Financial Systems and Auditing

 

Accounting and Auditing Professions

Accounting and audit professions are closely related and provide important information for business managers and stockholders. Such information comprises accounting records, financial statements, and other relevant financial data based on the main accounting principles. The paper examines basic accounting concepts and the need for accounting records as the first task; analyses business risks and fraud mitigation ways as the second task; studies audit procedures and documentation as the third task; explores sample audit opinion and management representation letter as the fourth task.

 

Today, every entity faces the need for accounting and audit; therefore, the latter have to be properly understood and maintained. For this reason, the evaluation of the basic accounting concepts and the understanding of the accounting records are essential for an effective establishment of a proper accounting and financial reporting system in a company. At the same time, the organization needs to evaluate its business risks and attract an independent external auditor to assure its actual financial position and operating results while conducting audit tests of control and transactions details.

This paper covers various aspects of accounting and auditing professions such as recording transactions, providing financial reports, assessing business and fraud risks, and cooperation between an auditor and a client. It incorporates a scenario analysis of a retail company audit engagement with particular problems detected in payroll records. In addition, the paper provides sample drafts of an unqualified audit opinion and a management representation letter.

Task 1

AC1.1

Accounting provides companies management and owners with important information on their financial condition at a given moment and performance during the selected period. In order to present such information, an accountant first needs to collect relevant financial data and introduce it in the accounting books using appropriate accounting records. Generally, an accounting record is entered in a general ledger and accounting books; it consists of the date of the transaction, a double entry of the amounts affecting either the financial condition or the performance of the company on at least two accounts, and possible notes if needed (Hermanson, Edwards & Maher 2011).

Although such records are currently maintained in electronic form using accounting software (e.g., QuickBooks or SAP), an accountant also keeps a range of paper records and documentation to support data in electronic accounting books and reported financial statements. Hard copies of accounting records are usually systematized by a class of accounting items (such as fixed assets and salary books) and contain originals or copies of contracts, timesheets, invoices, petty cash spot checks, etc. Both electronic and paper accounting records are very important for the company to store, as every entity exists on the going concern basis, with financial statements of future periods based on the data from the previous ones. In addition, companies are usually inspected by internal audit committees, independent external audit firms, tax authorities, and other regulatory bodies. Thus, accounting records provide the necessary documentary support for the information contained in the published financial statements and filed tax returns.

AC1.2

Accounting records and financial statements are prepared using fundamental accounting concepts. They ensure reliability and relevance of the provided information as well as its accuracy and adequate presentation. The fundamental concepts in accounting include accrual basis, a going concern assumption, an entity concept, time periodicity, and the monetary unit principle (Walther & Skousen 2009). The accrual basis of accounting requires that income and expenses are recorded when occurred and not when actually paid. For instance, salary to employees can be paid in the first week of January, but expenses and liabilities should be included in December of the previous year when the employees actually performed works, thus, showing actual financial results for the year. A going concern assumption is necessary to accrue expenses and prepare financial statements based on the assumption that a company will continue operations in the observable future (at least for the next year) (Weygant, Kimmel & Kieso 2009). This concept is important for an accountant to record deferred payments such as accounts receivable and payable on the balance sheet. The accounting entity principle states that assets, liabilities, income, and expenses of an entity should be recorded separately from those of its managers and owners. This is especially important for privately owned enterprises and limited liability companies where an entitys assets and liabilities are recorded separately from the owners personal property and debt obligations.

The time period concept allows to divide the observable life of an entity into reporting periods of equal length such as years, quarters, and months. This principle is important for preparing financial statements on a periodical and consistent basis. Finally, the monetary unit assumption requires all accounting records to contain money measurement and use the same recording currency so that amounts are addible. Besides, the chosen recording currency should have stable purchasing power (with inflation under 100 percent per year), ensuring the comparability and stability of the presented accounting reports.

