Seminar 3 Flashcards
Q3.1
Saint plc is a computer software company. A review of the company’s board minutes has shown that the company is committed to a period of substantial year on year growth. Sales in the current year have increased significantly above budgeted levels.
The company offers customers a warranty for one year which means that if there are any problems with the software in that first year Saint plc will fix the problems without charge to the customer. The directors have informed you that they have decided to review this warranty policy. The review has resulted in a substantial increase in the amount of money provided in the current year’s accounts to cover future warranty claims.
Requirement;
Discuss the main audit risks arising from this change in policy.
- Completeness and Accuracy of the Provision
Estimation Uncertainty: The provision for warranty claims involves significant estimation. There is a risk that management’s estimates may not accurately reflect the future costs, potentially leading to material misstatement.
Historical Data Reliability: The increased provision should be based on reliable historical data and a reasonable estimate of future claims. If the historical data is not accurate or not appropriately used, it can lead to incorrect provision amounts.
- Revenue Recognition
Revenue Manipulation: There is a risk that the increased sales are not matched with an appropriate increase in the warranty provision, which could distort the financial results.
Timing of Revenue: The company may attempt to recognize revenue prematurely to meet growth targets, while deferring the recognition of associated warranty costs, leading to inaccurate financial statements.
- Management Override of Controls
Bias in Estimates: Management may override controls to manipulate the provision for warranty claims to achieve desired financial outcomes, impacting the reliability of the financial statements.
Inadequate Documentation: There could be a lack of proper documentation and support for the changes in the provision, making it difficult to verify the accuracy and appropriateness of the estimate.
- Impact on Financial Ratios
Solvency and Liquidity Ratios: A substantial increase in the warranty provision can affect solvency and liquidity ratios, which may impact stakeholders’ perception and the company’s creditworthiness.
Earnings Management: Changes in the provision can be used to smooth earnings and manipulate profitability metrics, misleading users of financial statements.
- Disclosure Risks
Inadequate Disclosure: The financial statements must adequately disclose the change in policy and its impact on the financials. Inadequate disclosure can mislead stakeholders about the company’s financial health and management’s decision-making process. - Audit Evidence and Verification
Substantiating the Provision: Auditors need to obtain sufficient appropriate audit evidence to substantiate the provision. This includes reviewing historical warranty claim data, current year claims, and future estimates.
Testing Controls: Auditors must test the internal controls around the estimation process and the recognition of the warranty provision to ensure they are operating effectively.
Overall, the change in warranty policy increases the complexity and subjectivity of financial reporting, which heightens the audit risks. It’s crucial for auditors to apply professional skepticism and robust audit procedures to mitigate these risks and ensure the financial statements present a true and fair view of the company’s financial position.
Q3.2 Shape Limited is a clothing company. It sells its clothes direct to the public both through catalogues and a website. Most customers who use the catalogue order by telephone and the company operates its own call centre. Its combination of fashion and value for money has proved to be very popular with customers and it is currently experiencing its third successive year of rapid growth. Revenue for the current year is expected to be £30 million. During the current year it opened a second distribution centre and has upgraded its computerized ordering and inventory control systems. The company has experienced some difficulties in recruiting and retaining staff to cope with the rapid growth. In particular there have been high levels of staff turnover in the call centre and distribution/dispatch departments. As a solution the company has been actively recruiting students from local schools and colleges to work as part-time staff. Requirements:
(a) Using the information given about Shape Limited above, identify the key audit risks to be addressed by Shape’s external auditors. For each risk identified, your answer should briefly explain why you consider that risk to be significant for Shape’s audit.
- Revenue Recognition
Risk: Given the rapid growth in revenue to £30 million, there is a risk that revenue may be recognized improperly, either prematurely or inappropriately, to reflect better performance.
Significance: Revenue recognition is a critical area for audit because it directly impacts profit and can be susceptible to management manipulation to meet growth targets.
