Seminar 2 Flashcards
Explain how auditors obtain an initial understanding of an entity and knowledge of its business environment. (4 marks)
Review of Documentation:
Detail: Auditors examine key documents such as previous financial statements, internal reports, and organizational charts. This helps them understand the entity’s structure, financial health, and operational processes.
Interviews and Enquiries:
Detail: Auditors conduct interviews with management and staff to gain insights into the entity’s operations, control environment, and any areas of concern. These conversations provide a practical understanding of the entity’s day-to-day activities and strategic goals.
Industry and Economic Research:
Detail: Auditors research the industry in which the entity operates, including current trends, regulatory environment, and economic conditions. This context helps auditors identify potential risks and understand the entity’s market position.
Observational Procedures:
Detail: Auditors may observe operations and processes firsthand. For example, they might visit production facilities or offices to see how processes are carried out. This direct observation can reveal practical insights into the entity’s operations and potential areas of risk.
(a) Identify the risk factors, indicated by the finance director’s comments, which you would take into account during the planning stage of this audit (6 marks)
Personnel Changes:
The departure of the former operations director and two contract managers could impact the company’s ability to manage contracts effectively. New personnel may not yet be fully integrated, posing a risk to contract monitoring and customer satisfaction.
Financial Difficulties:
The company is experiencing cash flow problems, indicated by the extension of payment terms to trade payables. This suggests liquidity issues and could impact the company’s ability to meet its obligations, increasing the risk of financial misstatement.
Operational Challenges:
The focus on controlling costs by new management may lead to cost-cutting measures that could affect the quality of services provided, potentially leading to customer dissatisfaction and revenue loss.
Revenue and Profitability:
The company has had a challenging year with a significant drop in gross profit and a shift from profit to loss. This trend indicates potential issues with revenue recognition, cost management, and overall financial health.
Dependence on Contracts:
The principal activity of providing office cleaning services under fixed-price short-term renewable contracts suggests reliance on contract renewals for revenue. Any issues with contract renewals or customer satisfaction can significantly impact financial performance.
Forecasting and Projections:
The directors’ forecast of a return to profitability for the next year relies on assumptions that may be optimistic. This could pose a risk if the underlying assumptions are not realistic or achievable.
(b) Using analytical review, identify the additional risk factors indicated by the figures in the income statement. (9 marks)
Revenue Increase with Loss:
Detail: Revenue increased from £12,698,000 in 2023 to £13,926,000 in 2024. Despite this increase, the company reported a loss before tax of £941,000 in 2024 compared to a profit of £1,269,000 in 2023. This suggests that the increased revenue did not translate to profitability, indicating potential inefficiencies or increased costs that need further investigation.
Significant Increase in Cost of Sales:
Detail: The cost of sales rose significantly from £8,850,000 in 2023 to £11,920,000 in 2024. This includes a notable rise in wages and salaries from £7,578,000 to £10,329,000, which could be due to higher labor costs, inefficiencies in labor management, or increased hiring costs to replace departed staff.
Inventory Management:
Detail: Both the opening inventory increased from £99,000 to £126,000, and closing inventory increased from £126,000 to £266,000. This might indicate issues with inventory management or overstocking, which could lead to obsolete inventory and additional holding costs.
Operating Expenses:
Detail: Operating expenses have increased from £2,540,000 in 2023 to £2,866,000 in 2024. This increase, despite the focus on cost control, suggests that the cost control measures may not be effective or that there are other underlying operational issues.
Finance Costs:
Detail: Finance costs more than doubled from £39,000 in 2023 to £81,000 in 2024. This could be due to increased borrowing or higher interest rates, indicating potential liquidity issues or increased debt levels.
Gross Profit Margin Decline:
Detail: The gross profit margin has significantly declined. In 2023, it was £3,848,000 (30.3% of revenue), whereas in 2024, it was only £2,006,000 (14.4% of revenue). This steep decline indicates increased costs or decreased efficiency in generating profit from sales.
Cash Flow Problems:
Detail: The extension of payment terms to trade payables from 30 to 60 days indicates cash flow problems. This change could strain supplier relationships and affect the company’s ability to obtain credit or favorable terms in the future.
Dependence on Management Assumptions:
Detail: The finance director’s forecast of a return to profitability for the next year relies on optimistic assumptions. This reliance poses a risk if the assumptions are not realistic or achievable, affecting future financial stability.
Impact of Personnel Changes:
Detail: The departure of key personnel and their replacement with new staff focusing on cost control could impact the company’s ability to manage contracts effectively. There is a risk that new personnel might not be fully integrated or as effective, leading to potential inefficiencies and customer dissatisfaction.
