Analysis of Inventory

The financial crisis that has occurred across the world with the immediate collapse of the Lehman Brothers and HIH Insurance has led the wave of awareness and requirement of change which in turn have led the development and the adoption of the new auditing standard. The change has occurred in the auditing function because of the major reason that the auditor plays a fiduciary role between the auditee and the regulatory authorities. If the auditor hides anything from the authorities and the stakeholders than the uses of the stakeholders will decline and will lead to taking of wrong decisions by them. Through this report, the importance of the audit function has been detailed with reference to the new auditing standard having number 701 namely communicating the key audit matters in the auditor’s report. The report has been divided into two main headings. One is related to the analysis of the inventory of the Advanced Computer solutions Limited and the second is related to the analysis of the property plant and equipment of Green machine Limited. In both of the cases, the key risk assertions have been analysed and the audit procedures which shall be adopted in response to that key risk assertions have been detailed. Then the importance of the new auditing standard in both the cases have been discussed whether the same is required to be reported as the key audit matter in the auditor’s report. If it is required to be reported then what type of disclosure is required to be made and how it is to be made have been discussed. The report has then ended up with the necessary conclusion and recommendation.

In this question, the inventory of the company for the year ending 30^th of June 2018 has been analysed with the information available from the company.   

Following key assertions at risk have been analysed:

1. Valuation– The first assertion at risk which have been analysed is the valuation. It has been identified from the  below mentioned information:

From the above table it is inferred that the closing inventory in terms of the percentage has been increased from the 18% of sales in the year of 2017 to the 26% of sales in the year of 2018. Despite of this increase, the average inventory has been decreased from 5.4 times in the year of 2017 to 3.8 times in the year of 2018. It has been very clearly mentioned that the average inventory has been based on the closing inventory. On the one hand the percentage of inventory in terms of sales has been increased and on the other hand the average inventory has been decreased. It is depicted that some sort of the misstatement is there in the value of the inventory which has been stated in the balance sheet as on 30^th of June 2018. Thus, it clearly shows that the valuation of the inventory which has been done is not correct. If it would have been correct than the percentage of the inventory and the average inventory times would have been higher.   

Key Risk Assertions in Relation to Inventory

Along with this information, more information is available regarding the inventory is that company has been experiencing the high level of sales return due to the problem in the software that the company has launched in this year. If the sales return are at the highest then the closing inventory would have been higher in terms of the percentage of the sales as well as the average inventory. But it is not the case as per the information provided by the company.  

From the above discussion it can be clearly interpreted that the valuation of the inventory has not been done in the correct and fair manner and has undervalued the inventory which otherwise should be higher.

1. Completeness of Accounting of Inventory– The completeness has been asserted because of the reason that the value at which the inventory has been reported and presented in the financial statements does not reflect the true picture of the information that has been made available by the company. From the facts that have been decided and interpreted from the assertion of the valuation, it is explicit that the come doubts can be raised on the accounting of the inventory as to whether it has been completed in all the respects or not before providing the financial statements of the company to the auditor for the auditing purpose. It has been further evidenced by the following further information available with the company:

• Company has moved its inventory from one warehouse to six different warehouse and
• Company has entered into supply of the products to the government department with the various products.
• Company’s sale returns are high due to technical problem in software.

It depicts that the inventory is high and the company has not accounted all the transactions relating to the inventory in accounting books (Bajada and Trayler, 2010). Secondly, company is having the problem in the software and have high sale returns and still the company has been involved in the supplying the various products to the department.  Thus, the assertion of the completeness is also presented in the inventory.  

Auditor is required to perform the audit by following the defined audit procedures. In case of each of the assertion, the auditor is required to perform the following audit procedures:

Valuation – For the assertion of the valuation, following are the audit procedures:

• Physical verification of inventory with Cut Off Procedures– The auditor shall specify the cutoff date on which either the staff of the company or the auditor will start the verification of the stock in the physical terms. By adopting these procedures on the regular basis, the company and the auditor will have the knowledge that the inventory in quantitative terms as shown in the books of accounts tallies with the inventory lying at the premises of the company including the designated warehouses.
• Verification of the Sales Return– As during the period, it has been noticed that the company has encountered the sales return at the highest due to the problem in the software, it is necessary to verify each of the transaction and as to check whether the same have been properly accounted for in the books of accounts.

