Management Assertions and Audit Matters in Inventory Valuation

Auditing can be considered as one of the prime tools for the potential investors and other users of the financial statements in order to obtain knowledge and understanding about the financial position and standing of the business entities. Under the process of auditing, the responsibility is on the auditors to conduct inspection as well as examination of the required financial statements of the companies in order to get assurance that there is not presence of any material misstatements in them due to financial manipulation or frauds. At the time of the examination of the financial statements of the companies, along with other important aspects, the auditors are needed to inspect and examine the key assertions that the management has used for the preparation of the financial statements. Assertions are the implicit and explicit claims of the managements of the business entities while preparing the financial statements. Thus, considering the importance of the management assertions, the responsibility on the auditors is to check for the fact that whether there is any management assertion at risk or not. In case they spot any key management assertions at risk, they are needed to consider them as key audit matters and then, they are required to perform the required and appropriate substantive audit procedures for minimizing those audit assertions risk. This study takes an honest attempt to analyze different dimensions of key management assertions and key audit matters from the provide case studies.  

It can be seen from the provide case study of Computer Solution that there is a presence of two key management assertions that are at risk; and they are Accuracy and Completeness. They are discussed below:

Accuracy: At the time of the management of company inventories, both the management as well as auditors put major emphasis on this audit assertion. It needs to be mentioned that the auditors consider this management assertions as one of the major tools for spotting the errors as well as faults in the process of inventory management. At the same time, this assertion also provides major help to the managements of the companies in addressing a problem of inventory management as this assertion assists the management in correct physical count of the inventory along with its correct flow to the income statement as cost of goods sold. The provided scenario about Computer Solution shows the fact that the management of the company has been involved them in the process to move the inventories from six different regional inventory warehouses to one central inventory warehouse. The process to move the inventories or after the completion of the move of inventory may lead to specific kind of error in which the staff responsible for managing the inventory involves in mathematical error at the time of inventory counting. The presence of this kind of error can lead to the reduction of inventory turnover from 5.2 to 3.8 in 2018. In the presence of all these facts, this assertion can be considered as at risk in the auditing process.  

Key Management Assertions at Risk in the Case of Computer Solution

Completeness: This audit assertion is considered as another one of the major assertions by both the management and the auditors at the time of the valuation of inventories. It needs to be mentioned that this assertion puts the obligation on the managements of the companies for keeping the records of all the accounting transactions for the valuation of business inventory in the financial statements. At the same time, this management assertion is related to another major inventory valuation related risks that is risk of understating the inventory. For example, in the presence of some mistakes or errors, the staff responsible for the management of inventory does not record the amount of inventory in the financial statements after purchasing them for the production purposes. It needs to be mentioned that the loopholes as well as weakness in internal control of the companies can lead to the occurrence of this risk. It can be seen from the provide information about Computer Solution that at the end of the year, the amount of inventory in hand consists of both the inventories from 2018 and 2014 that is 22% and 18% of sales respectively. This particular aspect leads to the possible presence of some kinds of errors of financial fraudulent around the inventory management of Computer Solution. Thus, in the presence of all these aspects, it can be concluded that the completeness assertion related to inventory can be at the risk for the financial reporting of the company.    

Substantive Audit Procedures

After the identification of the key management assertions at risk, the responsibility of the auditors is to perform the correct substantial audit procedures with the aim to minimize them; and these processes are discussed below:

1. The earlier discussion indicates the presence of audit risk for the assertion of accuracy in inventory management of Computer Solution and the need for the auditors is to perform the correct substantive audit procedure to minimize them. In this particular case, it is needed for the auditor to adopt the substantive audit procedure of Observation in which the physical count of the inventory of Computer Solution will be observed by the auditor. As a part of this particular substantive audit process, it is necessary for the auditor of Computer Solution to discuss various dimensions of the mechanism of inventory counting with the responsible staffs. Some of the other steps that the auditor needs to take are the careful observation of the inventory counting process, testing specific sample of inventory in order to find any kinds of error in the inventory valuation process and others. It can be seen from the given scenario that there are many storage location for the storage of inventory in Computer Solution. Thus, the major responsibility of the auditor is to ensure that all the inventory storage locations have proper inventory testing and valuation mechanism implemented. Lastly, checking the inventory conformation documents and system can be another good move for the auditor.
2. The next risk of management assertion can be seen in the completeness of the inventory valuation process in Computer Solution. For addressing this assertion risk, the main requirement for the auditor is to perform the substantive audit procedure of that is the Reconciliation of the inventory count in the required financial statements of the companies. While performing this substantive audit process, the responsibility is on the auditors for tracing the valuation of inventory as per the physical inventory counting in the required financial statements of Computer Solution. This audit technique is implemented with the aim to verify that whether there is any error in the physical inventory counting of the companies.  

ASA 701 Communicating Key Audit Matters

ASA 701 Communicating Key Audit Matters puts the obligation on the auditors to follow four major requirements in the assertion risk assessment process and they are discussed below:

1. The first requirement puts the obligation on the auditors for the determination of the key audit matters in the financial statements of the audit clients and then to take into account whether these assertion risks create material effects on the financial statements of clients or not.
2. The second requirement puts the obligation on the auditors for the effective communication of the assertion risks as key audit matters. In this process, the major obligation on the auditors is to give the appropriate description of these key audit matters and the performed substantive audit procedures for addressing them.
3. The third requirement puts the obligation on the auditors for the effective communication of the key audit matters with the employees and staffs of organizational governance.
4. The last requirement puts the obligation on the auditors for the appropriate documentation of the key audit matters in the audit report of annual report of the company.

