Auditing & Assurance

Assignment: Auditing & Assurance

Introduction

The report on the auditing measures of ABC Learning Center Ltd (ASX code – ABS) has disclosed the major areas of risks and the factors that can affect the going concern concept of the company. The report also analyzes the possible areas of concern for the two companies and how does it impact the quality of the financial report.

Ratio Analysis

The auditors generally review the ratios for sales, accounts receivable, current assets, etc and compare them over time, to identify any unusual trends. If so, they are likely to make inquiries for reasons behind the trend change. The important financial ratios that are utilized by the auditing team, which is responsible for the efficient Analytical assessment of the historical financial records, basically fall under the below mentioned general categories:

Profitability/Return

• Net Margin

The net profit margins are continuously decreasing YOY despite increasing levels of revenues. The main reason observed to be the net interest expense, which shows a steep rise in the last couple of years. Also it will be interesting to note that the short term debt increased by a whopping 14000% YOY in the financial year 06/07. 

Liquidity/Efficiency

• Receivables Turnover Ratio: The AR TO ratio has jumped from 8 times to 18 times in FY 07 as compared to previous. The analysis indicates two main reasons, the sales increment by almost 3 times and the AR decrement by 42%. The decrement in AR is a sudden event after witnessing a continuous rising trend. Also, the cash pools are continuously increasing and jumped by a 70% YOY. The questions arise, why the company is collecting large amount of money from the market.

• Current Ratio: The current ratio following a rising trend and getting closer to the ideal ratio of 2 in the previous, suddenly sunk in FY 07 from 1.81 (in 06) to 0.27. This ratio is despite a rising trend in the current assets, but current liabilities increased by a massive 850%.

Also from the above point, it has been specified that the company is collecting large money from its receivables and filling its cash pools, but on the other hand it is not paying its trade payables and other current liabilities.

Another point to be noted is that with current ratio of as low as 0.27 of the company for FY 07, it will likely to face high liquidity issues and, will not be able to pay its current obligations.

Beneish M-Score models

The model uses various financial ratios and specified eight indexes to determine any manipulation in the earnings of a company. It is typically used by auditors to identify any financial fraud.

As per the model, an M-Score lower than -2.22 indicates that no manipulation has been made by the company. And a score more than -2.22 reflects that substantial manipulations have been conducted by the company to inflate or deflate its earnings.

As per the above M scores of ABC, the company seems to be a profit manipulator till FY 06 as the score remains higher than the threshold of -2.22, and the score is getting worse YOY. In the FY 07, the M-score unexpectedly jumped from red zone to green zone and recovers from -1.34 to -2.35. However, the above ratio analysis indicates that company is continuously engaged in manipulations in the financial statements and earnings of the company.

Audit Procedures

The following substantive audit procedures can be followed at ABC for the above mentioned audit analysis

• Physical inventory valuation: This process is related to the counting of stocks physical by making personal visits at the location sites where the goods are stocked. It is require by the auditor to properly pre-schedule this type of audit processes to avoid inconvenience that can occur in the business activities. The auditing team is also required to instantaneously investigate if any differences have been observed amongst the recorded figures and the physical count made by auditor (Groomer and Murthy 2018).
• Reconciling valuation of inventory to the general ledger: The auditing team is required to check the valuation of inventory after completing the physical counting of inventory with the sales books and purchase book (or records) of the company. A basic check includes calculation of the ending inventory by considering the beginning inventory (or ending inventory for previous financial year), the sales records and the purchase records. The formula is:

(Net purchases + Beginning inventory) – Net Sales = Ending inventory

It ensures discrepancies in inventory valuation can be identified and proper rectification can be implemented. The discrepancies that can occur due to some human error, machine error or sue to any other reason. For the case of ABC, the auditing team is required to crosscheck the inventory previously counted with the sales records and purchase records.

Risk Assessment and Areas of Audit Focus

Conclusion

As per the above analysis, the auditors must have identified areas and accounts that are exposed to material misstatements. The company, on the basis of M-Score can be declared to be engaged in manipulations of earnings. The ratio analysis shows various areas that seem to be abnormal or unusual than the past year’s trend.

Reference

Auditing and Assurance Standards Board. (2019). Pronouncements. https://www.auasb.gov.au/Pronouncements/Australian-Auditing-Standards/ASA-701-2015.aspx/

Brown, N.C., Pott, C. and Wömpener, A., (2014). The effect of internal control and risk management regulation on earnings quality: Evidence from Germany. Journal of Accounting and Public Policy, 33(1), pp.1-31.

Cohen, J., Krishnamoorthy, G. and Wright, A., (2017). Enterprise Risk Management and the Financial Reporting Process: The Experiences of Audit Committee Members, CFO s, and External Auditors. Contemporary Accounting Research, 34(2), pp.1178-1209.

Federal Register of Legislation. (2019). Details: F2009L04079. https://www.legislation.gov.au/Details/F2009L04079/

Groomer, S.M. and Murthy, U.S., (2018). Continuous auditing of database applications: An embedded audit module approach. In Continuous Auditing: Theory and Application (pp. 105-124). Emerald Publishing Limited.

Junior, R.M., Best, P.J. and Cotter, J., 2014. Sustainability reporting and assurance: a historical analysis on a world-wide phenomenon. Journal of Business Ethics, 120(1), pp.1-11.

Zhang, J., Yang, X. and Appelbaum, D., (2015). Toward effective Big Data analysis in continuous auditing. Accounting Horizons, 29(2), pp.469-476.