Audit Risks from Ratios and Internal Control and Sampling Method of API

This memo discusses the potential audit risks in API from ratio analysis and internal control regarding inventory. It also discusses the sampling methods for the audit of API.

Running head: AUDITING THEORY AND PRACTICE
Auditing Theory and Practice
Name of the Student
Name of the University
Author’s Note

1AUDITING THEORY AND PRACTICE
Memo
To: Wayne Wiadrowski
From: The Audit Manager
Date: 8th May, 2019
Subject: Audit Risks from Ratios and Internal Control and Sampling Method of API
Purpose and Scope
It is needed for the auditors to analyse as well as examine the financial statements of the
companies with the aim to find any kind of material misstatements due to frauds and errors.
The same is applicable in the case of Always Precise Instruments Pty Limited (API). The
main purpose of this memo is to discussion about the potential audit risks in API from ratio
analysis and internal control regarding inventory. In addition, it discusses about the sampling
methods for the audit of API. These aspects are showing the following discussion in table
format.
Audit Risks from Ratios and Audit Procedures
Ratio Analysis Audit Risk Audit Procedures
Current Ratio There is an increase
in the current ratio
of API. This ratio is
less than the industry
benchmark. The
reason can be the
increase in current
assets or the
decrease in current
liabilities.
The potential audit
risk in this case can
be the misstatement
in the current assets
and current
liabilities, for
example decrease or
increase in the
current assets or
liabilities from the
management’s end
(Knechel & Salterio,
2016).
Test of details is the
required audit
procedure in this
particular risk where
it is needed for the
auditor to test the
details of the
documents related to
the payment and
acquisition of the
current assets and
liabilities. This audit
procedure will help
in demonstrating the
correct values of the
current assets and

2AUDITING THEORY AND PRACTICE
liabilities (Gay &
Simnett, 2012).
Quick Asset Ratio The provided
information
demonstrates
increase in this
ration in the current
year. It implies that
API is converting
their current assets
in the quick assets in
less time so that the
current liabilities of
them can be met.
Material
misstatements in the
quick assets or quick
liabilities can be
considered as the
potential audit risk
in this case which
can involve the
overstatement of the
quick assets or
understatement of
the current liabilities
(Gay & Simnett,
2012).
Audit procedure in
this case include the
test of details and
test of control
related to the quick
assets and liabilities
where the auditor is
needed to test the
accounting books
and entries related to
the quick assets and
liabilities so that the
auditor can identify
the misstatements in
the quick assets and
liabilities
(Johnstone,
Gramling &
Rittenberg, 2013).
Return on Equity There is a decrease
in this particular
ratio in the year
2018 and this ratio
in API is less than
the industry
benchmark. This can
be a reason of the
increase in the
equity capital of the
company or the
decrease in net
The presence of
misstatement in the
equity capital can be
the potential risk in
this situation that
can lead to the
decrease or increase
in this ratio. The
amount of debts can
be reduces by
misstating the equity
capital (Legoria,
Test of details
related is the correct
audit procedure in
this case where the
responsibility of the
auditor is to check
the accounting
books, record and
transactions related
to equity share
capital in order to
identify

3AUDITING THEORY AND PRACTICE
income. Melendrez &
Reynolds, 2013).
misstatements in
them. This will
reduce to this
particular risk.
Return on Total
Assets
There is a decrease
in this particular
ratio in API in 2018
which indicates that
the company has not
been able in efficiently
using their assets in
the current year for the
purpose of profit
making.
Material
misstatements in the
account balances of
the assets of API can
be the potential audit
risk in this situation
due to the fact that
decrease in this ratio
is the indicator of
the earnings of the
firm (Gay &
Simnett, 2012).
Test of details is the
major audit
procedure in this
case where the
auditor is needed to
check the details of
the accounts balance
and accounting
transactions of the
company’s assets.
This procedure is
helpful in showing
the presence of
material
misstatements in the
asset balances
(Yoon, Hoogduin &
Zhang, 2015).
Gross Margin There is decrease in
the gross margin of
API in 2018. This
ratio is significantly
less than the industry
benchmark. The
main two reasons for
this decrease in this
ratio are decrease in
sales and increase in
cost of sales.
Misstatements in the
values of sales and
cost of sales are the
potential audit risk
in this aspect.
Keeping the gross
profit low can be the
motivation behind
this misstatement
(Moroney &
Trotman, 2016).
Test of details and
test of control are
the audit procedures
for this risk. Thus, it
is needed for the
auditor of API to test
all the transactions
relation to sales and
cost of sales, the
auditor is also
needed to test the

