and source (Rittenberg et al., 2011, p. 341). In order to increase their reliability, this report will carry out some tests as outlined by Colby, (2010). Colby (2010, p. 3), states that, to detect the concealed liabilities, an auditor needs to perform cutoff procedures that compare the invoices from vendors, receiving documents as well as cash disbursements in order to establish when liabilities were actually incurred. The amounts to the sub-ledger should then be traced to the on the balance sheet date. Colby (2010) says that the open invoice file should be examined to determine whether all open invoices were recorded. After this, subsequent disbursements should be examined to determine the respect with which they were made1. This follows the next substantive audit procedure, confirmation. Enquiries and confirmations Through inquiries, this report will be seeking information from knowledgeable persons in Havelock Europa Company and outside the company covering both financial and non-financial. Inquiries will be both formal and informal. The responses received will be used to corroborate other audit evidence received using other substantive tests. However, these inquiries might also not be sufficient enough to detect any material misstatements. Through confirmations, this report will be seeking to obtain representations from third parties, especially vendors. These will include the creditors and suppliers included in the Havelock Europa Company’s books and records. Some circulars will be sent to them requesting for their confirmation that some stated account balances pertaining to them are true or tie to those in their books. Scrutiny and review By performing scrutiny tests, this report will be reviewing the various documents and accounting records of the Havelock Europa Company such as the cash books and ledger accounts. Through this substantive procedure, this report will be able to determine unusual and large transactions that would warrant special attention. Recalculation and reperformance This report proposes to recalculate some of the purchases and accounts payable recorded amounts in order to assess their mathematical accuracy (Rittenberg et al., 2011, p. 344). This substantive test will help in giving audit evidence in regard to the correctness of the account balances and transactions undertaken in the year 2013 by Havelock Europa Company. In addition, through reperformance, this report will conduct some independent execution of procedures and controls as were done by Havelock Europa Company. References Colby, E.E., 2010. Financial statement fraud, Part 3. [Online] Available at: HYPERLINK "https://www.cga-pdnet.org/Non_VerifiableProducts/ArticlePublication/FinStatFraud/FinStatFraud_p3.pdf" https://www.cga-pdnet.org/Non_VerifiableProducts/ArticlePublication/FinStatFraud/FinStatFraud_p3.pdf [Accessed 13 April 2015]. Havelock Europa Plc, 2013. Havelock Europa Plc Annual Report 2013. Financial Report. Mansfield, Nottinghamshire: Barr Printers Havelock Europa Plc. McGraw-Hill Higher Education, 2006. Accounts Payable and Other Liabilities. [Online] Available at: HYPERLINK "http://highered.mheducation.com/sites/0073010847/student_view0/chapter14/index.html" http://highered.mheducation.com/sites/0073010847/student_view0/chapter14/index.html [Accessed 13 April 2015]. Public Company Accounting Oversight Board, 2014. Fact Sheet: Auditing Standard on Related Parties and Amendments on Significant Unusual Transactions and a Company's Financial Relationships and Transactions with its Executive Officers. [Online] Available at: HYPERLINK "http://pcaobus.org/News/Releases/Pages/06102014_Fact_Sheet.aspx" http://pcaobus.org/News/Releases/Pages/06102014_Fact_Sheet.aspx [Accessed 13 April 2015]. Public Company Accounting Oversight Board, 2015. AU Section 329 Substantive Analytical Procedures. [Online] Available at: HYPERLINK "http://pcaobus.org/Standards/Auditing/Pages/AU329.aspx" http://pcaobus.org/Standards/Auditing/Pages/AU329.aspx [Accessed 13 April 2015]. Rittenberg, L., Johnstone, K. & Gramling, A., 2011. Auditing: A Business Risk Approach. 8th ed. Boston, Massachusetts: Cengage Learning. Appendices Appendix I Income statement trend analysis Income statement Trend analysis 2012 2013 Change %tage change £000 £000 Revenue 92,462 89,590 (2,872) -3.11% Cost of sales 82,112 78,406 (3,706) -451.33% Gross profit 10,350 11,184 834 805.80% Administrative expenses 10,107 10,065 (42) -41.56% Operating profit/ (loss) 243 1,119 876 36049.38% Finance cost 758 487 (271) -3575.20% Profit before tax (515) 632 1,147 -22271.84% Tax (170) 349 519 -30529.41% Profit/(loss) after tax (345) 283 628 -18202.90% Appendix II Trend analysis of trade and other payables 2012 2013 £000 £000 Change %tage change Trend analysis Trade and other payables 23321 15969 -7352 -31.53% Appendix III Ratio analysis 2012 2013 Gross profit ratio 11.19% 12.48% Operating income margin 0.26% 1.25% Net profit margin -0.37% 0.32% Current ratio 1.49 1.64 Read More