Acct 3005 Auditing Practice and Thoery
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QUESTION 1
ASA520 of the Australian Auditing Standards addresses Analytical Procedures (APs), noting APs are one auditor skill used to comprehend the clients business, plan audit procedures and identify potential risks. They compare financial data from budgets, prior periods, forecasts, consider payroll costs, financial, non financial information and gross profits. Information is sourced from budgets, banking records, financials, clients or board minutes (Arens, Best et al (2010).
Advantages of APs is they can be broken into five components: expectation development, explanation generation, information search and explanation evaluation, decision making, and documentation (Hirst and Koonce, (1996), making the audit useful for both management and investors, enabling managers to develop statistics and key ratios, monitoring business progress; whereas investors use APs to forecast future sales based on prior sales history and industry knowledge. APs are an integral part of the audit process (O'Reilly, McDonnell et al (1998).
Research indicates auditors relying on APs alone encounter obstacles in explanations for discrepancies and have difficulty generating a majority of plausible causes for unusual fluctuations during APs, due to their failure to understand the problem may not contain the discrepancy causes (Bierstaker, Bedard et al (1999).
Auditors must judge reliability of information when assessing explanations for unexpected fluctuations found during APs, explanations can differ in degree of reliability due to its source (e.g., a third party, another audit team member, client or a decision aid). The inferential value of evidence received should be considered in context to the source (Reimers and Fennema (1999).
Auditors perform APs in planning the timing, nature and extent of testing. The timing of procedures may be performed at any time during the audit engagement. The Planning aids in identifying matters needing special consideration, assisting in the understanding of client’s industry and business , discussed in ASA315(Pearson, 2010, p. 207), where the auditor’s responsibility is to obtain an understanding of the entity and it environment and ASA330 (Pearson, 2010, p. 293) to assess ongoing concerns and reduce detailed testing, followed by ASA500 (Pearson, 2010, p. 276) requiring the auditor to use assertions in assessing risk and designing audit procedures in response to those risks. Testing allows evaluation of possible misstatements and reduces detailed tests, while ASA700 (Pearson, 2010, p. 431) discusses the completion phase, where the auditor considers a final review of material misstatements or financial problems, and has a final ‘objective look’ at the evidence and financial statements (Arens, Best et al (2010, p. 190-191) giving an opinion of whether the financial report gives a true and fair view.
Further we will discuss some related topics:Essay on management accounting
Essay on goodwillASA520 of the Australian Auditing Standards addresses Analytical Procedures (APs), noting APs are one auditor skill used to comprehend the clients business, plan audit procedures and identify potential risks. They compare financial data from budgets, prior periods, forecasts, consider payroll costs, financial, non financial information and gross profits. Information is sourced from budgets, banking records, financials, clients or board minutes (Arens, Best et al (2010).
Advantages of APs is they can be broken into five components: expectation development, explanation generation, information search and explanation evaluation, decision making, and documentation (Hirst and Koonce, (1996), making the audit useful for both management and investors, enabling managers to develop statistics and key ratios, monitoring business progress; whereas investors use APs to forecast future sales based on prior sales history and industry knowledge. APs are an integral part of the audit process (O'Reilly, McDonnell et al (1998).
Research indicates auditors relying on APs alone encounter obstacles in explanations for discrepancies and have difficulty generating a majority of plausible causes for unusual fluctuations during APs, due to their failure to understand the problem may not contain the discrepancy causes (Bierstaker, Bedard et al (1999).
Auditors must judge reliability of information when assessing explanations for unexpected fluctuations found during APs, explanations can differ in degree of reliability due to its source (e.g., a third party, another audit team member, client or a decision aid). The inferential value of evidence received should be considered in context to the source (Reimers and Fennema (1999).
Auditors perform APs in planning the timing, nature and extent of testing. The timing of procedures may be performed at any time during the audit engagement. The Planning aids in identifying matters needing special consideration, assisting in the understanding of client’s industry and business , discussed in ASA315(Pearson, 2010, p. 207), where the auditor’s responsibility is to obtain an understanding of the entity and it environment and ASA330 (Pearson, 2010, p. 293) to assess ongoing concerns and reduce detailed testing, followed by ASA500 (Pearson, 2010, p. 276) requiring the auditor to use assertions in assessing risk and designing audit procedures in response to those risks. Testing allows evaluation of possible misstatements and reduces detailed tests, while ASA700 (Pearson, 2010, p. 431) discusses the completion phase, where the auditor considers a final review of material misstatements or financial problems, and has a final ‘objective look’ at the evidence and financial statements (Arens, Best et al (2010, p. 190-191) giving an opinion of whether the financial report gives a true and fair view.
