Question

1. Why are the long-lived assets and inventory assertions of existence said to have an inherent risk of material misstatement that is higher than that of the account payable?

2. Do you think the blank confirmation is included in the positive or negative confirmation? Also explain what the advantages and disadvantages of each type of confirmation are, along with what kind of situation it is suitable to use!

3. Why is a cash account said to have a high inherent risk of possible fraud? Explain some of the controls related to cash accounts!

4. You are an auditor at a public accounting firm. You are conducting an audit for the financial year ending December 31, 2019. Your client has go public. This client is a property development company. Your client builds property in the form of apartment units, housing / real estate and also property investment products in the form of lots ready to build. In addition, this client also has a project development cooperation with its customers. The client is bound by a contract signed by both parties before a notary for the construction of a project with this customer. The project has not been completed 100%, however, the client says that the project has been completed 60% and the client acknowledges 60% of the development as revenue in the 2019 financial year.
Question:
a. In your opinion, as an auditor, what account should the client classify the apartment and housing / real estate complex be? Explain your answer!
b. What is the audit procedure that you will apply to ensure the recognition of revenue that is 60% of the project!
c. What audit evidence will you examine and what are the related assertions? Explain your answer!

5. You are an auditor at a public accounting firm. You and your team are entrusted by Partner to handle clients engaged in the home appliance retail business. Your client is a company that has go public. The client's financial statement in the previous year reported a loss, however this year reported a material gain. After you check, it turns out that the client reports income that is not much different from the previous year, however, there can be a profit due to the decrease in Cost of Goods Sold (COGS). The client reports that the amount of inventory has increased drastically, even though sales have not increased and the account payable balance is almost the same as in previous years, this has led to suspicion of a double counting scheme in the client's inventory. In addition, when a random check was carried out incidentally at one of the client's warehouses, it was found that many inventory were out of date but the client did not make adjustments.
Question:
a. If you wanted to perform an analytical procedure to check the suspected occurrence of this double counting scheme, what ratio would you calculate? Explain your answer!
b. What assertions are related to the above case? Explain your answer!

6.Your client Corp A is a company engaged in the production of heavy equipment and markets its products on a business to business (B2B) basis. Goods produced by Corp A are heavy equipment such as: Excavators, Bulldozers, Mobile Cranes, Motor Scrapers, etc. There are also a number of finished products in the form of heavy equipment which are self-used by Corp A. After several years of self-use, that heavy equipment is sold, which is in the fiscal year that you are currently auditing. Corp A recorded it as sales revenue which is increased their operating profit.
Question:
a. Do you think that recognize it as sales revenue is correct? Explain your answer!
b. What audit objectives relate to the above case! Explain your answer!

Answer 1

ANSWER 1

Types of Audit Risk

To understand inherent risk, it helps to place it within the context of audit risk analysis. Audit risk is the risk of error while performing an audit, and it traditionally is broken into three distinct types.

1. Control risk: Control risk occurs when a financial misstatement results from a lack of proper accounting controls in the firm. This is most likely to surface in the form of fraud or lazy accounting practices.
2. Detection risk: It's also possible that auditors simply fail to detect an otherwise easy-to-notice error in the financial accounts. This is known as detection risk. Normally, detection risk is countered by increasing the number of sampled transactions during testing.
3. Inherent risk: Considered the most pernicious of the major audit risk components, inherent risk can't be easily avoided through increased auditor training or creating controls in the auditing process. Nevertheless, it is one of the risks auditors and analysts must look for when reviewing financial statements, along with control risk and detection risk.

Common Examples of Inherent Risk

Inherent risk is common in the financial services sector. The reasons include the complexity of regulating financial institutions (the large and ever-changing amount of rules and regulations), the large networks of related companies, and the development of derivative products and other intricate instruments which require complicated calculations to assess.

2. ANSWER

Definition:

Confirmation—the auditor’ s receipt of a direct written or electronic response from a third party verifying the accuracy of information requested.
Confirmation procedures can be used to confirm the balance of receivable, payable, contigent liabilities, bank account, inventories and securities in custody, or to confirm the transaction of sales invoice, side agreement, purchases.

