AUDITING II HANDOUT PROBLEM 4 Name Section Essay Question (10 points). Your firm

Question

AUDITING II HANDOUT PROBLEM 4 Name Section Essay Question (10 points). Your firm has just recently obtained an audit client that has been growing rapidly. The company's stock is actively traded in the OTC (over the counter) market and believes that it has grown beyond the services that its former auditor can provide. However, you find that upon contacting the previous auditor, the reason for the change in auditors is really due to a dispute over how to recognize income on the client's contracts. The client wanted to recognize income on contracts for items that had been produced but not yet shipped to the customer. The client's rationale for taking this position is that the contracts were firm, and that all the principal revenue producing activities had been performed. Ifthe client had used this approach to recognizing revenue, net income would have increased by 35% during the last year The client is 40% owned by the CEO of the client who has a reputation for being able to tum around businesses that are in trouble. He bought out some of the previous owners three years ago. The company's primary products are in the materials handling industry, such as automated conveyors for warchouses and production lines. This new CEO has increased profits by slashing operating expenses, primarily personnel and research and development. In addition, he has outsourced a significant portion of component part production. Approximately 10 percent of the company's product is now obtained from a privately held corporation that is 50% owned by the CEO and his brother A brief analysis of previous financial statements shows that sales have been increasing by approximately 20% per year since the new CEO assumed control. Profitability has increased by an even larger percentage. However, a tour of the plant gives the impression that it is somewhat old and not being maintained up to current standards for the industry. Additionally, a large amount of inventory is sitting near the receiving dock awaiting final disposition. REQUIRED: ( Identify the elements of inherent risk associated with the revenue cycle that the auditor should consider as part of planning the audit For each element of inherent risk identified, briefly indicate the audit concern and suggest audit procedures to address the risks. (2)

Explanation / Answer

The elements of inherent risk associated with the revenue cycle that the auditor should consider as a part of planning audit:

Inherent risks are generally cased due error or misleading informations in the financial statements rather the failure of the control procedures. the various indicators of the inherent risk are:

1. Business environment : in the walk through test of the company it is seen that the infrastructure of the plant is not maintained and upto date , it is also seen that is awaiting its final disposition. Therefore the genuieness of the production capacity and the sales transactions are to be scrutinised.

2. Reduction in operating expenses : there can be high chances of mistating revenue by understating the expenses and inflating the value of profits . it is said in the above case that company has slashed its operating expenses in its research and development wing by outsourcing the purchase of product from a corporation co-owned by the company CEO. this can lead to a chance of a highly circutious transaction to mistate revenue.

3. understating the companys accounting policy: the auditor has to ensure that the companys accounting policy conforms to the relevent standars set . especially the revenue recognition policy has to be deeply studied as the client company wants to recognise income for the items produced but not yet shipped . this escalates the turnover with no actual sale or revenue recognition.

4. possibility of mere book transactions: there can be possibility of the transactions that mere book entries and not real . here in this case study it is mentions client purchases 10% product from the corporation co owned by its CEO . this has to be verified as to its genuiness.

5. Confirmation from previous auditor: it is very important to obtain information from the previous auditor as to reason for the withdrawal of the assignment and also the key activities of the company that has to be monitored

The audit procedure to be followed for each inherent risk addressed above:

1. A background study on the company , its market share , industry position , trend analysis in order to learn about its effective working condition

2. The accounting policies and procedures of the client entity has to be studies and confirm that it is as per the acceptable standars of the industry

3. the book transactions such as purchase, sale and expenses must supported by sufficient and appropriate evidence inorder to vouch its genuienity eg. the sale has to be supported by cash inflow and reduction in inventory as well

4. The debtors and creditors conformation from the management to is be obtained to check the revenue cycle of the client company . it helps to keep track on the payables and recievable and their periodic settlement

5. study of the tems and conditions of the contracts entered into by the client company inorder to asses its impact on the revenue recognition

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