By applying the principles of ASA 701 Communicating Key Audit Matters, the assertion risks of Computer Solution can be considered as key audit matters. Incorrect valuation of the company inventory can contribute towards the wrong reflection of the financial position of the companies due to the fact that it can affect the financial statements of the company materially. At the same time, the involvement of uncertainty as well as lack of transparency can be seen in the used assertion for inventory valuation by the management. These are the major rationales for considering them s key audit matters.

Substantive Audit Procedures for Key Management Assertions at Risk in Inventory Valuation

It is needed for the auditors under ASA 701 Communicating Key Audit Matters to provide all the information related to key audit matters in the report of the auditors in the annual report. Thus, the major responsibility of the auditor is to disclose the information that supports the decision of the auditors to consider the assertions as key audit matters. At the same time, it is also required for the auditors to provide information about the performed substantial audit procedures for addressing these key audit mattes.   

It can be seen from the provided scenario of Beautiful Hair that the whole situation involves the presence of two management assertions at risk related to intellectual property; they are Occurrence and Ownership. They are discussed below:

Occurrence: It can be considered as a major assertion for the management and the auditor for testing the truthfulness related to the correct occurrence of the acquisition of the intellectual property in the companies. According to the given scenario of Beautiful Hair, the intellectual property related to the secret formula can have material impact on the financial statements and thus, they have considered this as an intellectual property. Hence, this particular assertion can be at risk in case the intellectual property is not acquired correctly.

Ownership: In case of the valuation of intellectual property, this assertion is considered as one of the major aspects for the management and the auditor. Testing the presence of any lawful claim of the intellectual property for secret formula can be considered as the prime intention of the management of Beautiful Hair behind the use of this assertion. According to the given information of Beautiful Hair, the intellectual property of secret formula is valuable and can have major material effect on the financial statements of Beautiful Hair. Hence, it can be concluded that this management assertion can be at risk in the absence of proper ownership claim.  

Substantive Audit Procedures

The next responsibility of the auditor is to perform the appropriate substantive audit procedure for addressing the assertion risks and they are discussed below:

1. Occurrence of accusation related transaction for intellectual property is the first assertion risk in case of Beautiful Hair. In order to address this assertion risk, the auditor of Beautiful Hair can adopt the strategy of verification where the auditor will verify the process of the acquisition of the intellectual property for secret ingredients. In this particular process, it is needed for the auditor to conduct the inspection of all the acquisition of the intellectual property related documents of Beautiful Hair. It is important because the presence of all the acquisition related documents indicates the correct occurrence of the acquisition.
2. As per the earlier discussion, ownership is the second assertion at risk in Beautiful Hair. In order to address this assertion, the requirement for the auditor is to conduct the inspection of all the relevant documents for the title of the intangible assets. This step will assist in making it sure that Beautiful Hair has all the required ownership documents for the acquisition of the intellectual property of secret ingredients. Examples of these documents are title deed and the registration documents. These documents play a crucial role for the auditors for obtaining the evidence related to the ownership of the intellectual property for secret ingredients. The absence of these documents indicates that Beautiful Hair does not have any legal authority for acquiring the intellectual property of secret ingredients.  

ASA 701 Communicating Key Audit Matters

It is needed for the auditors to make compliance with some of the major requirements as per ASA 701 Communicating Key Audit Matters at the time of the assessment of the management assertions. Under these requirements, the responsibility on the auditors is the determination of the key audit matters by taking into account all the material issues in management assertions on the financial statements. The next objective involves in the communication of all of these key audit matters in the presence of the required audit judgments or opinions. At the same time, the requirement for them is to ensure the effective communication of these issues with the senior management employees responsible for the company’s governance. Lastly, they are needed to make the proper documentation of these key audit matters in the auditor’s report.

Management Assertions and Audit Matters in Intellectual Property Valuation

The auditor of Beautiful Hair has considered the issue related to intellectual property as key audit matters in the presence of some rationales. It needs to be mentioned that this assertions at risk related to intellectual property can have major material impact on the financial statements of Beautiful Hair and there will be major impact on the financial position of the company due to the removal of this intellectual property of secret ingredients from the balance sheet of Beautiful Hair.

In this aspect, the auditor of Beautiful Hair is needed to ensure that there is sufficient disclosure of all the information related to rationales for considering them as key audit matters in the auditor’s report in the annual report. Along with this disclosure, it is the obligation on the auditor of Beautiful Hair is to disclose the performed substantive audit procedures with the aim to address these audit assertion related risks that are associated with the intellectual property of secret ingredients of Beautiful Hair.

Conclusion

It can be observed from the above discussion that it is one of the prime responsibilities of the auditors of the companies to consider the assessment of the management assertion risks that can have material impact on the companies. It is evident from the above discussion that the managements of Computer Solutions and Beautiful Hair have taken into consideration four different kinds of management assertions that have been used for the valuation of inventory and the valuation of intellectual property. These major management assertions are accuracy and completeness for the purpose of inventory valuation; and occurrence and ownership for the valuation of intellectual property. According to the above discussion, the auditor of Computer Solution has used different substantive audit procedures for inventory valuation like observing the physic inventory count and reconciliation of the inventory counting process. On the other hand, the auditor of Beautiful Hair has used some other substantial audit procedures for the assertion related to intellectual property like the verification of the acquisition transactions, verification of all the documents of acquisition of intellectual property and others. The above discussion also indicates towards the fact that it is needed for the auditors of both Computer Solution and Beautiful Hair to comply with the principles and standards of ASA 701 Communicating Key Audit Matters at the time to consider the assertion risks.

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