Objective:

The purpose of accounts / transactions confirmation is to meet the Existence, Accuracy, and Cutoff objectives.

Form of Confirmation: Positive and Negative

Positive Confirmation
A positive confirmation = correct or incorrect, the recipient is requested to reply/ confirm with the stated amount/ information. Included as positive confirmation are:

• A blank confirmation.
• An invoice confirmation.
• Sales involve special terms or side-agreements confirmation.

Negative Confirmation
A negative confirmation = the recipient is requested to reply only when the recipient disagrees with the stated amount.

Difference:

1. Failure to reply:
   • Positive Confirmation
   Auditor should perform follow up procedures if the debtor does not reply. See the follow procedures below.
   • Negative Confirmation
   Regarded as a correct response, even though the debtor may have ignored the confirmation request.
2. 
   
3. Cost of confirmation:
   Negative Confirmation is less expensive than positive confirmation, because there will be no second confirmation request and no follow-up procedures.
4. 
   
5. Criteria to Use:
   For using Negative Confirmation, all of the following circumstances are present:
   1. The auditor has assessed the risk of material misstatement as low and has obtained sufficient evidence regarding the design and operating effectiveness of controls.
   2. The population of items is made up of a large number of small, homogenous account balances, transactions, or other items.
   3. The auditor expects a low exception rate.
   4. The auditor reasonably believes that recipients will give the requests adequate consideration. Adequate consideration exist when there are high response rates on audits in previous year or of similar clients.
   Typically, when negative confirmations are used, the auditor puts considerable emphasis on the effectiveness of internal controls, substantive tests of transactions, and analytical procedures as evidence of the fairness of accounts receivable, and assumes that the large majority of the recipients will provide a conscientious reading and response to the confirmation request.

3 ANSWER

How to Audit Cash

In this post, we will take a look at the following:

• Primary cash assertions
• Cash walkthrough
• Directional risk for cash
• Primary risks for cash
• Common cash control deficiencies
• Risk of material misstatement for cash
• Substantive procedures for cash
• Common cash work papers

Primary Cash Assertions

The primary relevant cash assertions are:

• Existence
• Completeness
• Rights
• Accuracy
• Cutoff

Of these assertions, I believe existence, accuracy, and cutoff are most important. The audit client is asserting that the cash balance exists, that it’s accurate, and that only transactions within the period are included.

Classification is normally not a relevant assertion. Cash is almost always a current asset. But when bank overdrafts occur, classification can be in play. The negative cash balance can be presented as cash or as a payable depending on the circumstances.

Cash Walkthrough

As we perform walkthroughs of cash, we normally look for ways that cash might be overstated (though it can also be understated as well). We are asking, “What can go wrong?” whether intentionally or by mistake.

In performing cash walkthroughs, ask questions such as:

• Are timely bank reconciliations performed by competent personnel?
• Are all bank accounts reconciled?
• Are the bank reconciliations reviewed by a second person?
• Are all bank accounts on the general ledger?
• Are transactions appropriately cut off at period-end (with no subsequent period transactions appearing in the current year)?
• Is there appropriate segregation between persons handling cash, recording cash, making payments, and reconciling the bank statements
• What bank accounts were opened in the period?
• What bank accounts were closed in the period?
• Are there any restrictions on the bank accounts?
• What persons are on the bank signature cards?
• Who has the authority to open and/or close bank accounts?
• What is the nature of each bank account (e.g., payroll bank account)?
• Are there any cash equivalents (e.g., investments of less than three months)
• Were there any held checks (checks written but unreleased) at period-end?

As we ask questions, we also inspect documents (e.g., bank reconciliations) and make observations (who is doing what?).

If controls weaknesses exist, we create audit procedures to address them. For example, if during the walkthrough we review three monthly bank reconciliations and they all have obvious errors, we will perform more substantive work to prove the year-end bank reconciliation. For example, we might vouch every outstanding deposit and disbursement.

