Auditing Worst Nightmare

8/8/2019 Auditing Worst Nightmare

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Audit Planning for Portmore Limited

Northern Caribbean University

Date: December 1, 2010

Lecturer: Mrs. P Green

Maurissa Phillips

Joanna Thomas

Tonnette Valentine

Carona Faulkner

Simone Pittter 31090200

Natoya Bennett


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Question One

You are responsible for planning the audit of Portmore Ltd for the year ended March 31, 2010.

Using the information the case study gives about the company as well as the summarymanagement accounts, identify those areas which you consider potential audit risks.

Audit Risk

Control risks

According to the text; Control risk is the risk that a material misstatement that could

occur in an assertion and that could be material, individually or when aggregated with other

misstatements, will not be prevented or detected and corrected on a timely basis by the entitys

internal control. The first area identified as a risk area deal with the fixed assets. This is

considered a control risk area because a material misstatement is likely to occur in quite a

number of the assertions.

In the classes of transaction, as it relates to the occurrence, it should be determined if the

fixed assets that have been recorded actually exist and does belong to the entity. Another area of

concern deals with the classification, the auditor would need to check that the assets have been

properly classified in the appropriate account. An area of concern would be as it relates to

obligation under finance lease. A fixed asset could have been recorded under this category or a

portion of the obligation under finance least could have also been classified as fixed asset and

this would cause the entity to appear to have more assets than they actually do.

The Accuracy of the transactions also might be a risk area, therefore it need to be

ascertain that the correct figures have actually been recorded as misstatement could occur in

recording the transaction as well as the transaction may not be recorded. The completeness of the


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transactions should also be a focus area, in that you want to ensure that all the fixed asset that

should have been recorded and account for have actually been recorded.

As it relates to the account balances the auditor has to check the valuation and allocation.

The correct figures ought to be recorded in the financial statement and this is likely to be a risk

area as omission or misstatements could occur from human error. A material misstatement in the

rights and obligations could also occur, in that the balances represent the entitys financial

position but do they really have the rights to the assets listed and also whatever liability

mentioned as well is the entitys obligation.

A material misstatement could occur in the presentation and disclosure of the fixed

assets, as it relates to the accuracy and valuation, completeness and occurrence and rights and

obligations. In the presentation and disclosure it needs to be ascertained that the correct amounts

have been recorded and that the stated values of the fixed assets are the actual values and that

assets are not over or under stated. The completeness of the presentation relating to the entity

fixed asset is also a risk area, in that the auditor will have to determine if all disclosure that

should have been included have been included and are correct. For example, as it relates to fixed

assets, disclosure as it relates to the depreciation thereof should be made in order to have to

correct valuation of that asset. Also the method of depreciation used is another factor that could

affect the value stated, therefore the entity have a have a clear understanding as to how

depreciation is to be calculated. And finally as it relates to disclosure, the occurrence and rights

and obligations need to be checked to ensure that all disclosures made relates to the entity and

they are aware of their obligations that have been stated.


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receivable that would state that credit sales were made either, so the accuracy and valuation of

this figure have to be a point of interest.

A material misstatement is likely to occur also in relation to the debtor therefore the

accuracy of those transactions needs to be focused on to determine if the transactions have been

recorded appropriately. The completeness is also a key area that should be audited to that all

transactions that should have been recorded have actually been recorded pertaining to debtors.

Also included in the risk that results from debtors, the issue of bad debt also needs to be taken

into consideration. Are provisions made in this regard and are the figures disclosed the actually

debtor figure that have been collected.

Due from subsidiaries can also be a risk area for material misstatement in relation to the

accuracy, occurrence and completeness of the transaction. It should be identified if these

transactions actually exist and the stated amounts are the correct figures. In P ltds financial

position there was no record for one period, we need to determine with information from its

subsidiary.

Another key area where material misstatement could occur relates to cash and bank, as

was stated earlier, for the period 31.3.09 to 31.12.09, there was no cash or bank figures present.