- Inventory Management
Risk: The upgrade of the computerized ordering and inventory control systems introduces risks related to system implementation, data migration accuracy, and the operation of new controls.
Significance: Errors in the new system can lead to misstatements in inventory levels and valuation, which are critical given the nature of the business.
- Staff Turnover
Risk: High staff turnover, especially in the call centre and distribution/dispatch departments, can lead to operational inefficiencies, errors, and potential fraud due to inexperienced or poorly trained staff.
Significance: These areas are crucial for accurate order processing and inventory management, impacting financial accuracy and customer satisfaction.
- Recruitment of Part-Time Staff
Risk: Recruiting students from local schools and colleges may result in employing inexperienced staff, increasing the risk of errors and reducing control effectiveness.
Significance: Inadequate training and supervision of part-time staff can lead to issues in order processing, customer service, and inventory management, which are pivotal for maintaining operational efficiency and accurate financial records.
- Internal Controls and IT Systems
Risk: The rapid growth and changes in IT systems may lead to weaknesses in internal controls, including the risk of control overrides and failure to properly integrate new systems with existing processes.
Significance: Strong internal controls are essential for ensuring the accuracy and completeness of financial reporting. Weaknesses in this area can lead to significant misstatements.
- Going Concern
Risk: Rapid growth and expansion, such as opening a second distribution centre, may strain the company’s financial resources and liquidity.
Significance: Evaluating the company’s ability to continue as a going concern is critical, especially during periods of rapid expansion and investment.
- Compliance with Regulatory Requirements
Risk: Changes in operations and expansion may lead to non-compliance with industry regulations and standards, particularly in employment and consumer protection laws.
Significance: Non-compliance can result in legal penalties, reputational damage, and financial losses, impacting the overall audit opinion.
Conclusion
Shape Limited’s rapid growth, changes in operational systems, and high staff turnover present significant audit risks. Addressing these risks requires thorough review and testing of internal controls, accurate revenue recognition, effective inventory management, and ensuring compliance with regulatory requirements to provide a true and fair view of the company’s financial position.
Q3.2
Shape Limited is a clothing company. It sells its clothes direct to the public both through catalogues and a website. Most customers who use the catalogue order by telephone and the company operates its own call centre. Its combination of fashion and value for money has proved to be very popular with customers and it is currently experiencing its third successive year of rapid growth. Revenue for the current year is expected to be £30 million. During the current year it opened a second distribution centre and has upgraded its computerized ordering and inventory control systems.
The company has experienced some difficulties in recruiting and retaining staff to cope with the rapid growth. In particular there have been high levels of staff turnover in the call centre and distribution/dispatch departments. As a solution the company has been actively recruiting students from local schools and colleges to work as part-time staff
(b) The auditors of Shape Limited are assessing the internal control activities for the computerised ordering and stock control system as part of their audit work programme.
List the internal control activities that you would expect to see in place for the ordering and inventory system if the auditors are to be able to place reliance on the internal controls.
- Segregation of Duties
Order Processing and Approval: Separate personnel should handle order entry and order approval to prevent unauthorized transactions.
Inventory Management: Different individuals should manage inventory recording, physical custody, and reconciling stock levels.
- Authorization Controls
Order Approval: All orders should be authorized by a responsible person before being processed.
Inventory Adjustments: Any adjustments to inventory (e.g., returns, write-offs) should be authorized by management.
- Access Controls
System Access: Access to the computerized system should be restricted to authorized personnel through user IDs and passwords.
Access Levels: Different access levels should be assigned based on job roles, ensuring that employees can only perform tasks related to their responsibilities.
- Data Entry Controls
Input Validation: The system should validate data entry fields to ensure accuracy (e.g., correct product codes, quantities).
Error Checks: Automatic checks to identify and correct input errors before finalizing transactions.
- Reconciliation Procedures
Inventory Reconciliation: Regular reconciliation of inventory records with physical counts to identify and resolve discrepancies.