Directional Risk for Cash

What is directional risk? It’s the potential bias that a client has regarding an account balance. A client might desire an overstatement of assets and an understatement of liabilities since each makes the balance sheet appear healthier.

The directional risk for cash is overstatement. So, in performing your audit procedures, perform procedures such as testing the bank reconciliation to ensure that cash is not overstated.

Primary Risks for Cash

The primary risks are:

1. Cash is stolen
2. Cash is intentionally overstated to cover up theft
3. Not all cash accounts are on the general ledger
4. Cash is misstated due to errors in the bank reconciliation
5. Cash is misstated due to improper cutoff

Common Cash Control Deficiencies

In smaller entities, it is common to have the following control deficiencies:

• One person receipts and/or disburses monies, records those transactions in the general ledger, and reconciles the related bank accounts
• The person performing the bank reconciliation does not possess the skill to perform the duty
• Bank reconciliations are not timely performed

Risk of Material Misstatement for Cash

In my smaller audit engagements, I usually assess control risk at high for each assertion. If control risk is assessed at less than high, then controls must be tested to support the lower risk assessment. Assessing risks at high is usually more efficient than testing controls.

ANSWER 4 a,b & c

Here we present the 7 step guide to a smooth financial audit and closing of of your housing society accounts, as key takeaways from the Webinar.

1) Understanding what is being audited

• Collections made by Association from Members in form of maintenance dues, usually collected monthly or quarterly
• Collections made by Association from non-members, like rent collected general store inside the apartment, etc.
• Payments made by Association to Vendors. This would include payments made to Housekeeping, Security, payment for common area electricity, water, etc
• Assets of the Associations like Elevators, Transformers, Generators, Water Treatment Plants, Electronics, Gym / Clubhouse equipment, etc.
• Investments of the Association which are typically Fixed Deposits

2) Understanding the parties involved in the audit

• Treasurer, who is a part of the Management Committee, who is also an owner
• Accountant, who does the day to day accounting entries
• Auditor, is a person who will be appointed by the Association for auditing the Society Accounts

3) Setting up your Accounting System for Success

1. Immediate entry of Collections into the Books is very important. With systems like a payment gateway for collecting maintenance dues, these entries happen automatically and hence save a lot of time and effort of management committee members
2. Daily entry of Expenses is very important
3. Bank Reconciliation (Matching the payments and expenses with the bank statement) should be done on a monthly basis
4. Monthly Payment of TDS, Service Tax, Professional Tax
5. Quarterly filing of TDS and Half Yearly Filing of Service Tax
6. Appoint an Auditor early on during the financial year. The Auditor would be able to advise you with regard to the right accounting practices which are to be followed. Its also advised if he keeps having a look into your book of accounts on a quarterly basis. This makes the audit process at the end of the financial year very smooth.

4) Accounting Discipline to be Kept in Mind

1. Zero Cash Collections: This is because accounting of cash is messy and at the end of the year, unaccounted cash causes the most amount of problems
2. Minimal Cash Payments: It is a best practice to enter into bulk contracts with vendors, so that small payments which necessitates payment by cash, are avoided. Other than petty cash payments like refreshments for meetings, etc. its best to avoid cash payments. Cash payments made should be entered into the system on the same day.
3. Publishing of Cash Flow reports to Members periodically: This helps in maintaining transparency and also catching hold of any discrepancy early, rather than later in the financial year during audit.

5) Apartment Financial Audit Preparation

During Apartment financial audit preparation there are certain aspects of your Society’s accounting which you need to take care before the auditor starts looking into your accounting system. Its best to start the audit preparation around May-June, so that as an Association you are prepared for the closing of Society Accounts well within stipulated time.

1. All Financial Entries should be complete: All deposits, collections, payment entries should be done in the system
2. Bank Reconciliation Complete: The bank balance amount which your bank is showing should match the bank balance your financial system is showing minus some floating amounts like cheques deposited but not credited yet, etc.

