Auditing and Assurance: Financial Analysis and Risk Assessment Report

This report provides a comprehensive analysis of auditing and assurance principles, focusing on risk assessment and financial analysis. It examines factors that increase or decrease the risk of material misstatements, considering the case of Homes South Ltd (HS). The report identifies specific audit risks and recommends appropriate audit procedures. Additionally, the report analyzes financial information from Darfield Electronics, identifying mismatches in financial data and assessing potential audit risks, such as overstatement of revenue, misallocation of costs, and insufficient provisions for doubtful debts and outdated inventories. The report highlights the importance of understanding financial statement analysis and risk management within an auditing context.

Running head: AUDITING AND ASSURANCE
Auditing and Assurance
Name of the Student
Name of the University
Author’s Note

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Table of Contents
Introduction................................................................................................................................2
Answer to Question 1.................................................................................................................2
Answer to Question 2.................................................................................................................6
Analysis of the Information...................................................................................................6
Identification of Audit Risks..................................................................................................8
Audit Response......................................................................................................................9
Conclusion and Recommendations..........................................................................................10
References................................................................................................................................11

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Introduction
Auditing refers to the process to examine the financial records of an organizations in
order to determine that whether they are correct and they are recorded in accordance with the
applicable accounting rules and principles (Leung et al. 2015). External auditors come from
outside companies for examining the financial and accounting records of the client
organizations in order to provide independent audit opinion on these financial and accounting
records. Law puts the obligation on the listed companies to have their financial reports
audited by external auditors. External auditors have the prime responsibility to gather all
information of the audit clients that are required to conduct the audit. After that collection of
all the required information and facts, it is needed for the auditors to analyse the factors that
would create impacts on the material misstatements. At the same time, external auditors are
also required to analyse the draft financial information of the clients in order to identify the
audit risks in them. After identifying the audit risks, the external auditors are accountable to
undertake appropriate audit procedures in respond to the risks identified (William Jr, Glover
and Prawitt 2016). There are two parts of this report. The first part of the report involves in
indicating the factors that would affect the risks of material misstatements along with reasons.
The second part involves in analysing the draft financial information for the identification of
audit risks along with the required respond from the auditors.
Answer to Question 1
Consideration of the provided information Homes South Ltd (HS) shows that there
are two types of factors in the company; one would likely to increase the risks of material
misstatements and the other would probably decrease the risks of material misstatements.
Both these types of factors are discussed below:

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Factors Contributing to the Increase in Risk of Material Misstatements
1. It can be seen from the provided situation that there is a major volatility in the interest
rate and this interest rate is a major factor for the mortgage business of HS. This
volatility in the interest rate is continuously increasing and decreasing in short
intervals which is affecting the mortgage business of the company. For this reason,
the price of mortgage is being affected and this can lead to the risk of material
misstatements (Hosseinniakani, Inacio and Mota 2014).
2. George Watson is the majority shareholder of HS whereas he is also the Chief
Executive Officer and is responsible for controlling the Board of Directors of the
company. It indicates that George Watson has the large amount of power and can
influence the decision making process of the company. This increases the chances of
fraud in the key accounts of the financial statements by him that can lead to material
misstatements in the financial reports of HS (Bhattacharjee, Maletta and Moreno
2016).
3. It is mentioned in the provided case of HS that the management of the company is
compensated based on the profitability of branches. This increases the chance of
fraudulent activities around the profitability of the branches by deliberately
overstating the profits or understating the expenses in order to increase the
profitability of the branches. This incentive or motivation of the management of HS to
increase the profitability for getting higher compensation increases the chance of
material misstatements in the financial statements of the company (Ruhnke and
Schmidt 2014).
4. As per the provided information, the formula of HS that is the accounting estimation
has failed in correctly estimating the allowance amount for loan losses. It indicates
towards the presence of key uncertainty in the accounting estimates and assumptions

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used by the management of HS in the accounting for allowance for loan losses. This is
a crucial aspect that can increase the risk of material misstatements (Abdullatif 2013).
5. In the year 2019, a new branch office was opened by HS in a metropolitan area that is
30 kilometres from the principal business place and this branch has not been able in
producing profitability yet. This increases the fraud risk of manipulating the amount
of revenues and expenses of the branch for increasing the profit of the branch.
Therefore, this needs to be considered as a crucial factor that can increase the risk of
material misstatements in HS (LópezPuertas‐Lamy, Desender and Epure 2017).
6. A new computer system has been installed by HS in 2019 in order to increase the
operational efficiency. However, certain negatives are associated with this new
accounting system. In case there is any types of errors in the new system and in case
the new system shows errors in collecting data, there can be material misstatement in
the financial statement of the company (Lobo and Zhao 2013).
Factors Contributing to the Decrease in Risk of Material Misstatements
1. HS operates in the finance industry that is governed as well as regulated by extensive
legislations and regulations imposed by the government. Compliance with these
extensive legislations and regulations reduces the scope of fraudulent activities in the
financial statements of the companies operating under this industry. This is a crucial
factor that reduces the risk of material misstatements in HS (Askary, Arnaout and
Abughazaleh 2018).
2. It can be seen that the main operations of HS are in the prosperous rural area that has
experienced significant growth in the recent year. When a company is already
profitable, there is not much incentive or motivation for its management to
manipulatively increase the profitability. This factor reduces the risk of material
misstatement (Al-Khaddash, Al Nawas and Ramadan 2013).