Further we will discuss some related topics:Essay on management accounting
APs form an expectation of trend and ratio analyses, combined with model-based
procedures to identify potential misstatement. Trend analysis relies on data
from a single account, in contrast to ratio analysis incorporating direct
expected relationships between two or more accounts. Model-based procedures
differ in that expectation formation is implicit in trend and ratio analyses.
Expectation formation is explicit in model-based procedures and they use
operating and external data in addition to financial data to develop the
expectation.
APs provide a tool to evaluate the “reasonableness” of financial disclosures by comparing a client’s reported performance to expectations gained through knowledge of the client based on past experience and developments within the company and its industry, by taking a broader view of an entity’s performance vis-à-vis its environment (Trompeter and Wright (2010) therefore affording a reasonable indicator of client performance, assisting management to identify how the business has performed internally and against their competitors.
QUESTION 2
Auditors commonly utilise three types of analytical procedures to form an expectation: Trend Analysis, Ratio Analysis and Model-based procedures.
Analysis of ratios for NPL short-term debt paying ability as Appendix One found: •Cash Ratio used to assess the very short term solvency or liquidity. NPL has $58,000 cash on hand against $8,143,000 in current liabilities, with a very low liquidity cash ratio of 0.7%, noting NPL shows an improvement of 0.1% from the previous year. •Quick Ratio used to determine financial liquidity of NPL currently with $4,637,000 cash and current receivables against $8,143,000 in current liabilities, with a very low liquidity quick ratio of 0.57%, a 0.19% improvement from previous year; NPL is insolvent, with insufficient liquidity to meet immediate and short-term commitments.
•Current Ratio used to assess those assets that can be quickly converted to cash shows NPL has $8,261,000 current assets against $8,143,000 current liabilities, with a current ratio of 1.01, a 0.44% improvement from previous year. A desirable ratio is above 1, which indicates that NPL would probably become bankrupt if they were required to payout current debts.
These figures for NPL potentially place them in a position which could result in lower financial performance in the future or they might be forced into liquidation to meet their obligations, either will detract from the future value of their investment due to net cash flows.
Analysis of NPL’s liquidity activity has found in Appendix Two; •Accounts Receivable Turnover is 4.7% and Days to collect Accounts Receivable are 77.66 days combined with Inventory Turnover being 5.69% and Days to sell Inventory are 64 days. The receivables and have increased and cash declined in relative importance showing a possible deteriorating of cash as a result of inability to collect from customers. Inventories increased which could contribute to the decreased cash position, through additional purchasing or lack of turnover. •Property Plant and Equipment (PPE) decrease also indicates a need for cash to further pay off debt and cover costs of increased inventory and receivables.
Further investigation into causes of NPL’s cash and PPE decrease, and increase in receivables and inventory turnover is required, and activation of internal controls ensuring inventory levels are counted and reported correctly for inventories as per paragraph 8 AASB 102. Also PPE as per paragraph 15 AASB 116 needs to ensure they are being valued correctly (AASB 102 & AASB 116) and investigate sale of PPE to meet short term obligations, so NPL meets the ongoing concern assumption (ASA 570) implying that NPL is not at liquidation risk (Victor, 2010).
NPL needs to assess the potential future liquidity, economic changes in the recent election changes to exports, lifting of tariffs, creating raised competition, addressing these changes and impact on their international market share ensuring that funds will be available, to honor all cash outflow commitments when they fall due. The risk of illiquidity may increase if principle and interest cash-flows are mismatched (Kennedy and Shaw (1991).
Appendix Three shows a debt-to-equity ratio of 2.7:1, which appears high for the size of NPL, which poses a greater risk of insolvency, with a ratio above 1:1 indicating, •debt is higher than owners' equity
•the business is negatively geared
•the external lenders are bearing more risk than the owners •external lenders have a stronger financial interest in the business than the owner Indicating NPL may have difficulty in its borrowing capacity as to much debt can put NPL at risk and indicates possible difficulty in meeting interest and principal repayments (Shakeel, 2010), and effect the Times Interest Earned Ratio indicating reliance on borrowing funds, further.
The trend changes in Appendix Four and Five, indicate there are issues in cash flow and growing concern regarding ability to continue as a going concern, even though NPL has been profitable in the past, combined with additional information received from the Australian Taxation Office regarding potential material over-claimed foreign credits, being a possible failure to disclose a breach of regulatory requirement, which has the potential to significantly impair operating capability need to be investigated as per ASA320 Para 22 (Pearson, 2010) and the inability to confirm inventories recorded accurately. Further audit investigation is required into complaints of discrepancies in payments on account and inability to repay bank borrowings on due date, to satisfy the integrity of the financial records.
