The unacceptable report that an auditor develops for failing to identify the manipulation associated with the transactions or frauds present in the account. The main risk factors associated with the specific audit engagement take into account detection risk (DR), inherent risk (IR) and control risk (CR) and it is calculated as follows:
AR = CR x IR x DR
According to Cohen and Simnett (2014), the risks involved in the types and nature of the businesses or financial transactions are referred as inherent risks. For MGC Limited, the IR transactions have lower IR compared to the cash transactions and cheques are used to settle the latter. The control risk generally occurs due to malpractice in recording the financial transactions or making an error in the accounting books, which the systems of internal control of an organisation have not identified or rectify the same. In case of MGC Limited, the internal control appraisal has been greater, as there are no job segregations.
The possibility of accumulation of manipulations, misstatements and unidentified frauds is perceived as detection risk (Junior, Best and Cotter 2014). The major reasons behind the occurrence of these risks in MGC Limited constitute of human factors and sampling factors, while the control risk happens due to ineffectiveness of the systems of internal control.
Analytical review with key financial ratios and the areas requiring special audit attention:
The intention of financial auditing is to dissect the statement related to financial transactions of a firm coupled with giving a rightful insight of the business transactions (Knechel and Salterio 2016). Hence, the financial auditor has applied professional and ethical judgement when conducting the audit procedure of MGC Limited. The auditor’s approach has been unbiased for providing a rightful insight of the financial transactions related to the business. After analysing the financial ratios of MGC Limited, the same has been contrasted with industry average. The financial ratios of the organisation for the years 2014 to 2016 have been depicted in the form of a table (Refer to Appendix). It has been observed that the solvency position of MGC Limited has declined in 2016 compared to the previous two years. The current ratio of the organisation has been 1.60 in 2016, which is below the industry average of 2.01; however, it has improved over the years.
Along with this, the industry average of quick ratio has been 1.15 in 2016 and the same for the organisation has been 0.54 in 2016 that has enhanced compared to the past year. The debt-to-equity ratio of MGC implies that the organisation has employed higher debts in its capital structure, since greater debt amount has been recognised n 2016, while the lowest debt amount has been recognised in 2014. On the other hand, “times interest earned ratio” implies that the organisation has adequate ability to settle off its debt in 2014, which declined significantly in 2015 and below the industry average in 2015 and 2016.
The average collection period of the organisation has been enhanced in 2016 (39 days) in contrast to the previous two years. This reveals that the firm has been struggling with its liquidity position and it has not performed effectively to meet the industrial average of 32 days in 2016 (William Jr, Glover and Prawitt 2016). According to the average payment period obtained, the blockage of cash assets is higher in 2014 with 104 days compared to that of 2015 and 2016. On the other hand, the inventory turnover ratio of MGC Limited has been highest in 2016 with 233 days and lowest in 2015 with 187 days. Both gross and net margins of the organisation have risen in 2014; however, considerable fall has been observed in 2015. As a result, MGC Limited has performed below the desired industrial average (Luo 2015).
From the evaluation of the financial statements of the organisation, the auditor has not detected any material misstatement, which signifies that no audit risk is present (Louwers et al. 2013). The debt level needs to be reduced in capital structure for discharging its short-term and long-term dues. The minimisation of credit terms and rise in inventory turnover rate are recommended to MGC Limited. Finally, cost of sales is required to be minimised to increase revenue and overall profit margins.
Suggestion of overall audit strategy pertinent for this engagement:
The audit is required to concentrate on substantive methods for minimising the risk control issues and material misstatement. Hence, in this case, combined approach could be adopted for audit engagement through the following values:
- Based on the evidence of audit MGC Limited recognises unnamed revenue. Therefore, qualified opinion is needed to correct this mistake.
- There is need to ascertain the instances associated with early income realisation.
- The consideration of sales return account and allowances account is needed.
- There is necessity to ensure that discounts are recorded as well as provided to the customers. If it fails to record the same, the sales account would be overstated.
Cohen, J.R. and Simnett, R., 2014. CSR and assurance services: A research agenda. Auditing: A Journal of Practice & Theory, 34(1), pp.59-74.
Junior, R.M., Best, P.J. and Cotter, J., 2014. Sustainability reporting and assurance: a historical analysis on a world-wide phenomenon. Journal of Business Ethics, 120(1), pp.1-11.
Knechel, W.R. and Salterio, S.E., 2016. Auditing: assurance and risk. Routledge.
Louwers, T.J., Ramsay, R.J., Sinason, D.H., Strawser, J.R. and Thibodeau, J.C., 2013. Auditing and assurance services. New York, NY: McGraw-Hill/Irwin.
Luo, Y., 2015. Acctg 626 Audit and Assurance Services.
William Jr, M., Glover, S. and Prawitt, D., 2016. Auditing and assurance services: A systematic approach. McGraw-Hill Education.