AC1.3

An organization can apply different accounting systems in terms of implemented policies and procedures, purchased and installed accounting software, and the number of the accounting personnel or consultants employed. The nature and structure of the introduced accounting system notably depends on the size of a business, industry specifics, management requirements, budget availability, and several other factors. The size of an entity can be considered as the most definitive factor in the established accounting system.

It is obvious that it is impossible to compare the accounting departments as well as the used software and policies of a local grocery store that provides financial statements to the sole proprietor with a large retail network such as Wal-Mart, publishing US GAAP based financial statements according to the Securities and Exchange Commission requirements. Still, both companies will need some inventory management applications and cash control procedures. At the same time, different nature of the industry and applied business model will impose the need for other policies and procedures as well as accounting software complexity. Thus, a legal consultant firm does not need any specific inventory recording application, while a company selling only bulk orders and paying vendors from the bank account does not need any cash control procedures. Additionally, the management of a company might either require only financial accounting or request some managerial accounting reports that would impose different needs for the software and accountants qualifications (Warren, Reeve & Duchac 2014). Besides, in a wide variety of accounting software available, a company makes an informed choice of the system to adopt in frames of its available budget. This also relates to the implemented accounting policies and possible payments to involved internal and external accounting specialists.

Task 2

AC2.1

The business risk of an organization is directly related to its chosen strategy, business model, the environment of operations, established internal procedures, and the used sources of financing. Respectively, there can be determined five main components of the companys business risk. They comprise operational, project, market, regulatory, and financial risks.

The operational risk of an organization arises in everyday operations. It relates to possible unexpected consequences for a firm due to human errors, technological factors, software processing drawbacks, and inadequate internal policies. Such risk can be partially mitigated by developing strong internal controls and periodical checks of the operations efficiency and compliance with the policies and procedures.

Project risk relates to one-time specific projects of an organization. Unlike everyday operations, projects are constrained in time and usually provide an increase in the companys wealth or customer perception. Project risks arise from improper project management practices (e.g., due to insufficient managers qualification or experience), budgeting gaps, poor scheduling, or misunderstanding of the customer needs. Among the ways of mitigating project risks one can use PERT matrix in order to comprise different probabilities and scenario developments in the project planning process.

Market risk does not directly depend on the internal factors of a company but rather represents a chance of unexpected changes in the external environment that might have a negative impact on the business performance. For instance, market risk appears when new competitors enter the market, existing competitors develop new product lines better suited to the customer preferences, price competition, raw materials cost fluctuations, etc. Thus, an organization can only partially overcome this risk by getting a stronger position in the market and entering into long-term contracts with customers and suppliers.

Regulatory or political risk occurs due to possible new legislation applied in the country where an organization conducts its main business or pays taxes. Thus, new licensing requirements, higher tax rates, nationalization announcements represent significant business risk, especially in the developing economies. Although this risk is not under the control or even prediction of a company, still, it can be partially mitigated by the respective insurance coverage acquired.

Financial risk is primarily linked to the companys financial leverage, used to provide funds for operations. Naturally, higher debt financing increases the financial risk of an entity due to a higher dependency on the interest rates and additional restrictive requirements imposed by the creditors. Besides, this risk might result in a poor solvency position of a company if its operational profit and generated cash do not cover the required interest payments on the debt financing (Epstein 2014). In order to decline the level of financial risk, a company needs to effectively balance debt and equity financing as well as implement sound budgeting practices.

AC2.2

Due to inherent business risks, every company needs to develop and implement a certain control system. The latter covers developed policies, implemented procedures, periodical risk assessment actions, and reactive upgrading measures. Therefore, an effective control system should cover all the aspects of business risks and mitigate them to the greatest extent. Thus, a companys control system can cover such policies as financial policy, HR manual, anti-corruption policy or code of ethics, inventory management policy, procurement manual, etc. When implemented, these controlling policies turn into internal procedures within an organization covering its bookkeeping and financial reporting practices, inventory management requirements, cash controlling, fraud risk, conflict of interests mitigation ways, and other critical aspects of an entitys operations.