Due to the requirement for an audit report on NPL due by the 10th April, and insufficient time to complete further investigations into trend variances and discrepancies a disclaimer of opinion should be issued as Para 23 ASA701, noting an inability to complete the audit in accordance with Auditing Standards in available time, including a clear description of the substantive reasons for opinion.
APs provide a tool to evaluate the “reasonableness” of financial disclosures by comparing a client’s reported performance to expectations gained through knowledge of the client based on past experience and developments within the company and its industry, by taking a broader view of an entity’s performance vis-à-vis its environment (Trompeter and Wright (2010) therefore affording a reasonable indicator of client performance, assisting management to identify how the business has performed internally and against their competitors.
QUESTION 2
Auditors commonly utilise three types of analytical procedures to form an expectation: Trend Analysis, Ratio Analysis and Model-based procedures.
Analysis of ratios for NPL short-term debt paying ability as Appendix One found: •Cash Ratio used to assess the very short term solvency or liquidity. NPL has $58,000 cash on hand against $8,143,000 in current liabilities, with a very low liquidity cash ratio of 0.7%, noting NPL shows an improvement of 0.1% from the previous year. •Quick Ratio used to determine financial liquidity of NPL currently with $4,637,000 cash and current receivables against $8,143,000 in current liabilities, with a very low liquidity quick ratio of 0.57%, a 0.19% improvement from previous year; NPL is insolvent, with insufficient liquidity to meet immediate and short-term commitments.
•Current Ratio used to assess those assets that can be quickly converted to cash shows NPL has $8,261,000 current assets against $8,143,000 current liabilities, with a current ratio of 1.01, a 0.44% improvement from previous year. A desirable ratio is above 1, which indicates that NPL would probably become bankrupt if they were required to payout current debts.
These figures for NPL potentially place them in a position which could result in lower financial performance in the future or they might be forced into liquidation to meet their obligations, either will detract from the future value of their investment due to net cash flows.
Analysis of NPL’s liquidity activity has found in Appendix Two; •Accounts Receivable Turnover is 4.7% and Days to collect Accounts Receivable are 77.66 days combined with Inventory Turnover being 5.69% and Days to sell Inventory are 64 days. The receivables and have increased and cash declined in relative importance showing a possible deteriorating of cash as a result of inability to collect from customers. Inventories increased which could contribute to the decreased cash position, through additional purchasing or lack of turnover. •Property Plant and Equipment (PPE) decrease also indicates a need for cash to further pay off debt and cover costs of increased inventory and receivables.
Further investigation into causes of NPL’s cash and PPE decrease, and increase in receivables and inventory turnover is required, and activation of internal controls ensuring inventory levels are counted and reported correctly for inventories as per paragraph 8 AASB 102. Also PPE as per paragraph 15 AASB 116 needs to ensure they are being valued correctly (AASB 102 & AASB 116) and investigate sale of PPE to meet short term obligations, so NPL meets the ongoing concern assumption (ASA 570) implying that NPL is not at liquidation risk (Victor, 2010).
NPL needs to assess the potential future liquidity, economic changes in the recent election changes to exports, lifting of tariffs, creating raised competition, addressing these changes and impact on their international market share ensuring that funds will be available, to honor all cash outflow commitments when they fall due. The risk of illiquidity may increase if principle and interest cash-flows are mismatched (Kennedy and Shaw (1991).
Appendix Three shows a debt-to-equity ratio of 2.7:1, which appears high for the size of NPL, which poses a greater risk of insolvency, with a ratio above 1:1 indicating, •debt is higher than owners' equity
•the business is negatively geared
•the external lenders are bearing more risk than the owners •external lenders have a stronger financial interest in the business than the owner Indicating NPL may have difficulty in its borrowing capacity as to much debt can put NPL at risk and indicates possible difficulty in meeting interest and principal repayments (Shakeel, 2010), and effect the Times Interest Earned Ratio indicating reliance on borrowing funds, further.
The trend changes in Appendix Four and Five, indicate there are issues in cash flow and growing concern regarding ability to continue as a going concern, even though NPL has been profitable in the past, combined with additional information received from the Australian Taxation Office regarding potential material over-claimed foreign credits, being a possible failure to disclose a breach of regulatory requirement, which has the potential to significantly impair operating capability need to be investigated as per ASA320 Para 22 (Pearson, 2010) and the inability to confirm inventories recorded accurately. Further audit investigation is required into complaints of discrepancies in payments on account and inability to repay bank borrowings on due date, to satisfy the integrity of the financial records.
Due to the requirement for an audit report on NPL due by the 10th April, and insufficient time to complete further investigations into trend variances and discrepancies a disclaimer of opinion should be issued as Para 23 ASA701, noting an inability to complete the audit in accordance with Auditing Standards in available time, including a clear description of the substantive reasons for opinion.
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