The focus should be more on the cash as oppose to the bank because there is a bank overdraft for

the period so that prove that there really was no cash at bank, however a bank statement could

further clarify this. So the area of focus ought to be on the accuracy, occurrence, completeness

and valuation and allocation of cash and bank.

Relating to the accuracy, the emphasis is placed on the account balance as well as the

presentation and disclosure. Are the balance presented a true presentation of the entitys cash and


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bank balance. In this area material misstatement could have easily been made whether by human

error or otherwise. Therefore it has to be ascertained if the transactions have been recorded

appropriately. We also need to check the completeness of the transactions ensuring that all the

transactions that should have been recorded have been recorded and all disclosures relating to

cash and bank have been included. We have to ensure as well that the valuations are appropriate

and if any adjustments should have been made that are not accounted for.

Inherent Risk

Inherent risk is defined as a risk that the account or section being audited is materially

misstated, without considering internal controls, due to error or fraud. In simpler terms, inherent

risk is the risk related to the nature of the activities. The auditor has no control over the level of

inherent risk. The assessment of inherent risk is solely dependent on the judgment of the auditor

and all available knowledge. Because of this, the auditor needs to consider the nature of the

entity, the nature of the strategy it adopts, the complexity of determining the account amount as

well as past history.

From the assessment done of Portmore Limited Company, the following inherent risks were

found:

Inherent risk at the entity level

One way of assessing inherent risk is to look at managements operating style. Kooyah

imposes a management fee on its subsidiaries to reflect their share of the services

provided for them by the group. However, this fee is determined centrally and is out of

the control of subsidiaries. The sum charged for management fees is material since


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Kooyah is liable to tax on it. There is no set way in which the fee is calculated, if there is,

it should be disclosed. There is an inherent risk since this fee could be easily manipulated

by management to suite their purposes. Management charges decreased by 60% on the

year ending March 31, 2009. After that year end, there was another decrease of 11% in

the months leading up to the 31st of December that same year. In addition the actual

figures for management fees are much higher than the budgeted figures. As auditors we

would approach this risk using the assertion accuracy and valuation as it relates to the

presentation and disclosure of information in fair and appropriate amounts. Since the

final company budget is approved by both the management team at Kooyah and the

divisional heads of P Ltd, there should not be a vast variation in budgeted figures for

management fees and the actual. .

There is also reason, as auditors, to examine closely how the group prepares its budget.

The system is very complex. Budgeted figures are material because this is what is

presented to investors and other users of this information, who will then make serious

economic decisions by predicting the performance of the company. Budgets can also be

seriously subjective, thus the assertion mentioned above would be used to assess this risk.

Inherent risk at the account balance and transaction level

The processes of making cardboard is highly automated, thus fixed assets are very

important to P Ltd. Because of its importance, the fixed asset balance is material and

subjected to inherent risk. There has been an 18% increase in fixed assets in the previous

financial year, plus an additional increase of approximately 4% by the end of December

in that same year. This is not strange; according to the interview done with the managing


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director, they have been steadily upgrading their fixed assets. However, the fixed asset

ratio has decreased where there was an increase in fixed assets. This could be interpreted

to mean that sales are low or the investment in plant is too much. As auditors we would

need to test the existence of such assets and if they are valued correctly since there is the

likelihood that scrapped inventory are not written off the books or that tools and

equipment used in production are stolen. The company also leases some of its assets;

therefore inherent risk in valuation is high. The property rights and obligation and

classification risk is also high since under the lease there may be confusion as to who

actually owns the asset. Leased assets should be capitalized, if it is left out of the

financial statement of position it could lead to a material misstatement.

The statement of financial position shows that stocks which were valued at $441,000 at

the end of the financial year March 31, 2009, was valued at $280,000 (a 57.5% decrease)

by the end of December of the same year. The stock figure is of critical importance as

these are the materials needed for production. As it relates to stocks there is a high

inherent risk with respect to the existence and valuation assertions. Special procedures

are sometimes required to determine stock quantity and value; if these are used they

should be disclosed in the financial statements. Accounting for stocks also includes

accounting for wastage and goods returned to supplier. In addition, if stocks are stored at

different sites, it would be hard to maintain physical control over theft and damage.