6) Handling the Apartment Financial Audit Process:

During the Apartment financial Audit, here are the activities conducted by the auditor:

1. He will review and drill down into the trial balance. A trail balance would show the balance across accounting heads, classified across assets and liabilities.
2. Review of bank reconciliation and matching with Bank Statement
3. Review of Tax Collection, Remittance and Filing
4. Auditor will help in Posting of Journal Entries
   1. Accrued interest of FDs
   2. Provision amounts which are payable in last financial year, but you do not have visibility right away
   3. Depreciation

The Auditor would thus generate the Income & Expense Statement, take a print out of the statement from the accounting tool and put his signature and stamp on it. This would end the audit process.

7) Avoid the Frequent Mistakes made by Apartment Association or Societies:

1. Not performing Bank Reconciliation Regularly
2. Mistakes related to Taxes
   1. Not deducting TDS from Vendor Payments
   2. Service Tax (Service Tax to be collected if collection is equal to or greater than Rs. 5000 per household per month)
   3. Income Tax: Any Collection from members (Owners/Tenants) is exempt from Income tax. Collection from Non-Members (Rent from Vendors, Sponsorships, etc.) is within Income Tax Scope

Here is a presentation which details out the various ADDA Features which help in making Society Accounting hassle free for Apartment Treasurers & Accountants.

ANSWER.5 A&B

(a) Analytical procedures

• Analytical procedures can be used at all stages of an audit, however, ISA 315 Identifying and Assessing the Risks of Material
• Misstatement through Understanding the Entity and Its Environment and ISA 520 Analytical Procedures identify three
• particular stages.
• During the planning stage, analytical procedures must be used as risk assessment procedures in order to help the auditor to
• obtain an understanding of the entity and assess the risk of material misstatement.
• During the final audit, analytical procedures can be used to obtain sufficient appropriate evidence. Substantive procedures can
• either be tests of detail or substantive analytical procedures.
• At the final review stage, the auditor must design and perform analytical procedures which assist them when forming an overall
• conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity.

(b) Ratios

Ratios to assist the audit supervisor in planning the audit:
20X8 20X7
Gross margin 7,410/19,850 = 37·3% 6,190/16,990 = 36·4%
Inventory holding period 1,850/12,440 * 365 = 54 days 1,330/10,800 * 365 = 45 days

OR

Inventory turnover 12,440/1,850 = 6·7 10,800/1,330 = 8·1
Receivables collection period 2,750/19,850 * 365 = 51 days 1,780/16,990 * 365 = 38 days
Payables payment period 1,970/12,440 * 365 = 58 days 1,190/10,800 * 365 = 40 days
Current ratio 4,600/(1,970 + 810) = 1·65 3,670/1,190 = 3·08
Quick ratio 2,750/(1,970 + 810) = 0·99 (3,670 – 1,330)/1,190 = 1·97

(c) Audit risks and auditor’s response
Audit risk Auditor’s response
During the year, Darjeeling Co has spent $0·9m on
developing new product lines, some of which are in the
early stages of their development cycle. This expenditure
is classed as research and development under IAS® 38
Intangible Assets. The standard requires research costs to
be expensed to profit or loss and only development costs to
be capitalised as an intangible asset.
The company has included all of this expenditure as an
intangible asset. If research costs have been incorrectly
classified as development expenditure, there is a risk
that intangible assets could be overstated and expenses
understated.
Obtain a breakdown of the expenditure and verify that it
relates to the development of the new products. Review
expenditure documentation to determine whether the costs
relate to the research or development stage. Discuss the
accounting treatment with the finance director and ensure it
is in accordance with IAS 38.

As auditors, we usually audit inventory by testing the various audit assertions including existence, completeness, rights and obligations, and valuation. In the audit process of inventory, physical inventory count may be the most important part of the inventory audit. This is due to physical inventory count can provide evidence on existence and completeness.