Completeness – For the assertion of the valuation, following are the audit procedures:

• Verification of Purchase and Sale Bills – The auditor is required to verify each of the purchase and sale bills so as to check whether the same have been accounted for in the books of account or not in an accurate manner. The verification also includes the rate of the items at which they have been purchased and sold.
• External Confirmation– Confirmation from the debtors and creditors shall be obtained as to check whether all the entries have been accounted or not. Confirmation is most importantly required for the parties from whom the goods sold have been returned.      

As per the new auditing standard 701, the key audit matters are the matters which have the significant impact on the presentation of the financial statements of the company. These matters are totally on the part of the professional judgment of the auditor issuing the audit report (AASB, 2015). The auditor’s report these matters to the persons who are assigned and charged with the governance of the company. Auditor is required to undertake the following considerations:   

• Areas which have the risks in significant terms and involved the judgment of the auditor (Thomson, 2017).
• Areas where the appropriate audit evidence is not provided to the auditors or the auditor is unable to collect the audit evidence (Masytoh O, 2010).   
• The appropriate effect of the substantial transactions on such audit.

Inventory being an important part of the current assets as stated in the financial statements of the company, its proper valuation, recording and measurement is of the utmost importance. Following are the key audit matters which shall be reported by the auditor of the company and its necessary disclosures are:

• First key audit matter is the situation where the company has agreed to supply the goods at the price equal to the 10% below the cost price. It is significant because it will be providing the losses to the company and still the company has agreed for the same. The auditor shall disclose complexity which is involved and the chances for going into liquidation (Cordos and Fülöpa, 2015).
• Second key audit matter is that the inventory has been wrongly valuated because of the reason that the inventory in percentage terms has been decreased which otherwise would have been increased due to sale return. Thus, the complexities of the circumstances and the estimates used for inventory valuation led the disclosure as the key audit matter.    

In this question, the property plant and equipment of the company for the year ending 30^th of June 2018 has been analysed with the information available from the company.   

Audit Procedures for Inventory

Following key assertions at risk have been analysed:

Inaccurate Accounting of Expenditure – The first assertion at risk which has been analyzed is inaccurate accounting of expenditure or amount spent by the company in relation to its Property, Plant & Equipment. The repairs and other running expenditure of the machineries are treated as part of cost rather than considering the same in Income statement of the company. On the other hand, major purchase of parts and accessories of machinery is treated as normal running and maintenance expenditure and debited in Income statement rather than treating the same as Cost of Plant and Machinery as per AASB 116 (McKee, 2015)   . It shows the accounting personnel are not performing their jobs in appropriate manner and they have lack of knowledge in context of identifying the nature of expenditure. The impact of this assertions leads to wrong profitability and wrong valuation of Property, Plant and Equipment which is the major backbone for valuation of business.

Improper Accounting Estimates – Accounting estimates are the estimates which has been used in the recording the transaction in accounting books and they are based on past experiences and accounting principles. In the given situation, second assertion which is at risk is accounting estimate used by the company in recording of depreciation (Xu, 2013). The company is using the depreciation rate as per the below table:-

From the above information which has been disclosed by the company in regard to depreciation rate, it shows that the rate of depreciation has been used without considering the useful life of an asset. The accounting estimate should be based on particular value and it should be consistent. The company is using the policy of defining the range for depreciation rate which indicates misleading position of the PPE.

In case of each of the assertion, the auditor is required to perform the following audit procedures:

Inaccurate Accounting of Expenditure – For this assertion, following are the audit procedures:

• Vouching of Expenses- The auditor is required to verify each and every invoices of the expenditure so as to check whether the expenses have been accounted for in the books of accounts under the requisite head or not (Kachelmeier, Schmidt and Valentine, 2016).
• Verification of Internal Controls – Internal controls are the means through which the internal control policies of the company is set under which each of the function is required to be performed under the defined guidelines. The auditor is required to check whether the company has the internal controls system in place or not with regard to the approval of each of the accounting entry under the proper heads.