The debtor balance reported in the 2009 accounting period is an increase of

approximately 9%. Since then, the figure went up again by 4%. The Debtor turnover

ratio implies that P Ltd is inefficient in managing debtors or that they have less liquid

debtors. The debtor balance is material; the sooner receivables are received, the sooner P


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Ltd can reinvest in their business or fund operations. Because of its nature, the debtor

amount can be easily misstated or manipulated. There may be pressure, and due to the

low level of sales it is reasonable to assume there is pressure, to overstate the debtors

balance by writing off accounts as uncollectable to conceal fraud. Management can also

overstate cash and debtors balance to project a higher working capital. As auditors we

need to find out if the debt balance is existent as stated. Accuracy and valuation assertion

Bad debt provision is an estimate therefore, it is has an inherent risk. Provision for bad

debt reported at the end of the financial year March 31, 2009 was $2000 a decrease of

50% from the previous year. By December 2009, there was a 100% decrease. The

amount written off emptied the provision account. If the amount which depleted the

provision for bad debt account was more than $2000, then this could lead to a material

misstatement in receivables. The inherent risk would be related to the accuracy assertion

since there is the risk that the appropriate amount is not stated in the statements.

Overheads another estimate is also an inherent risk related to the accuracy and valuation

assertions. The identification, measurement, and allocation of indirect materials, labour

and manufacturing overhead require an appropriate allocation or apportionment method

which should be disclosed. If an incorrect measurement or valuation method is used , for

example using direct labour hours instead machine hours to determine the rate at which

overheads are to be charged in a machine intensive department, will not give a fair

representation of overheads used in that department.

Depreciation is susceptible to material misstatement because it is an estimate. There is an

inherent risk relating to existence, accuracy and valuation assertions. At the end of the


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financial year ending March 31, 2009, the statement of financial position showed an

increase in fixed assets, however, the income statement did not show an increase in

depreciation. An increase in fixed assets would normally mean an increase in

depreciation. If this was because there was change in the method of depreciation, this

should be disclosed in the financial statements so that users of the information can be

aware of this change. As auditors, we would have to make sure that this change of

method will enhance presentation and accuracy and will give a true and fair view.

Detection Risk


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Question Two

Based on the trends in the management accounts, what questions should the auditor ask in order

to gain a fuller understanding of P Ltds performance and Prospects?


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Analytical Review

P Ltds asset turnover for the financial year ending March 2008 was 3.14 and this shows a 3%

decrease at the year ending March 2009 to 3.04. The budgeted ratio for the nine months period to

December 2009 in the current financial year is 2.22 but the actual ratio for the same period is

2.16, which is also a 3% decrease. The projected ratio (actual figure used) for the full financial

year to March 2010 is 2.88, which is a 5% decrease asset turnover. This decrease is in line with

the Managing Directors statement that the company is updating fixed assets. Compare this to the

revenue for the same period however, shows that the additional assets are not generating the

anticipated revenue. For the financial year ended March 2008, revenue was $3,769,000 and this

did increase by 5% at financial year end March 2008 to $3,949,000. The nine months in the

current financial year to December 2009 showed revenue of $2,952,000 a decrease of 5% from

the budgeted amount of $3,115,000 in the same period. Additionally, if we use the actual

revenue for the current financial year and project it to the year end assuming that revenue is

accrued equally this amount would be $3,936,000, almost on par with the previous year and

5% below the budgeted revenue of $4,153,000 for the full year ending March 2010. The

Managing Director states that he wants to increase sales by 5% annually; however the company

is not using the assets efficiently enough to make this happen.