Although, usually, a company needs to have a separate policy to mitigate fraud risk (such as anti-corruption policy), all other policies and procedures should incorporate the means of preventing and detecting fraud in specific areas regulated by them within an organization. In this respect, fraud can be defined as purposeful actions of informed parties aimed at gaining personal interest through illegal or unethical ways and happening at the companys cost (Gray, Manson & Crawford 2015). Implemented control system needs to provide guidance for fraud identification. Thus, procurement manual and procedures are to incorporate vendors checks for the possible conflicts of interest with the employees within the company, authorized to select suppliers, especially at the tender basis for large procurement. In addition, an accounting policy should include written management judgments and selected options when the standards provide several possibilities (e.g., in the choice of a depreciation method and fixed assets revaluation practices) in order to prevent inconsistent treatment of accounts and misrepresentation of financial results.

AC2.3

Risk of fraud exists in every business enterprise. It arises from everyday operations and implemented one-time projects. There are several main areas providing an opportunity for fraudulent actions. The most evident example of fraud risk occurs in petty cash operations. For instance, a cashier can purposefully enter incorrect prices in customer bills or not recognize all sales in the cashiers book. Periodic spot checks of the safe and the cashiers desk as well as comparisons with other accounting books can help in detecting such fraud. Another significant and related area is inventory management. Every warehouse provides excellent opportunities for biasing the actual inventory existence and related records in the journals. Thus, an inventory manager may not enter all the positions that arrived from the suppliers in the inventory journal, adjust transfers from a warehouse to retail shops or manufacturing facilities, or conduct excessive write offs of some products that are simply taken away by the manager of other personnel from the warehouse.

Such fraud can be prevented trough the adoption of inventory software and electronic tools to recognize and check the newly arrived inventory or transfers. Furthermore, a company should conduct periodical inventory stocktaking procedures including year-end or semi-annual total inventory stocktaking and several sample spot checks during a year (Brigham & Ehrhardt 2014). Finally, to detect fraud, every entity can adopt companywide measures such as interviews of general staff, external audit of internal controls, critical evaluation of applied accounting estimates and others.

Task 3

AC3.1

A comprehensive audit planning procedure starts with defining the scope of the audit, overall and specific materiality levels and risks related to the audit engagement. The audit of a retail sector company is assumed to be a low-volume and low-risk engagement in terms of inherent risks. The scope of such audit covers the assurance about the companys financial statements such as a year-end balance sheet, the income statement for the audited financial year, and the statement of cash flows. Besides, a company might provide for the auditing notes to the financial statements, as the clients management particularly stresses poor control and the necessity for additional audit procedures to test the payroll section. Materiality level depends on the volume of a companys operations. Generally, it can be stated at 1 – 2 percent of the total entitys assets, the sales volume of the net profit. For a retail company, the best practice is to plan the overall materiality level as a percentage of gross or net sales revenue for the audited period. In addition, specific materiality should be planned for payroll testing as a percentage of the total payroll expenses for the year.

Audit risks related to the engagement include general business risks of a retail company, specific control risks on a payroll section, overall accounting and financial reporting risks, fraud risks, and information technology risks.

AC3.2

Auditors apply audit tests to assure the fair representation of the audited financial statements of a company (Arens, Elder & Beasley 2014). They comprise tests of control, analytical procedures, and tests of details. Tests of control should cover the main sections where internal controls are critical and, at the same time, can decrease the volume of other audit tests applied to operations. Thus, in a retail company, the auditor can conduct tests of control over a payroll cycle, revenue cycle, inventory management procedures, procurement process, and cash operations. The tests provide the analysis of the adequacy of documentary flows, used internal policies and procedures, possible internal audit and spot checks, etc. Further, the auditor works with the analytical tests of related accounts reviewing the main trends, reasons for them, and unexpected or one-time transactions. Finally, the tests of details are applied to every section that was not fully assured by the tests of control and analytical procedures. For this scenario, an auditor should particularly test the transactions of payroll expenses including a sample of the salary payments, vacation and sick leave accruals, other possible fringe benefits to employees, the taxes and social charges paid by the company on salaries and as an employer.