Order Reconciliation: Periodic reconciliation of orders processed with sales records to ensure completeness and accuracy.
- Automated Controls
System Alerts: Automated alerts for unusual or high-value orders to trigger additional review.
Stock Level Monitoring: Automated monitoring of stock levels to flag low inventory or overstock situations.
- Audit Trails
Transaction Logs: Detailed logs of all transactions, changes, and approvals within the system, which are accessible for audit purposes.
Historical Data: Maintenance of historical data to support audit trails and facilitate review of past transactions.
- Physical Controls
Secure Storage: Physical security measures for inventory storage areas, including restricted access and surveillance.
Regular Stock Counts: Scheduled physical inventory counts to verify recorded stock levels.
- Review and Monitoring
Management Reviews: Regular management reviews of inventory levels, order processing efficiency, and system reports.
Internal Audits: Periodic internal audits to evaluate the effectiveness of internal controls and identify areas for improvement.
- Training and Supervision
Staff Training: Comprehensive training programs for employees on the use of the computerized system and internal control procedures.
Supervision: Ongoing supervision and support for staff to ensure adherence to controls and procedures.
Q3.2
Shape Limited is a clothing company. It sells its clothes direct to the public both through catalogues and a website. Most customers who use the catalogue order by telephone and the company operates its own call centre. Its combination of fashion and value for money has proved to be very popular with customers and it is currently experiencing its third successive year of rapid growth. Revenue for the current year is expected to be £30 million. During the current year it opened a second distribution centre and has upgraded its computerized ordering and inventory control systems.
The company has experienced some difficulties in recruiting and retaining staff to cope with the rapid growth. In particular there have been high levels of staff turnover in the call centre and distribution/dispatch departments. As a solution the company has been actively recruiting students from local schools and colleges to work as part-time staff.
(c) Discuss the steps the auditors could take if weak internal controls were found.
- Communicate Findings to Management and the Audit Committee
Immediate Reporting: Auditors should promptly communicate significant deficiencies or material weaknesses in internal controls to senior management and the audit committee.
Detailed Report: Prepare a detailed report outlining the weaknesses identified, potential risks, and the impact on financial reporting and operations.
- Assess the Impact on the Financial Statements
Risk Assessment: Evaluate the extent to which weak internal controls could lead to material misstatements in the financial statements.
Substantive Testing: Increase the level of substantive testing and perform more detailed procedures on areas most impacted by weak controls.
- Recommend Improvements
Action Plan: Work with management to develop an action plan to address and rectify control weaknesses. This may include redesigning processes, enhancing oversight, or implementing new controls.
Training: Suggest training programs for staff to improve their understanding and adherence to internal control procedures.
- Monitor and Follow-Up
Ongoing Monitoring: Implement a plan to monitor the effectiveness of new or improved controls over time.
Follow-Up Audits: Schedule follow-up audits to ensure that recommended improvements have been implemented and are functioning effectively.
- Adjust the Audit Approach
Adapt Audit Strategy: Modify the audit approach based on the identified weaknesses. This may involve increasing sample sizes, performing more extensive testing, or focusing on high-risk areas.
Use of Specialists: Engage IT or internal control specialists to assist in evaluating complex systems or controls.
- Consider the Impact on the Audit Opinion
Qualified Opinion: If significant weaknesses in internal controls impact the reliability of financial statements, auditors may need to consider issuing a qualified opinion or including an emphasis-of-matter paragraph in their report.
Going Concern: Assess whether the control weaknesses raise concerns about the company’s ability to continue as a going concern.
- Documentation and Evidence
Comprehensive Documentation: Maintain comprehensive documentation of all findings, communications, and actions taken in response to identified weaknesses.
Audit Evidence: Gather sufficient and appropriate audit evidence to support the conclusions reached, particularly in areas impacted by weak controls.