The Debtors turnover ratio has decreased from 9.08 at financial year end 2008 to 8.70 the

following year, a 4% difference. The nine month period of the current financial year also showed

a 5% decrease of 6.23 from the budgeted amount of 6.53. Receivables have been increasing

steadily over the years, going from $415,000 to $454,000 at financial year end 2008 and 2009

respectively, and the amount at the end of the nine month period for the current year, $474,000,


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was only slightly lower than the budgeted amount of $477,000. This suggests that the company

is finding it harder to fully collect its receivables.

The average collection period ratio increased steadily over the period under review,

moving from 40.19 as at March 2008 to 41.96 as at March 2009 and further to 43.99 at

December 2009. The budgeted time line of 41.96 days is less than the actual time it takes to

collect its debts, that is, 43.99 days. This suggests the company is having liquidity problems,

because they are taking longer to pay their bills. Evidence of this is also found in the current and

quick ratio, the current ratio being below 2 and the quick ratio being below 1 for the period under

review. Both current and quick ratio fell from 1.37 at financial year end 2008 to 1.19 at 2009 and

0.79 at financial year end 2008 to 0.60 at 2009 respectively. If the company is unable to pay their

bills, eventually there will be a going concern problem.

The cash on hand and in the bank at financial year end March 2008 of $101,000 were

completely used up and the company reported a bank overdraft of $29,000 in the Statement of

Financial Position as at March 2009. Based on the budget for the current year (nine months), this

overdraft should have been paid and $6000 balance incurred at the bank. This is not referred in

the actual figures for the same period and overdraft instead increased by $1000 to reach $30,000.

Finance charges are of particular concern because the company has no outstanding loans and

because there are no finance charges for year end March 2008 even with obligations under

finance leases due, it is assumed that the finance charges are for the overdraft only. Charges for

the financial year ending March 2009 was $48,000, 165% of the overdraft amount; likewise for

the current financial year (full) the budgeted amount is $43,000 which means that this is

expected, even with the anticipated positive bank statement.


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The Return on Capital Employed (ROCE) is 16% as at March 2008, 17% as at March

2009 and 8% for the nine months in the current financial year. A company must have a ROCE

that is greater than the rate at which it borrows and this is not nearly enough to cover the finance

charges for the bank overdraft, which seems to be 165%.

Dividends from subsidiaries were not received in the financial year ending March 2009.

Additionally the budgeted amount for the current financial year was $50,000 but the actual

amount received was $30,000.They are either not pulling their weight or are re-investing profits.

Indirect and direct labour has increased over the period under review, so too has the

office salary. The Sales representatives salary decreased significantly over this period but the

commission has increased. This suggests that a lower number of sales staff is being used and

could explain the less than anticipated revenues for the company.

Questions

1. Are there any specialized customers who get a longer time to pay their bills?

2. If yes, what factor determines which customer gets this VIP treatment?

3. What procedures are in place to collect the debt owed to the company?

4. Are the acquired assets in proper working order?

5. Are all assets in the statement of financial position used by the company in their normal

operations?

6. Are the assets producing the expected output?


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7. What is the interest charge on the bank overdraft?

8. What method is used to allocate overheads such as light and power?

9. Is there a set schedule for the maintenance? What type of maintenance is done on the

companys assets? For example do you have preventative maintenance and then a general

one say every 3 or so years?

10. What series of work does maintenance cover? Meaning, what is classified as

maintenance, for example, machine, equipment, plant, grounds.

11.What factors determine if the item is classified as consumables? If value is a factor, what

is the maximum value?

12. How do you treat the recording of your assets that are on the finance lease contract? Do

you record the interest paid or owed separate from the principal?

13. Does office staff clock in the same as production staff? Was new office staff employed

or was overtime done?

14. Are there any Legal issues that the company is currently involved?

15. What elements make up the management charges?

16. How profitable are the subsidiaries of P Ltd?

17.Was there a reduction in sales staff or was there a renegotiation of salary and

commission?

18. If sales staff is cut, why is the company paying more for commission?

19. Are all assets insured?

20. Who is authorized to approve cheques and purchases?

21. What are the correct procedures this company uses to pay out overtime?

22.

Auditing Worst Nightmare

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