Audit risks and materiality have a significant effect when applying the Generally Accepted Auditing Standards. It is risky that an auditor may not appropriately modify his or her opinion because of material misrepresentation of financial statements by the client. The concept of materiality recognizes that some items are inherent in the accurate presentation of financial statement. The major purpose for audit engagement is the establishment of materiality threshold by a company in order to assess the risks that the client company might face when it engages the services of an auditing firm (Pickette, 2006, p.169). Auditing firms vary in their classification of accounting items as either material or immaterial, which could pose profound risk to the client company.
Discuss the risks to an audit should the client become aware of the materiality thresholds used on audit engagements by the auditing firm.
Detection of risks arises when the auditing procedure does not evaluate some accounting items. The lack of evaluation may result when the audit procedure considers some financial items to be immaterial to the accuracy of the organization’s financial statements. Either the detection risk is due to the audit’s procedure inability to detect material items not included in the financial statements by error, or intentionally. Moreover, detection of risks arises when the auditing procedure does not dedicate enough workforce and time for the audit procedure to ensure that every item that could lead to misstatement of financial information is subject to scrutiny before the financial audit report is completed. Detection risk comprises of sampling and non-sampling risk. Sampling risk is the risk that a sample selected by an auditor does not represent the whole population. Non-sampling risk arises when the auditor does not recognize material information due to other factors other than sampling risk.
The analytical procedure risk arises when the auditing firm uses an auditing procedure that fails to detect material misstatement of financial statement by the organization. Analytical procedure risk may arise due to lack of proper planning before commencing the audit and poor supervision.
An organization also faces inherent risk due to a narrow materiality threshold that fails to detect misstatement of financial statements by the auditing procedure. The business may face the challenge of survival in the industry if key stakeholders learn that the financial statements of the organizations have misrepresentations, either erroneously or intentionally.
Discuss the general principles or guidelines that dictate when companies are entitled to record revenue and how the $7.8 million barter transaction and the two consignment sales discussed in the case may have violated these principles.
The profit in the income statement is of considerable importance to financial statement users. It is imperative that the organization maintains accurate financial statements to enable users of the financial information, both internally and externally, to make sound financial decisions. The Generally Accepted Accounting Principles (GAAP’s) require accountants to recognize revenue in the financial period it accrues (Porter & Norton, 2010, p.169). Revenue is recognizable when the assets received in exchange for goods and services are easily convertible into cash or equivalent of cash.
Barter transactions involve non-monetary transactions, which accountants should recognize when the earning process is complete at the fair value of products or services in a barter transaction. The fair value for barter transactions is the carrying amount of goods and services in a barter transaction; in most cases, it is usually zero. The North Face Inc. undertook a barter transaction towards the end of the fiscal year 1997. The consideration for the barter transaction was partially cash and trade credits, which should not reflect as revenue in the financial statements. The then chief financial officer structured the barter transaction in order to recognize profits from the barter transaction with the intention of inflating profits. The barter transaction, estimated at $7.8 million dollars, was in two portions; one paid in cash and trade credits worth $ 3.51 and $ 1.64 dollars respectively, as recognized in the final quarter of 1997. The other portion of $ 2.65 million, in trade credits, was recognized in the first quarter of the year, 1998.
Barter transactions reflect in the financial statement in carrying value of the goods when the earning process is complete. The North Face Inc. should have recognized the portion of the barter transaction only, which was complete by the end of the financial year 1997; that is, $3.51 millions. The North Face Inc. failed to observe the accrual principle, which requires that revenues reflect in the year they accrue. In the year 1998, Todd Katz, the vice president, arranged for two large consignments worth $9.3 and 2.6 million dollars to wholesalers disguised as sales. The terms of the consignments gave the wholesalers the prerogative to return any unsold merchandize. The transactions with the wholesalers did not constitute sales and should not have reflected as sales, not unless the North Face Inc. received revenue for the goods delivered.
Explain the principle objectives of auditor’s work papers and how these objectives were undermined by Deloitte’s decision to alter North Face’s 1997 work papers.
Audit work papers are critical to the success of the audit procedure. They serve the main objective of ensuring accuracy in the audit report; they enable the auditing team to review the already complete reviews. Audit work papers establish what is pending to eliminate detection risk by evaluating all material items and facilitate the review of audit procedure by a third party (Bragga, 2010, p.394). In addition, audit work papers ensure that the process of audit control is effective. The team in charge of the North face Inc. in Delloite, failed in ensuring the objective of the audit work papers was met by not documenting all material items to support the opinion of the audit. The work papers are subject to review before an advisory partner completes the audit procedure. If the audit work papers by Deloitte were conclusive, then the advisory partner could have noticed the accounting misrepresentation by the North Face Inc., in the fiscal years 1997 and 1998. When Will Border, the Delloite representative in charge of the North Face Inc. in the financial year, 2008, noticed the misrepresentation proposed by Pete Vanstraten, he questioned the former representative who argued that the misrepresentation should have been part of the working papers for the previous financial year. This means that, the auditing procedure was not accurate, for it failed to reflect material misrepresentation. After the revisions that came after Will Border detected the discrepancy, the new working papers for the year 2007, did not reflect the revisions.
North Face’s management teams were criticized for strategic blunders that they made over the course of the company’s history. Discuss the auditor’s responsibility to assess the quality of the key decisions made by client executives.
Auditors play a critical role in ensuring that the management of an organization act responsibly when selecting and implementing strategies and making material decisions on behalf of the organization. The auditors for the North Face Inc., through ineffective audit produces, enabled management of the corporation to engage in unethical accounting practices. The management was able to inflate profits in order to conceal their ineffectiveness in managing the organization. For example when Crawford the, the companies, chief financial officer, realized he could not recognize profits from the barter transactions, he sought the advice of the Delloite auditor responsible for the North Face Inc. From the advice he got he was able to restructure the barter transactions and recognize profit just to misrepresent the financial performance of the company.
In conclusion, financial audits ensure that the organization’s financial statements are accurately representing the organization performance and competitive position in the industry for internal and external users. Auditors play a critical role by evaluating the strategies undertaken by management. In addition, audits evaluate how the undertaken strategies are contributing to the achievement of the organizations (Moeller, 2009, p.287). Moreover, audits promote ethical behavior and values by ensuring that the strategies undertaken by the organization are geared towards achievement of the interest of all stakeholders. Finally, audits enhance performance management by increasing accountability for decisions taken by individuals in top management of the organization.
Bragga, S. M. (2010). Accounting Best Practices. USA: John Wiley and Sons Publisher.
Moeller, R. R. (2009). Brink’s Modern Internal Auditing: A Common Body of Knowledge. USA: John Wiley and Sons Publisher.
Pickette, K. H. (2006).Audit planning: a risk-based approach. New Jersey: Wiley Publishers.
Porter, G. A., & Norton, C. L. (2010).Financial accounting: The Impact on Decision Makers. USA: Cengage Learning.