Detecting Fraud in Financial Reports

This assignment examines the potential for fraud within a company's financial reports, specifically highlighting two areas of concern: manipulation of accounts due to weak internal controls and the hasty installation of a new IT system that may have been motivated by cost-saving or fraudulent intent. The assignment emphasizes the auditor's role in investigating these risks through proper documentation review, expert advice, and reconciliation of costs and results. It also stresses the importance of management transparency in providing auditors with all necessary information for a comprehensive audit.

By student name
Professor
University
Date: 25 August 2017.

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Contents
Question no 1…………………………………………………………………...2
Question no 2…………………………………………………………………...6
Question no 3…………………………………………………………….....….8
Refrences.....……………………………………………………………….......10
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Question no 1
While accepting the audit of the client, the auditor needs to understand the business, internal
and external business environment, the industry in which it is operating, the management and its
assertions. It is important that the auditor apply his professional skepticm and judgment before taking
major decisions. Audit is conducted with the objective of determining the risk of material misstatements
given the assumption that the management has tried to identify and mitigate all the types of risks. One
of the important aspects of auditing is studying and mitigating the risks posed by the related party
transactions by adequately disclosing the same in the financials (Raiborn, Butler & Martin 2016). The
auditor must also provide the reasonable assurance to both the internal and the external users, the
auditor needs to check the going concern assumption, consistency, etc. The various procedures which
the auditor undertakes for completion of the substantive audit includes observation of the key controls
in practice, inspection of the books of accounts and supporting and evidence on the basis of which
incomes and related expenditure are recorded in the books etc. It also includes using different
procedures to conclude on the existence of the asset and liabilities on the reporting date, whether the
same has been properly disclosed in the notes, whether proper valuation of the intangibles and
inventory has been done, and whether the completeness of the accounts is being ensured. An example
of the same would be to check the outflows of cash and bank from the bank statements and the cash
ledger book and reconciling the same at the period end (Knechel & Salterio 2016).
Once the substantive procedures are went through, the auditor also makes makes use of the
analytical procedures before making an audit plan. This generally includes comparison of the client’s
financial numbers with the industry data, the numbers in the previous period in the last year and just
previously ended quarter, analysis of key financial ratios, trend analysis, budgeted and forecasting
procedures and finally concluding with the trends of the non-financial data. Besides all this, the auditor
is also responsible to check the method and procedure being followed to book the expenses, recognition
of the revenue in the books, whether the same has been done on a reasonable basis or it is overstated
or understated. Based on all the above procedures and the effectiveness of the internal control existing
in the organization, the auditor plans the audit steps to be taken and the nature of the procedures to be
followed, the time to be allocated and extent to which the checking will be done by establishing the
audit materiality-planning threshold. In case the internal control is weak, the risk is more and therefore
less reliance can be placed on what is reported. Similarly, if the internal control being established and
practiced within the entity is strong, more reliance can be placed on it and therefore the audit plan need
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not be revisited. Misstatements in the financials can be of various types like specific errors, immaterial
errors or projected frauds. All this needs to be taken into consideration before expressing an opinion of
the financial statements and laying the audit strategy (Jones 2017).
Stewart and Kathy are the auditors who will be auditing the client DIPL limited and they are
taking over from the old auditors Jay and Associates. There has been manychanges, which DIPL has
undergone in the recent past like change in the IT system, implementing it without testing and proper
planning, changes in the policy of reporting, the depreciation method, etc. Besides this, there is huge
concern as some of the transactions have been recorded in the period to which it does not pertain. In
the likes of above discrepancies, the responsibility of the new auditor has multiplied and therefore it
needs to bring in front of the management the summary of the major observations noted. In the
absence of Industry data, the comparative analysis with industry was not possible and hence the
analysis has been restricted only to the ratio analysis for the last 3 years.
