Question

Part C Part C.1 Background information Gifts Ltd (Gifts) operates 30 specialty gift stores. The company’s year-end is 30 June 2018. The audit manager and partner recently attended a planning meeting with the finance director and have provided you with the planning notes below. You are the audit senior, and this is your first year on this audit. The audit manager has asked you to undertake some research to gain an understanding of Gifts, so that you are able to assist in the planning process. He has then asked that you identify relevant audit risks from the notes below and also consider how the team should respond to these risks. Gifts spent $2.1 million in refurbishing all of its stores and extending their central warehouse. In order to finance this refurbishment, Gifts borrowed $2 million from the bank. This is due to be repaid over five years. The company will be performing a year-end inventory count at the central warehouse, as well as at all 30 stores, on 30 June 2018. Inventory is valued at selling price less an average profit margin, as the finance director believes that this is a close approximation of cost. Prior to the 2018 financial year, each store maintained its own financial records and submitted returns monthly to head office. During the 2018 financial year all accounting records were centralised within head office. Therefore, at the beginning of the 2018 financial year, each store’s opening balances were transferred into head office’s accounting records. The increased workload at head office has led to some changes in the finance department and in May 2018 the financial controller left. Her replacement will start in late June 2018. REQUIRED: a) List two (2) sources of information that would be of use in gaining an understanding of Gifts, and for each source describe what information you would expect to obtain. b) Using the background information provided above, identify six (6) audit risks and explain the auditor’s response to each risk in planning the audit of Gifts. Part C.2 The finance director of Gifts is considering establishing an internal audit department and is unsure what factors he should consider when making his decision. REQUIRED: Bearing in mind the differences and similarities between the roles of an internal auditor compared to an external auditor, outline four (4) factors the finance director should consider before establishing an internal audit department.

Answer 1

B)

Transition Disclosures

Disclosures in the notes to their financial statements are required about the transition to the new standard. Some of the disclosures may be significant and therefore subject to more extensive substantive procedure testing. Auditors will also be looking for omitted, incomplete or inaccurate disclosures.

Companies should be particularly mindful of how they describe the implementation process and the anticipated effects of the new standard on the company's financial statement. The PCAOB alert also encourages auditors to carefully review any interim financial statement disclosures, including whether the interim disclosures agree with management report to the audit committee about the anticipated effects of the new revenue recognition standard.

Transition Adjustments

Entities have two options for transitioning to the new standard: they can use the full retrospective method or the modified retrospective method. Under the full retrospective method, entities will recast all prior periods presented in the financial statements as if the standard had been applied during those years. Under the modified retrospective method, entities will disclose how adopting the standard affected each line item along with explanations of significant changes between reported results and what would have been reported under previous accounting guidance.

Auditors will be paying particular attention to whether the transition and resulting change in accounting method was appropriately applied, including whether practical expedients were used correctly.

Internal Controls over Financial Reporting

The new standard may change how an entity has traditionally recognized revenue, which may require updates to processes and systems gathering contract data. Additionally, the new standard may require the use of estimates where estimates were not previously used, and the entity may also need to implement changes over financial statement disclosures.

Prior to the financial statement audit, entities may want to walk-through the updates they made to internal controls with their auditor so the author understands the flow of transactions and the relevant controls in place.

Auditors will be paying particular attention to controls over revenue, especially if your organization has any controls over revenue that are manually performed by your management team. If spreadsheets are used for any part of the process, for example, that might be a focal point for auditors because manual controls, by their nature, leave more potential for error.

Identifying and Assessing Fraud Risk

The potential for fraud may increase under the new revenue recognition standard with new fraud risks existing related to the evaluation of the transition adjustment to the new standard and increased fraud risks over ongoing revenue recognition process.

For instance, estimates and significant judgments come into play with the standard, particular for contracts with variable consideration or when management is determining the standalone selling price of a separate performance obligation. Auditors will be taking a close look how estimates and judgments were reached, so extensive documentation of the process and data used to create estimates is highly recommended. Fraud could occur if the standalone selling price or variable consideration is purposefully set at too high of an amount.

The new standard also carries a risk of fraud if performance obligations are improperly identified so that revenue is accelerated or deferred. Auditors will be paying particular attention to performance obligations and how the organizations determined which ones would be recognized at a point in time versus over time.

