The information in the financial statements of your client, Honesty Company Limited, represents claims by management in relation to its responsibility to prepare financial statements which gives a true and fair view of the company’s state of affairs and results of operations for the year under review. These claims are referred to as financial statements assertions.
Required:
As a member of the engagement team charged with the audit of the client’s financial statements for the year ended October 31, 2019:
a) Outline the audit objectives for the audit of stock (inventories) in the financial statements. Your answer should relate to the financial statement assertions. (8 marks)
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The audit objectives of the audit of stocks(inventories) are to ensure:
- Completeness: That all stocks belonging to the client at the balance sheet date have been reported or included in the financial statements.
- Existence: That the stocks were in existence at the balance sheet date
- Rights and Obligation: That the client has title to the stocks or the entity hold or controls the rights to the stocks
- Valuations and allocation: That stocks are included in the financial statements at appropriate amounts and any resulting valuation or allocation and adjustments are appropriately recorded.
- Presentation and disclosure: That stocks are properly classified, presented and adequately disclosed in the financial statements.
b) Discuss FOUR (4) sources from which evidence can be obtained to confirm the quantities and value of stocks. (8 marks)
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Sources of evidence on quantity and value of stocks: Evidence on quantity and value of stocks can be obtained from:
- Observation of stock taking: Careful observation of client stock taking may enable the auditor to form opinion about the quantity and value of client stocks.
- Stock summary sheets and valuation: Examination of the stock summary sheets prepared by the client and comparison with sample evidence taken during stock taking will provide evidence on the stock quantities.
- Checking of the extensions and summary of the stock valuation will provide evidence of the value of stocks.
- Client stock systems: Where the client has an adequate stock system which is maintained on perpetual inventory system, evidence can be obtained from it to substantiate stock quantities and valuation.
- Third party confirmation: Evidence about quantity and value of client stock can also be obtain from confirmation replies from third parties holding client stock.
c) Explain why stocks present high audit risk. (4 marks)
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Stocks present high audit risk because of the following reasons:
- Lack of double entry records: For most clients the stock quantities and value are not obtained from double entry book keeping but through physical stock count and valuation which can be manipulated by management that intends to engage in fraudulent financial reporting
- Materiality of stocks: For most entities stocks represent large proportion of the assets of the company. Materiality of this magnitude is bound to increase audit risk.