It is also important for us to evaluate whether the inventory reported in the financial statements is correctly valued. The misstatement on inventory not only affects the balance sheet but also the income statement. Likewise, the whole financial statements may be materially misstated due to the over or undervaluation of the inventory.

Audit Assertions for Inventory

In the audit of inventory, we usually test the audit assertions included in the table below:

Audit assertions for inventory
Existence	Inventory balances reported on financial statements actually exist at the reporting date.
Completeness	Inventory reported on the balance sheet includes all inventory transactions that have occurred during the accounting period.
Rights and obligations	All inventory reported on financial statements as at the reporting date really belongs to the company.
Valuation	Inventory balances truly reflect its economic value.
Presentation and disclosure	Inventory is properly classified and sufficiently disclosed in the notes to financial statements.

In the audit of inventory, we usually focus more on existence and valuation. This is due to we concern more about whether the inventory does actually exist; and that it has been properly valued in accordance with applicable accounting standards.

Audit Procedures for Inventory

In the audit of inventory, we want reasonable assurance that the inventory actually exists and is really owned by the client. And inventory balances are all included on the balance sheet and their value reflects actual economic value on the market.

Existence

In the audit of inventory, existence or occurrence assertion tests whether the inventory on balance sheet actual exists and whether inventory transactions actually took place.

Example: test of existence in physical inventory count procedure

• Observe the annual inventory counting procedures of the client
• Select a sample of items in the inventory record
• Count the actual inventory on hand to make sure they match with the record.

Example of the inventory addition test:

• Select a sample of additions of inventory during the year
• Vouch them to the supporting documents such as supplier’s invoice and good receive note. (This is to ensure the occurrence of inventory addition)

Completeness

Completeness assertion in the audit of inventory tests whether all the inventory at year-end is included in the balance sheet and all purchases and sales of inventory are recorded. One high risk of inventory is that the company bought the inventory but the purchases were not recorded into the inventory account. This could be the result of intentional fraud or unintentional error, in which they both lead to an understatement of inventory.

Example: test of completeness

• Select a sample of inventory received notes (or good received notes) and
• Trace them back to detail inventory listing
• Reconciled detail inventory listing to general ledger

Example: test of completeness in inventory count procedure

• Observe the annual inventory counting procedures of the client
• Select a sample of counted items in the store or warehouse
• Trace the counted items to detail inventory listing.

Rights and obligations

In the audit of inventory, completeness assertion tests whether all the inventory recorded in the balance sheet really belongs to the company.

Example: test of rights and obligations

• Check to see if there is any inventory held for the third party and if there is, make sure it is not included in the balance sheet and appropriately separated from other inventory during the inventory count.
• Review the purchase invoice or purchase agreement to ensure that the inventory really belongs to the company.

Valuation

Valuation assertion tests whether the inventory figures in the client’s account are correct and the evaluation method used by the client in determining the cost of various items for inventory valuation is appropriate.

One important rule that always applies to the inventory valuation is that the value of the inventory is measured at the lower of cost and net realizable value. As the auditors, we need to confirm that the client correctly follows the above rule or the misstatement might occur.

More likely than not, the overstatement statement tends to happen in this case as the client sometimes determines the value by cost on all of the inventory including obsolete inventory which their net realizable value is usually lower than the cost.

One more important aspect of the inventory valuation is whether the overhead allocation made by the client is appropriate. We usually meet this case when testing the working-in-progress and finished goods of the client’s manufacturing products.

Example: test of valuation

• Determine whether the inventory valuation method used by the client is appropriate
• Recalculate the client’s inventory valuation
• Inquire the related personnel such as production and warehouse personnel about the existence of obsolete inventory.
• Make sure that the obsolete inventory is properly labeled and separate from other inventory
• Make sure that the cost of the obsolete inventory value is written down to the market value (if any)

ANSWER 6 A&B

What Is Operating Revenue?

Operating revenue is the revenue that a company generates from its primary business activities.

For example, a retailer produces its operating revenue through merchandise sales; a physician derives their operating revenue from the medical services that they provide. What constitutes operating revenue varies based on the business or the industry.