Recognizing Revenue in Conformity with the Financial Reporting Framework

PCAOB staff has frequently observed deficiencies with how auditors test the recognition of revenue. In its alert, it encourages auditors to understand contractual arrangements before applying auditing estimates or substantive analytical procedures. Specifically, auditors will be looking to know:

• How performance obligations are identified, including whether the company is acting as a principal or an agent
• How the company determines the transaction price and estimates variable consideration
• How the transaction price is allocated in determining the standalone selling price
• When a performance obligation is satisfied and thus, the period in which revenue should be recognized
• What assets should be recognized from the costs to obtain or fulfill a contract with a customer

Entities will want to make sure their reporting makes those questions as easy for their auditors to understand as possible.

Revenue Disclosures

Another common deficiency area relates to revenue disclosures. The PCAOB has found audit deficiencies where revenue was inappropriately disclosed in financial statements. Under the new standard, entities will want to make sure they have accurate disclosures about revenue recognized from contracts with customers, broken into categories by type of contract. They'll also want to clearly state contract balances, including opening and closing balances of receivables, contract assets and contract liabilities. Performance obligations will also be closely examined as well significant judgments made in applying requirements to the contract. Costs related to fulfilling or obtaining the contract will need thorough explanation as well.

How to Prepare for Revenue Recognition Audit Risks

Prior to adopting the standard, entities may want to meet with their audit team or with another knowledgeable resource that can walk through how the standard may affect current processes and practices for contracts. Understanding the changes needed under the new standard is one of the best defenses against financial reporting deficiencies. For comments, questions or concerns about the revenue recognition standard, please contact Mark Winiarski of MHM's Professional Standards Group.

C)

Following factors should be considered:-

1. Make a Internal audit team considering well professionals,

2. Establish a strong internal control system within organization,

3. Allocate the work to different professional,

4. Work done professionals should be cross checked by others

‎C.2)

There are multiple differences between the internal audit and external audit functions, which are as follows:

• Internal auditors are company employees, while external auditors work for an outside audit firm.
• Internal auditors are hired by the company, while external auditors are appointed by a shareholder vote.
• Internal auditors do not have to be CPAs, while a CPA must direct the activities of the external auditors.
• Internal auditors are responsible to management, while external auditors are responsible to the shareholders.
• Internal auditors can issue their findings in any type of report format, while external auditors must use specific formats for their audit opinions and management letters.
• Internal audit reports are used by management, while external audit reports are used by stakeholders, such as investors, creditors, and lenders.
• Internal auditors can be used to provide advice and other consulting assistance to employees, while external auditors are constrained from supporting an audit client too closely.
• Internal auditors will examine issues related to company business practices and risks, while external auditors examine the financial records and issue an opinion regarding the financial statements of the company.
• Internal audits are conducted throughout the year, while external auditors conduct a single annual audit. If a client is publicly-held, external auditors will also provide review services three times per year.

The main similarities between internal and external audit are as follows:

1. Both the external and internal auditor carry out testing routines and this may involve examining and analyzing many transactions.
2. Both the internal auditor and the external auditor will be worried if procedures were very poor and/or there was a basic ignorance of the importance of adhering to them.
3. Both tend to be deeply involved in information systems since this is a major element of managerial control as well as being fundamental to the financial reporting process.
4. Both are based in a professional discipline and operate to professional standards.
5. Both seek active co-operation between the two functions.
6. Both are intimately tied up with the organization’s systems of internal control.
7. Both are concerned with the occurrence and effect of errors and misstatement that affect the final accounts.
8. Both produce formal audit reports on their activities.

A)

When trying to deter fraud, most companies focus their time on developing effective internal control procedures and segregation of duties. Though developing these types of systems are important, a common element of the COSO Internal Control Framework that is often overlooked is the organization’s control environment.

The control environment is important to all organizations since it is the first element of the COSO Internal Control Framework and, more importantly, the foundation of the internal control structure.   The control environment, which has also been described as the “tone at the top” includes management’s integrity and ethical values, management’s philosophy and operating style, and the oversight provided by the board of directors. Many times managers and owners set the control environment for their organization by their actions and thought process without even knowing it. For instance, if a manager is reluctant to follow company policy or consistently demonstrating the quality of getting ahead no matter what the cost, then the manager may be inadvertently influencing the company’s culture and enticing employees to do the same.

To ensure that the control environment is acting as a solid foundation for internal control matters, management should consider the following:
• Develop and implement a code of conduct that states what is regarded as acceptable business practices
• Maintain high ethical expectations with employees, suppliers, customers, investors, competitors, and others. Ethical behavior at the top permeates down throughout the organization.
• Be wary of placing undue pressure on employees to meet unrealistic performance targets, especially for short term results.
• Develop formal job descriptions to define the tasks of a particular job.
• Ensure that the board of directors, if any, exercises oversight relating to financial reporting and internal control.