AC3.3

Audit process should be documented starting from the audit acceptance to issuing final reports to the client. Such documentation is required by audit licensing authorities and necessary in case of possible future clients inspections by government authorities or further audits of the same companies. Client acceptance documentation includes the analysis of the business as a whole and the review of the independence of the audit firm and individual members of the engagement team of the audited company. This documentation also includes draft and final engagement contracts as well as a possible interview with the previous auditor. Further, the auditor needs to document the planning stage with the estimation of the engagement risks, scope, and materiality levels. Besides, the planning documentation includes a detailed schedule of audit tests and reporting dates, the results of the cycles tests of control, and the planning meeting memorandum. Then, an audit engagement team starts fieldwork incorporating analytical procedures and tests of details that should be documented for every inspected section to provide the evidence that the auditors have obtained reasonable assurance about the companys presented financial data.

Finally, the auditor documents all the findings in the management letter points and provides the client with an audit opinion on the audited financial statements. Simultaneously, the audit company should receive such documents from the assured company as a management representation letter, the list of transactions with related parties, and the list of legal proceedings if any. In addition, finalizing audit documentation includes the confirmation of the quality control manager that the engagement was conducted with due quality and scope, and the audit opinion is in line with the companys provided financial statements.

Task 4

AC4.1

Draft Audit Report

To the Board of Directors of Example Company

Address of Example Company

Date

The accompanying financial statements of Example Company (hereinafter – the Company) has been audited, which comprises the balance sheet as of December 31, XXXX, and the statement of comprehensive income for the year ended December 31, XXXX.

Management’s Responsibility for the Financial Statements

The management bears responsibility for the preparation as well as fair presentation of all financial statements according to the International Financial Reporting Standards. In order to introduce internal control, the management decides whether it is required to prepare financial statements free from material misstatement, whether due to error or fraud (Eilifsen et al. 2014).

Auditor’s Responsibility

We are responsible for expressing an opinion regarding the financial statements grounded in the audit we conducted in accordance with the International Standards on Auditing. As required by the standards, we comply with ethical requirements and conduct the audit to receive reasonable assurance that the financial statements are free from material misstatement.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the financial statements for the year ended December 31, XXXX are prepared in all material respects, in accordance with the International Financial Reporting Standards.

Audit firm director

Audit Draft LLC

AC4.2

Management Representation Letter Draft

To Director of Audit Draft LLC

Address of audit firm

Date

Dear Director,

This representation letter is provided in connection with your audit of the financial statements of Example Company for the year ended December 31, XXXX. We acknowledge our responsibilities for preparing the financial information in conformity with the International Financial Reporting Standards. We confirm that, to the best of our knowledge and belief, we provided you with all the necessary information and access to the involved persons (Louwers et al. 2013).

In particular, we provided you with all available financial data related to the audited period; measurement methods and management judgments; accounting policies applied; effects of uncorrected misstatements; existing contingent liabilities; and subsequent events after the reporting date. We also disclosed to you all the information on related party transactions and any legal proceedings involving the companys interest. We recognize our responsibility for establishing an adequate level of internal controls and providing you with all available information of detected or suspected instances of fraud and incompliance with the legislation, accounting standards, and internal regulations.

Yours truly,

Chief Executive Officer

Example Company

Conclusion

Financial accounting provides businesses with necessary data about their financial position and operating results. It is based on a range of important accounting concepts and relies on the accounting records maintained by a company. Due to inherent business risks and possible fraudulent actions, every company has to not only properly record its operations, but also establish relevant internal controls and contract an independent auditor, to provide additional assurance about the composed financial statements. An audit firm, in its turn, needs to cover its own risks while imposing a materiality level and documenting the clients risk assessment. In addition, before issuing an audit opinion confirming the companys financial statements, an auditor documents all the stages of the conducted inspection and obtains a management representation letter from the audited client.