4AUDITING THEORY AND PRACTICE
internal control of
API related to sales
and gross profit with
the aim to discover
any material
misstatements in
sales and cost of
sales.
Marketing Expenses There is an increase
in the marketing
expenses of in the
current year and it is
more than the
industry benchmark.
Increase in this
marketing expenses
of the company has
implication on the
net profit.
Misstatements in the
marketing expenses
of API can be the
potential audit risk
in this aspect which
includes the
overstatements of
the marketing
expenses of the firm.
The company can
show less sales
related expenses by
showing increased
amount of marketing
expenses (Beasley et
al., 2013).
Test of details is the
correct audit
procedure that needs
to be undertaken in
this regards where
the auditor is needed
to check the
accounting entries as
well as accounting
books of the firm
related to the
marketing expenses.
Misstatements in the
marketing expenses
can be identified
with this procedure
that reduces this
potential audit risk.
Admin
Expenses/Sales
There is a decrease
in this ratio in the
year 2018 which is
less than the market
benchmark.
Profitability position
of the company can
Misstatement in the
administrative
expenses can be the
potential audit risk
that can be raised
from this situation.
More specifically,
Test of details is the
appropriate audit
procedure for this
potential risk where
it is needed for the
auditor to test all the
accounting details as

5AUDITING THEORY AND PRACTICE
be improved by
decreasing these
expenses.
there can be
understatement of
these expenses of
API.
well as accounting
transactions related
to the occurrence
and payment of the
administrative
expenses in API.
This audit procedure
will make the
auditor able in
identifying the
misstatements in the
administrative
expenses that is
required for
minimizing this risk
(Buckless,
Krawczyk &
Showalter, 2014).
Times Interest
Earned
There is a decrease
in this particular
ratio in the current
year and it is less
that the industry
benchmark. This
situation implies that
the company has
made less interest
payment in the
current year as
compared to the
previous year. Not
handing sufficient
earnings can be the
Misstatements in the
interest expenses of
API can be the
potential audit risk
where there is a
possibility that the
interest expenses
have been
understated that led
to decreased interest
payment.
Test of details as
well as test of
control are the audit
procedures that need
to be performed in
this situation. It is
needed for the
auditor to check the
accounting
transactions as well
as other details of
interest expenses.
This will lead to the
identification of the
misstatements in

6AUDITING THEORY AND PRACTICE
reason of this. company’s interest
expenses (Byrnes et
al., 2018).
Days in Inventory There is decrease in
the days in inventory
of API in 2018 and it
states that the
company has taken
more time to clear
their inventory in the
current year.
Major misstatements
in the closing
inventory balances
of API can be the
potential audit risk
in this case. More
specifically, there
can be overstatement
in the closing
inventory that can
reduce the gross
profit.
Test of control is the
main audit
procedure for this
potential audit risk
where it is needed
for the auditor to test
the internal control
process of the
company. Testing
this internal control
will provide the
scope to the auditors
to identify the
misstatements in
inventory so that this
risk can be reduced
(Christensen, Glover
& Wolfe, 2014).
Days in Accounts
Receivable
There is increase in
the days in accounts
receivable of API in
the current year. It
indicate that there is
decrease in the
accounts receivable
turnover ratio of the
company in the
current year.
Misstatements in the
balances of accounts
receivable are the
potential audit risk
in this aspect. There
can be overstatement
of the balances of
accounts receivable
in API in the recent
year due to internal
control weakness or
other factors.
Test of details and
test of control are
the major audit
procedures that need
to be applied in this
case. Under these
processes, it is
needed for the
auditors to test the
internal control of
the company related
to accounts