The new auditing standards require the key audit matters to be communicated with the persons who are charged with the governance of the company. Following key audit matters have been identified and the same shall be reported in the independent auditor report of the company.

• The first key audit matter which has been observed is the accounting of the expenditure with the improper bifurcation between the revenue and capital expenditure. It has affected the results of the financial statements of the company majorly the statement of the profit and loss account. By misleading the stakeholders of the company through the financial statements which are materially misstated, the decision taken by them will be wrong and thus it has the necessary complexities and requires the professional judgment and has the major impact on the audit and thus has been classified as the key audit matter.
• The second key audit matter is regarding the rates of the depreciation which have been used by the management of the company for the different classes of assets irrespective of the fact that some assets have less useful life and some assets have more and thus some are required to be depreciated at the highest rates and some to be depreciated at the lower rates respectively. But the company has calculated the depreciation at the rates which are very low for some of the assets like building and plant and machinery despite of the fact that these assets have less useful life (Xu, 2011). Through this the statement of the profit and loss will not give the true picture of the profit for the year and also the balance sheet will not give the true picture of the net worth of the company including the realizable value of the asset. By having such complexity and the major impact on the audit, it has been classified as the key audit matter.    

Conclusion

The report issued by the auditor plays significant role in the financial industry as all the stakeholders of the respective company on the basis of this report take decisions in response to the company. The decision may be related to the investment in equity or financing of loans by the financial institutions or taking up an employment in the company and etc. With the emergence and the applicability of the new auditing standard, the importance of the auditor’s report has been further increased and the same has been welcomed by the stakeholders including the government authorities. Through this report, the basic and important content of the balance sheet have been analysed. One is inventory and the other one is property plant and equipment. The key risk assertions have been properly identified and the respective audit procedures have been detailed with proper references. In order to conclude the report, the concepts have been exhibited and the importance of auditing function has been properly laid down.       

The recommendation from the findings of the report is that the audit shall be conducted in a much defined manner and the key matters shall be reported so as to enable the users and the stakeholders to make the effective and efficient decision.  

References

AASB, (2015), “ASA 701, Communicating Key Audit Matters in the Independents Auditors report”, available on https://www.auasb.gov.au/admin/file/content102/c3/ASA_701_2015.pdf  accessed at 18/01/2019.

Bajada, C. and Trayler, R., (2010). “How Australia Survived the Global Financial Crisis. The Financial and Economic Crises: An International Perspective”, Edward Elgar: Cheltenham, UK and Northampton, USA, pp.139-154.

Cordos, G.S. and Fülöpa, M.T., (2015), “Understanding audit reporting changes: introduction of Key Audit Matters.” Accounting and Management Information Systems, 14(1), p.128.

Kachelmeier, S.J., Schmidt, J.J. and Valentine, K.,(2016). “The disclaimer effect of disclosing critical audit matters in the auditor’s report.”, Accounting Journal, Vol 5, pp 22-26

Masytoh O, (2010), “The analysis of determinants of Going Concern Audit Report”, Journal of Modern Accounting and Auditing, Vol 6(4), pp 27-36.

McKee, D., (2015). “New external audit report standards are game changing.: Governance Directions, 67(4), p.222.

Thomson, J., (2017), “Five lessons from the Spectacular fall of Eddy Grooves”, available at https://www.smartcompany.com.au/finance/five-lessons-from-the-spectacular-fall-of-eddy-grroves.html    accessed on 18/01/2019.

Xu, Y., (2011). “Audit reports in Australia during the global financial crisis”. Australian Accounting Review, 21(1), pp.22-31

Xu, Y., (2013). “Responses by Australian auditors to the global financial crisis.” Accounting & Finance, 53(1), pp.301-338.