(ii) Audit risk
Management were disappointed with 2009 results and hence undertook strategies to improve the 2010
trading results. There is a risk that management might feel under pressure to manipulate the esults through the judgements taken or through the use of provisions.
A generous sales-related bonus scheme has been introduced in the year, this may lead to sales cut-off errors with employees aiming to maximise their current year bonus.
Revenue has grown by 28% in the year however, cost of sales has only increased by 10%. This increase in sales may be due to the bonus scheme and the advertising however, this does not explain the increase in gross margin. There is a risk that sales may be overstated.
Gross margin has increased from 44•4% to 52•2%. Operating margin has decreased from 22•2% to 19•6%. This movement in gross margin is significant and there is a risk that costs may have been omitted or included in operating expenses rather than cost of sales. There has been a significant increase in operating expenses which may be due to the bonus and the advertising campaign but could be related to the misclassification of costs.
The finance director has made a change to the inventory valuation in the year with additional overheads being included. In addition inventory days have increased from 58 to 70 days. There is a risk that inventory is overvalued.
Receivable days have increased from 61 to 71 days and management have extended the credit period given to customers. This leads to an increased risk of recoverability of receivables.
The current and quick ratios have decreased from 5•8 to 2•6 and 4•4 to 1•8 respectively. In addition the cash balances have decreased significantly over the year. Although all ratios are above the minimum levels, this
is still a significant decrease and along with the increase of sales could be evidence of overtrading which could result in going concern difficulties.
Response to risk
Throughout the audit the team will need to be alert to this risk. They will need to carefully review judgemental decisions and compare treatment against prior years.
Increased sales cut-off testing will be performed along with a review of post year-end sales returns as they may indicate cut-off errors.
During the audit a detailed breakdown of sales will be obtained, discussed with management and tested in order to understand the sales increase.
The classification of costs between cost of sales and operating expenses will be compared with the prior year to ensure consistency.
The change in the inventory policy will be discussed with management and a review of the additional overheads included performed to ensure that these are of a production nature.
Detailed cost and net realisable value testing to be performed and the aged inventory report to be reviewed to assess whether inventory requires writing down.
Extended post year-end cash receipts testing and a review of the aged receivables ledger to be performed to assess valuation.
Detailed going concern testing to be performed during the audit and discussed with management to ensure that the going concern basis is reasonable.
|