7AUDITING THEORY AND PRACTICE
receivable and the
auditor is also
needed to test the
accounting records
like transactions and
others related to the
accounts receivable
in the current year.
This will help in
detecting the
misstatements in
accounts receivable
(Ettredge, Fuerherm
& Li, 2014).
Debt to Equity Ratio There is decrease in
this particular ratio
in API in the current
year. Increase in debt
is the major reason for
the increase in this
ratio for API.
Misstatements in the
debts is the potential
audit risk in this
situation. There can
be overstatement in
the debt balances of
API that has led to
the increase in this
ratio (Gunny &
Zhang, 2013).
Test of details is the
main audit
procedure that needs
to be performed in
this case. The
auditor is needed to
examine the
transactions and
accounts balances
related to the debts
of the company for
finding any kind of
material
misstatements in
them. This will help
in the reduction of
this audit risk (Gay
& Simnett, 2012).

8AUDITING THEORY AND PRACTICE
Weaknesses in Inventory Internal Control, Audit Risk and Procedures
Internal Control Weakness Audit Risk Audit Procedure
The computer is responsible
for generating the purchase
orders when the stocks of
raw materials fall below
70%. This is a weakness as
any error in the system can
lead to the generation of
disputed purchase orders.
As per audit risk, this
particular weakness has
major impact on the
purchase orders. The
purchase order may be
below the requirement or
over the requirements which
can make loss for API (De
Simone, Ege & Stomberg,
2014).
Since this is a major internal
control risk, the necessary
audit procedure is the test of
internal control. The
responsibility of the auditor
in this case is to ensure
periodically testing of the
computerized system in
order to ensure that there is
not any scope of error in the
system and the whole
system is updated (Gay &
Simnett, 2012).
As per the above, another
major weakness in the
inventory internal control of
API is the sole dependency
of the computerised system
for the generation of
production orders. The
presence of any error or
glitch in the computer
system can adversely affect
the production orders.
This weakness creates a
particular audit risk where
the production process of the
company can be majorly
impacted. Due to this risk,
here can be over placement
or under placement of the
raw materials or finished
goods or both. The date can
also be changed which can
make the ordered raw
materials and finished goods
of no use (Gay & Simnett,
2012).
This is related to control risk
and the necessary audit
procedure is the test of
internal control. It is needed
for the auditor to ensure
periodically testing of the
computerized system in
order to ensure that there is
not any scope of error in the
system and the whole
system is updated (DeFond
& Lennox, 2017).
It can be seen that the
computer system of API is
responsible for the selection
of the suppliers of raw
materials and finished goods
There is a control audit risk
related to this weakness
which can affect the supply
raw materials and finished
goods. There may not be the
Since this risk is control risk
in nature, substantive audit
procedure needs to be
applied where the
responsibility on the auditor

9AUDITING THEORY AND PRACTICE
based on the latest price and
their delivery time. This is a
weakness as the presence of
any error or fault in the
computer system can lead to
the selection of wring
suppliers.
selection of the appropriate
suppliers in the presence of
any error.
is to test the computer
system on periodic basis
(Badara & Saidin, 2013).
The accounts clerk of API
has the password access of
the master file amendments
while he also responsible for
filing the copy 2 of the
purchase orders and GRN.
This is a major weakness in
the internal control.
An audit risk can be
developed from this where
the accounts clerk can
manipulate the master file.
The required audit
procedure in this case is the
test of details where it is
needed for the auditor to test
all the documents related to
the master file so that fraud
can be detected (Pizzini, Lin
& Ziegenfuss, 2014).
It can be seen that the
production controller has the
password access for printing
the production orders and
master file amendments.
This is a weakness of
internal control as the
production controller can
amend the master file by
manipulatively printing
wrong production order.
There is an audit risk due to
this weakness where the
production of the company
could be adversely affected
due to over production or
less production than the
requirement (Gay &
Simnett, 2012).
Proper segregation of
responsibility is the correct
audit step where it is needed
to deter the production
controller from having these
two responsibilities
(Vovchenko et al., 2017).
It can be seen that the stores
staff has the password
access of both the printing
of raw material purchase
orders as well as GRN
printing and GRN printing
for finished goods. This is
An audit risk is associated
with this weakness where
the purchase of raw
materials and production of
finished goods can be
adversely affected.
The main audit step in this
situation is the segregation
of duty where two staffs will
be responsible for purchase
order printing and GRN
printing respectively (Ege,
2014).