Results
2013 2014 2015
Total current assets 5,385,938 7,509,150 9,600,929
Total current liabilities 3,780,000 5,120,250 6,397,500
Result 1.42 1.47 1.50 Negatve
2013 2014 2015
Total current assets - Inventory - Prepaid expenses 3,129,750 4,837,788 5,420,429
Total current liabilities 3,780,000 5,120,250 6,397,500
Result 0.83 0.94 0.85 Negative
1. Short term solvency or liquidity Ratios
Current Ratio = Total current assets/ Total current liabilities
Liquid ratio /Quick Ratio = (Total current assets - Inventory - Prepaid
expenses)/ Total current liabilities
Results
2013 2014 2015
Total Debts 3,780,000 5,120,250 13,897,500
Total Assets 5,120,250 15,903,900 26,147,991
Result 74% 32% 53% Positive
2013 2014 2015
Total Debts 3,780,000 5,120,250 13,897,500
Total owners' equity 9,150,000 10,783,650 12,250,491
Result 41% 47% 113% Negative
2. Debt Management Ratios
Debt ratio = (Total Debts / Total Assets) or ((Total assets- total owners'
equity)/total assets)
Debt to Equity Ratio = (Total Debt/Total owners' equity) or ((Total
assets- total owners' equity)/total owners' equity)
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Results
2013 2014 2015
Sales 34,212,000 37,699,500 43,459,500
Accounts Receivable 2,482,500 4,320,000 5,073,309
Result 13.78 8.73 8.57 Negative
2013 2014 2015
No. of days 365 365 365
Receivable turnover 13.78 8.73 8.57
Result 26.49 41.83 42.61 Negative
2013 2014 2015
COGS 28,207,500 31,620,000 36,855,000
Inventory 2,256,188 2,671,362 4,180,500
Result 12.50 11.84 8.82 Negative
2013 2014 2015
No. of days 365 365 365
Inventory turnover 12.50 11.84 8.82
Result 29.19 30.84 41.40 Negative
2013 2014 2015
Sales 34,212,000 37,699,500 43,459,500
Net Fixed Assets 7,544,062 8,394,750 15,572,062
Result 4.53 4.49 2.79 Negative
2013 2014 2015
Sales 34,212,000 37,699,500 43,459,500
Total Assets 12,930,000 15,903,900 26,147,991 Negative
Results 2.65 2.37 1.66
3. Asset management Ratios
Inventory Turnover = COGS/Inventory
Days' Inventory = 365/Inventory Turnover
Fixed Assets Turnover = Sales/net Fixed Assets
Total Assets Turnover = Sales/Total Assets
Receivables Turnover Ratio = Sales/Accounts Receivable
Days Receivable = 365/Receivable turnover
Results
2013 2014 2015
Net income 2,359,190 2,291,362 2,972,183
Sales 34,212,000 37,699,500 43,459,500
Result 6.90% 6.08% 6.84% Indifferent
2013 2014 2015
Operating Profit 6,780,000 7,230,000 8,308,088
Sales 34,212,000 37,699,500 43,459,500
Result 19.82% 19.18% 19.12% Indifferent
2013 2014 2015
Net income 2,359,190 2,291,362 2,972,183
Total owners' equity 9,150,000 10,783,650 12,250,491
Result 25.78% 21.25% 24.26% Indifferent
4. Profitability ratios
Profit Margin / Net Profit ratio = Net income / Sales
Operating Margin ratio = Operating Profit/Sales
Return on Equity = Net income/total owners' equity
The current and the liquid ratio have moved steadily and have remained within the limits of two and
one respectively. The debt equity ratio has from 0.41:1 to 1.13:1, which is still under the standard trend
of 2:1, which means the company has an adequate cushion to take loans and thus the benefit of low
interest cost. the debt collection cycle and the inventory liquidation cycle both are on the negative trend
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which have increased from 26 to 42 days and 29 to 41 days respectively. This shows the loss of control
over these areas such that the funding is not coming at the right time to the company The profitability
ratio of DIPL over last 3 years is evident of the fact that the profits has not increased and has remained
constant at around 6.5-7%. In addition, the company is failing to give increased returns to the
shareholders (calculated through ROE), even after increasing the mix of debt in the capital structure.
The financial viability of the company can be easily judged on the basic of these nalyticals that may be
applied to the overall accounts of the company. It helps in asserting the liquidity position of the
company and also helps the investors in taking important decisions. In case of DIPL, the ratio analysis
shows that the books of account are prepared ina correct manner showing the overall financial
prospects of the company (Grenier 2017).
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Solution 2
Risk assessment and mitigation, is an important aspect of auditing. It is important that any
auditor must check all the possible sources that may have any risk associated with them and mitigate
the same. The three main type of risk that is associated with an audit is inherent risk, control risk and
detection risk. Inherent risks are the type of risks that are present even if the management has ensured
proper control measures. These risks are not in the hands of the management and it is important that
the auditor must apply all types of substantive and analytical process to mitigate the overall risk. Control
risks are the type of risks that occur when the company has low internal control established; it is
because of mismanagement that often leads to materiality in the financial statements. Detection risks
occur in case the auditor fails to establish enough professional skepticm and fails to detect major errors
that might affect the overall profitability of the company. As an auditor of the given company, it is the
duty to conduct its audit in such manner that major risks are properly identified and mitigated. In the
case of DIPL, these are the few types of risk that the company may be exposed to given its nature of
business and operations (Sonu, Ahn & Choi 2017).
The first type of inherent risk that is the company might face is in the deviation from the routine
transactional and adoption of non-routine transaction that might affect the overall profitability of the
company. The management of the company are considering new methods for calculation of
depreciation, considering the life of asset to be twenty years where as in general policy as per the
standard the life is thirty years. The Ceo of the company is taking such a decision based just on his
knowledge and not on any kind of research that has been undertaken in this regard. This might lead to
material misstatement and affect the overall profitability of the company. It is important that before
taking such steps the management must take expert guidance so that chances of risk are reduced (Fay &
Negangard 2017).