Understanding Operating Revenue

Distinguishing operating revenue from total revenue is important because it provides valuable information about the productivity and profitability of a company's primary business operations.

Despite the fact that operating revenue is recorded separately on financial statements, some firms may attempt to mask decreases in operating revenue by combining it with non-operating revenue. Understanding and identifying the sources of revenue is helpful in assessing the health of a firm and its operations.

Operating Revenue vs. Non-Operating Revenue

Non-operating revenue is revenue generated by activities outside of a company's primary operations. This type of revenue tends to be infrequent and oftentimes unusual. Examples of non-operating income include interest income, gains from the sale of assets, lawsuit proceeds, and revenues from other sources not connected to operations.

For example, a private university may classify tuition received as operating revenue, whereas gifts from alumni are considered non-operating revenue (because they are not expected nor are they part of ordinary university operations).

The terms "profit" and "income" are often used interchangeably in day-to-day life. In corporate finance, however, these terms can have very different and specific meanings, depending on the context in which they are used.

While income does mean positive flow of cash into a business, net income is something much more complex. Profit is generally understood to refer to the cash that is left over after accounting for expenses. Though both gross profit and operating profit fit this definition in the simplest sense, the kinds of income and expenses that are accounted for differ in important ways.

Financial statement manipulation is a type of accounting fraud that remains an ongoing problem in corporate America. Although the Securities and Exchange Commission (SEC) has taken many steps to mitigate this type of corporate malfeasance, the structure of management incentives, the enormous latitude afforded by the Generally Accepted Accounting Principles (GAAP) and the ever-present conflict of interest between the independent auditor and the corporate client continues to provide the perfect environment for such activity.

Due to these factors, investors who purchase individual stocks or bonds must be aware of the issues, warning signs and the tools that are at their disposal in order to mitigate the adverse implications of these problems.

Specific Ways to Manipulate Financial Statements

When it comes to manipulation, there are a host of accounting techniques that are at a company's disposal. Financial Shenanigans (2002) by Howard Schilit outlines seven primary ways in which corporate management manipulates the financial statements of a company.

1. Recording Revenue Prematurely or of Questionable Quality
   1. Recording revenue prior to completing all services
   2. Recording revenue prior to product shipment
   3. Recording revenue for products that are not required to be purchased
2. Recording Fictitious Revenue
   1. Recording revenue for sales that did not take place
   2. Recording investment income as revenue
   3. Recording proceeds received through a loan as revenue
3. Increasing Income with One-Time Gains
   1. Increasing profits by selling assets and recording the proceeds as revenue
   2. Increasing profits by classifying investment income or gains as revenue
4. Shifting Current Expenses to an Earlier or Later Period
   1. Amortizing costs too slowly
   2. Changing accounting standards to foster manipulation
   3. Capitalizing normal operating costs in order to reduce expenses by moving them from the income statement to the balance sheet
   4. Failing to write down or write off impaired assets
5. Failing to Record or Improperly Reducing Liabilities
   1. Failing to record expenses and liabilities when future services remain
   2. Changing accounting assumptions to foster manipulation

Key Points

• Under accrual accounting, revenues are recognized when they are realized (payment collected) or realizable (the seller has reasonable assurance that payment on goods will be collected) and when they are earned (usually occurs when goods are transferred or services rendered).
• For companies that don’t follow accrual accounting and use the cash -basis instead, revenue is only recognized when cash is received.
• Revenue recognition is a part of the accrual accounting concept that determines when revenues are recognized in the accounting period.
• The matching principle, along with revenue recognition, aims to match revenues and expenses in the correct accounting period. It allows a better evaluation of the income statement, which shows the revenues and expenses for an accounting period or how much was spent to earn the period’s revenue.

Key Terms

• fixed asset: Asset or property which cannot easily be converted into cash, such as land, buildings, and machinery.
• intangible asset: Any valuable property of a business that does not appear on the balance sheet, including intellectual property, customer lists, and goodwill.

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