10AUDITING THEORY AND PRACTICE
an weakness as fraud will
not be detected since the
staff has both the
responsibility of order
printing and GRN printing.
Orders will be generated to
the suppliers and sub-
contractors based on the
master file. This is a
weakness since many people
have the access to the master
file amendments which
creates the scope for
manipulation in the selection
of suppliers and sub-
contractors.
This weakness is related to
an audit risk where the
whole production process of
the API can be adversely
affected due to the
possibility of manipulation
in the selection process of
suppliers and sub-
contractors (Alzeban &
Gwilliam, 2014).
The correct internal control
audit procedure is to ensure
that a single person has the
password access to the
master file amendments
since this can reduce the
possibility of frauds and
manipulation.
It can be seen that the stock
sheet report does not include
the quantities of the stocks
as the count teams complete
them. This can be
considered as a weakness in
the inventory internal
control as the absence of
quantities can lead to wrong
stock takes.
A particular audit risk is
related to this weakness
which can adversely affect
the inventory account of
API. There can be
overstatement or
understatement of inventory
in the company (Skaife,
Veenman & Wangerin,
2013).
As a part of the audit
procedure, it is needed for
the auditor to ensure
observing the physical
inventory count so that there
is no misstatement in the
inventory count. It is also
needed to ensure the
inclusion of quantities in the
stock listing (Gay &
Simnett, 2012).

11AUDITING THEORY AND PRACTICE
Sampling Methods
Assertion Which Population Sample Selection
Method
Justification for
Sample Selection
Method
Completeness Completeness assertion
states that the presence of
all the transactions and
accounts needs to be
there in the financial
statements. This assertion
is concerned with the
understatement of
inventories. For this
reason, Wayne is
required to collect the
sample from raw
materials purchased and
finished goods.
Based on the nature of
the assertion, the
appropriate sample
selection method for
API will be the
systematic method of
sampling. It requires
ascertaining uniform
interval through the
dividing the whole
physical units from the
whole source (Elder et
al., 2013).
This is the simplest
method of sample
selection for the
auditors. Under this
particular sample
selection method, it
can be assured to
Wayne that there will
be the application of an
even system for the
sampling of the total
population of the
selected sample. In
case of API, Wayne
will be able in
sampling the raw
materials purchased
and finished goods in
an even manner. For
this reason, the chance
for the detection of the
misstatements in the
inventories of API
increases which is a
good aspect for the
auditor. This method
includes the use of
random number tables
that will be useful for

12AUDITING THEORY AND PRACTICE
Wayne (Gay &
Simnett, 2012).
Existence Existence assertion is
associated with the
testing of the fact that the
transactions regarding
inventories have
happened. This is
considered as a crucial
assertion for inventory. It
is needed for the auditor
to select the sample from
the purchase of raw
materials since it
provides the scope to
vouch them against the
purchase requisition.
Vouching is a crucial
process where the
auditors track a particular
amount to the supporting
document.
On the basis of the
nature of this
assertion, the
appropriate sample
selection method for
Wayne is random
sampling where it is
needed for Wayne to
select the sample from
the purchase orders of
API on haphazard
basis. Random number
of tables needs to be
used in this process
(Sandvig et al., 2014).
The main justification
for the selection of this
method is there is
equal chance for the
whole population of
purchase orders to get
selected by Wayne
under random
sampling method
which is needed for
accurate audit
sampling. It needs to
be mentioned that API
has a huge inventory
based where it is no t
possible for take all
inventory and random
sampling will be
appropriate for this.

13AUDITING THEORY AND PRACTICE
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