Identification of unresolved problems
From the given information in the case study, I shall now outline some of the points which need to be discussed further and which may have an impact on the financial statements of the firm:
Stock count at Acton
It is stated that, due to unavailability of stock, the actual physical count was not performed at the site. From the perspective of performing comprehensive risk based audit, it is critical that all aspects of stock valuation must be comprehensively performed in order to ascertain the correct valuation of the stock. Not performing the actual physical stock count may result either into under-valuation or over-valuation of the stocks in the books of the firm. Further, it is assumed that no further provisioning is necessary in order to account for any changes in the value of stock arising out of the damage or obscellence of stock. Without reasonable assessment, it is again probable that the profitability of the firm may have been over-stated.
The impact of stock over-valuation of the financial statements may result into less cost of sales being recorded into the books of the firms. As such, the overall profitability of the firm may be over-stated to a great extent and this again may mislead the investors/shareholders to make wrong assumptions about the future profitability of the firm. Furthermore, it is critical to note that auditor needs to be proactive in his approach to identify internal control lapses, and as such non-counting of stock may reflect upon the internal control weakness of the organization.
Probably the most important issue that needs to be explored is the inclusion of the loan into accounts receivables. As per the prevailing accounting standards and laws, the loans to firms are reflected in the non-current assets of the firm under investments. In addition to being included into the trade debtors, this loan has to be of less than one year, which is unfortunately not the case. It is therefore critical that the loans to the related company shall be reclassified as investment rather than accounts receivables. The potential impact of this may be the deliberate overstatement of the current assets of the firm to improve the current ratio and provide a favorable picture of the liquidity of the firm.
Furthermore, the procedures adapted for the confirmation also need to be done through writing letters to the firm. The confirmations required may include confirmation for balances as well as proper classification of the receivables in the books of Perfect Pizza. In this regard, it is therefore critical that the auditor must obtain confirmation of the same from Perfect Pizza and investigate any discrepancies that may arise as a result of the disagreements in the balances.
A broader understanding of the ageing of the receivables shall also be obtained in order to confirm the unconfirmed balances and perform further procedures in order to ascertain their true nature by performing adequate ageing analysis. A proper ageing analysis will determine how much provisions are required against such accounts and subsequent adjustments of the financial statements of the firm.
A similar process also needs to be adapted for the unconfirmed balances of debtors, as well as further investigate any sales returns, and check whether the receivables have been adjusted properly. The important issue of disagreement on one invoice also needs to be checked and confirmed whether the firm has recorded any revenue against this transaction and whether adequate provision has been recorded.
Revaluation of Assets
Prudence requires that the fixed assets of the firm must be revalued by an independent surveyor or valuator. However, in this case, the same has been done by one of the Directors which ultimately may be overstatement of the valuation as surplus arising on the revaluation forms the part of the equity of the firm. Further, it is important to note that the revaluation surplus is showed by increased the value of the assets as “additions” which is not the proper treatment. It is therefore critical that the firm’s policy for recording the additions of assets shall be reviewed and checked as to what are the criteria under which additions to the assets are recorded.
This therefore not only indicates significant control lapses but also indicates deliberate overstatement of the asset values. It is also mentioned that the additions to the assets have been overstated as the investments into new additions have been accrued rather than including them into the capital commitments. Due to this, not only the cash flows of the firm have been affected but also the overall assets have been overstated thus strengthening the balance sheet of the firm.
How problems need to be resolved
The above discussion broadly set out some of the unresolved issues and how they may affect the financial statements of the firm. The above discussion also outlined as to how these issues will be corrected in order to ensure that the accounts are prepared in accordance with the generally acceptable accounting standards and prevailing audit procedures.
To discuss them in more detail and provide a comprehensive analysis of whether further investigation needs to be undertaken as well as utilizing other means in order to further clarify the issues:
There is a need to perform further tests in order to correctly identify the nature as well as exact valuation of the stock. Though a complete physical count may not be possible, it is critical that further tests must be undertaken. Thus, certain substantive procedures must be undertaken in order to further clarify the matter. Some of the tests may include:
- A comprehensive review of the procedures for releasing and taking stock at the point of sales as well as purchase. The basic purpose shall be to check and verify the adequacy of different methods adapted by the firm to record the stock and its movement. Also, a representation from the management regarding the adequacy of the procedures will further provide a comfort level to the auditors in terms of ensuring that the internal controls are adequate to ensure that the stock is properly recorded in the books of accounts.
- The auditor need to check whether the stock at Acton has been valued at NRV or cost, whichever is lower. This is just to confirm that the stock balances are properly recorded and are in accordance with the generally accepted accounting principles. Further, the auditor also need to confirm that there were adequate segregation of duties at the depot and that the stock purchasing and releasing is done by different individuals within the firm with proper supervisory oversight.
- The auditor also needs to perform a comprehensive analysis of whether the firm has made any provisions against the diminution in value of stocks historically. If the firm has historically made such adjustments in the past, then the claim of depot manager may not be substantial and further tests need to be performed.
The most adequate method of overcoming the issue of accounts receivable shall be asking the management to alter the accounts and properly classify the different items shown under accounts receivables. The alteration of the accounts will include changing the current assets of the firm and properly adjust the accounts receivables and secondly, the loans given to the related party shall be shown under the heading of non-current assets.
In addition, there is a need to perform certain other routine tests before altering the accounts. Some of the tests that may be required to ascertain the complete picture of the accounts receivables will include performing the ageing analysis. This was also discussed in first section of the report and it is critical that the ageing analysis must be performed. A proper ageing analysis will allow the auditor to compute adequate provisioning for bad debts and will help to adjust the accounts.
A representation from the management regarding the disputed transaction is also necessary in order to further ascertain its correct nature. In this regard, it is also critical that the auditor must further perform some tests and try to check the audit trail in order to verify that goods dispatched were in normal conditions or not. Further, if the claim is correct, it also becomes necessary to check whether any insurance clauses were inserted and if yes, whether it has been claimed by the firm. Finally the adjustment of accounts is necessary in order to account for this transaction.
Management representation is necessary in case of a valuation performed by one of the Directors. Management representation, however, clearly indicates that all due prudence has been exercised while revaluing the assets of the firm. It is also possible that the auditors may ask for a fresh and new revaluation in order to correctly assess the value of the assets and re-adjust the accounts accordingly. If management disagree with the auditor’s decision for asking for a new revaluation, then a qualification into the audit report may be necessary in order to ensure that the matter is brought to the attention of the stakeholders. However, this must be in accordance with the threshold set for materiality because addition is only of £400,000/- which needs to be compared with the overall materiality level set by the auditor.