The second type of risk is associated in the adoption of the new IT system by the company
without any proper scrutiny and research. The management is adopting the same without reconciling
the cost and the profit. There are high chances that the system might fail and might not work as
stipulated. The management needs to conduct proper research before taking such an important step. It
is important that the auditor verify all the documents related, so that there are no discrepancies in the
future. In case the auditor feels that, the system is not functioning as needed it might ask the
management to replace the same. Whenever a new system is adopted in place of an old system, proper
training must be provided to the staff so that they do not manhandle it. The auditor must also reduce
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any kind of risk of material misstatement that it might come across while verifying the validity of the
system. The management must also ensure that strong control measures are undertaken so that any
kind of inherent risk can be counter attacked. It makes the work of the auditor easy and ensures that the
system work efficiently without any kind of problem. The auditor along with the support of the
management mitigates the inherent risks that the company faces in these few ways (DeZoort & Harrison
2016).
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Solution 3
Fraud occurs when the management or the employees of the company indulges in certain
activity like manipulation or records or defalcation of cash, for their own benefits. The work of the
auditor is to verify the records of the company and to make sure that any kind of fraud risk factor is
mitigated and removed. Fraud occurs because of the negligence of the management and it is important
that proper control be established to prevent the same. Identification of fraud risk factor is the work of
the management of the company and the auditor can help in mitigation of the same. While conducting
the audit, the auditor must apply such methods that help in identification of major fraud risk factors.
Often the management might be the culprit, the auditor should not rely on what the management
portrays and should apply his own research techniques before reaching a conclusion (Bae 2017).
In case of DIPL, the major fraud risk factor that the company faces is in the non-segregation of
important work departments. There is lack of authority and delegation of work systematically. In the
company, the accounts receivable department is handles by a single person, who manages all the work.
A single clerk does the verification of the books, making the payments, reconciling the amount and
asserting the validity of the records. A single person also handles the cash receivable department. A
single person does all the work from downloading the e receipts, making the collection, updating and
reconciling the book. All these leads to lack of establishment of duty and responsibility. If the power is
given in one hands, he can easily manipulate the accounts, as per his own preference and it will be hard
for the management to ascertain the same easily. It is thus important for the auditor to make sure that
the management has installed proper control systems. Work must be properly divided and it must be
authorised. Surprise checks of accounts must be done, so that any kind of error can be easily identified.
The second area where there might be fraud is in the installation of the new IT system. The
management installed the same in allot of haste, without undertaking nay precaution. There are high
chances that some personal motive of the management was involved in this case. The management had
done the same to save cost the wrong way or to manipulate the books. It is important on part of the
auditor to properly investigate into the matter; the auditor can also take expert advice to know the
poorer value of the system. Proper reconciliation of the cost and results must be done. In any case, if the
auditor feels that the magemnt is not giving the required level of support, the auditor can qualify the
audit report. It is the duty of the management, to provide the auditor with all the necessary information
that he might need to verify the viability of the accounts. All the important documents regarding the
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project must be given to the auditor. The auditor can mitigate the major risks that the organisation
might face in these few ways (Sonu, Ahn & Choi 2017).
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References
Bae, SH 2017, 'The Association Between Corporate Tax Avoidance And Audit Efforts: Evidence From
Korea', Journal of Applied Business Research, vol 33, no. 1, pp. 153-172.
DeZoort, FT & Harrison, PD 2016, 'Understanding Auditors sense of Responsibility for detecting fraud
within organization', Journal of Business Ethics, pp. 1-18.
Fay, R & Negangard, EM 2017, 'Manual journal entry testing : Data analytics and the risk of fraud',
Journal of Accounting Education, vol 38, pp. 37-49.
Grenier, J 2017, 'Encouraging Professional Skepticism in the Industry Specialization Era', Journal of
Business Ethics, vol 142, no. 2, pp. 241-256.
Jones, P 2017, Statistical Sampling and Risk Analysis in Auditing, Routledge, NY.
Knechel, WB & Salterio, SE 2016, Auditing:Assurance and Risk, 4th edn, Routledge, New York.
Raiborn, C, Butler, JB & Martin, K 2016, 'The internal audit function: A prerequisite for Good
Governance', Journal of Corporate Accounting and Finance, vol 28, no. 2, pp. 10-21.
Sonu, CH, Ahn, H & Choi, A 2017, 'Audit fee pressure and audit risk: evidence from the financial crisis of
2008', Asia-Pacific Journal of Accounting & Economics , vol 24, no. 1-2, pp. 127-144.
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