Audit



Auditing

Question 1)

Effect of overstating inventory on balance sheets and accounts

The case study mentioned shows that the CEO of the company has not allowed the loss of inventory to be reported to the account as it will effect the performance of the company in the very first year. The loss which had occurred was had a greater impact on the profit of the company as compared to the overstating of the inventory that has resulted in the loss. The below table further classifies the audit procedure to be used to manage the accounts being effected by overstatement of the inventory.

Account(s) affected

Understated/ Overstated

Relevant Audit Assertions

Audit procedure that would detect these attempts

Cost of Goods Sold

Over stated

Proper Management of raw material, labour and other direct cost

Internal Audit of inventory holdings including suppliers

Gross Profit

Under Stated

Rechecking inventory used and in hand

Internal audit

Net Income

Understated

Rechecking inventory used and in hand

Internal Audit

Inventory

Overstated

Recounting of inventory and loss of inventory should be taken into account.

Internal and external audit

Taxes Payable

Understated

External Audit Procedure.

Cost of Goods Sold

Overstating beginning inventory overstates the cost of goods sold, which is an income statement account. It includes raw materials, labour and other direct costs of production. An overstated beginning inventory balance implies an overstated ending inventory balance for the prior period. Cost of goods sold is beginning inventory plus purchases minus ending inventory for a period, which could be a month, quarter or year.

Gross Profit and Net Income

Overstating beginning inventory understates gross profit and net income. Gross profit is sales minus cost of goods sold. As overstated beginning inventory overstates the cost of goods sold, it understates gross profit. Net income is gross profit minus expenses, such as sales and administrative expenses, interest and taxes. If gross profit is understated, net income must also be understated.

Most inventory fraud is executed by rank-and-file employees who have access to inventory. But management-level staff may manipulate inventory on a balance sheet for far greater stakes. Managers may feel excessive pressure to satisfy financial projections or performance expectations, or to facilitate a merger or loan. The perpetrators could create records for fictitious inventory, and then support its existence with false journal entries, inventory count sheets, purchase orders, and shipping and receiving documents.

Fictitious inventory isn't the only risk. Often, inventory is purposely overstated to present a more profitable financial picture; in other cases it's understated to reduce income taxes. Management can also manipulate the company's inventory counts. A manager could, for example, include a shipment received late in the accounting period in the current inventory but record the associated liability in the next period. Further, he or she might capitalize inventory — particularly manufactured goods improperly.

In addition, internal and external auditors should be employed to ensure inventory activity is all above-board. Auditors can perform statistical analyses of financial data and reconcile amounts recorded as having transferred in and out of inventory with the actual physical inventory.

Question 2)

Inherent Risks that increase the risk of material misstatement ( at least 10)

Reason why they require ...