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3. It can be observed from the facts of the case that there is a considerable growth of the
products in which HS deals which increases the scope of the company to deliver more
products for increasing the sales and profitability. This is a crucial aspect that
decreases the risk of material misstatements.
4. It can be seen from the provided information of HS that there is a favourable
availability of funds for the business of HS for the additional mortgages. The
company has been able to continuously sell their mortgages as a source of new
lendable funds. Therefore, the presence of adequate funds decreases the risk of
material misstatements (Al-Khaddash, Al Nawas and Ramadan 2013).
5. It is provided in the case that there has been very little turnover of employees in HS’s
accounting department which indicates towards superior knowledge and skillset of the
employees under this department. Therefore, long-standing employees with effective
accounting skills and knowledge decreases the risk of material misstatements.
6. It can be seen that the internal auditor of HS uses to directly report to the audit
committee chairman who is a minority shareholder instead of George Watson. This
helps in retaining the integrity and honesty of the internal audit team and this keeps
informing the minority shareholders about the internal affairs of HS. This factor
decreases the risk of material misstatements (Vaicekauskas and Mackevičius 2014).
7. It is mentioned in the provided case of HS that J Audrey Pearce has been auditing the
financial statements of HS for last five years and it means that he is well aware of the
trends of the financial performance and position of HS along with the industry.
Therefore, this is tough for the management of HS to manipulate the financial
accounts in the presence of the auditor that ultimately decreases the risk of material
misstatements.

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8. It is clearly mentioned in the case that the management of HS has always been
receptive to the suggestion of the auditors on different aspects. This implies the
presence of effective internal control within HS as per the suggestion of the auditor.
This is a crucial fact that reduces the risk of material misstatements in the financial
statements of HS (Vaicekauskas and Mackevičius 2014).
Answer to Question 2
Analysis of the Information
It can be seen from the above table that there is a 27.78% growth in the revenue of
Darfield Electronics from 2020 to 2021, but there is only 10% growth in the cost of goods
sold for the same period along with 50% increase in the gross profit. Large mismatch can be
seen between the increases in operating expenses as operating expenses have increased by
79.33% where there is only 17.85% increase in operating profit (Griffiths 2016).

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As per the above table, there is an increase in the trade receivable days from 52 days
in 2020 to 65 days in 2021. Large disparity can be seen between the increase in revenue and
receivables as revenue of Darfield Electronics has increased by 27.78% where receivables
have increased by 58.60% that is more than double of revenue (Titera 2013).
There is an increase in the inventory days of Darfield Electronics from 52 days in
2020 to 70 days in 2021. There is another crucial mismatch between the increases in cost of
goods sold and inventory because of the aspect that cost of goods sold has increased by 10%
from 2020 to 201 whereas inventory has increased by almost third time of cost of sales that is
31.42% in the same period (García Blandón and Argilés Bosch 2013).
The above table shows that the trade payable of Darfield Electronics has increased
from 44 days in 2020 to 53 days in 2021. Like cost of sales and inventory, there is a
mismatch between the increases in cost of sales and trade payables as the former has
increased by 10% by the latter has increased by 33.09% that is three times that cost of sales
(Titera 2013).

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As per the above table, current ratio of Darfield Electronics has registered a decrease
that is from 5.38 to 2.47; and the same can be seen in case of quick ratio that is from 4.05 to
2020 to 1.63 in 2021 (García Blandón and Argilés Bosch 2013).
Identification of Audit Risks
1. Considering the mismatch between the increase in sales and cost of sales, it can be
said that Darfield Electronics may have made error in recording the sales as the sales
may have been recorded in the incorrect place. There is a major risk of the presence of
overstatement in revenue because of the presence of large sales growth without a
comparative alteration in cost of sales. This is a crucial aspect of audit risk that needs
to be take into account by the auditor (Arzhenovskiy and Bakhteev 2015).
2. There has not been increase in the cost of sales of Darfield Electronics in 2021 in
accordance with the rate of increase in revenue; but at the same time, there has been
major increase in the operating expenses of the company. All these aspect indicate
towards the possibility that there may have been a misallocation of costs where the
costs have not been classified as well as allocated based on their nature (Wang and
Cuthbertson 2015).
3. It can be seen from the analysis of the information of Darfield Electronics that the
trade receivables of the company have registered a large increase; at the same time,
trade receivable days have also been increased majorly from 2020 to 2021. Since this
increase is not in accordance with the increase in revenue, there is a risk of the
presence of insufficient provision for doubtful debts by the management of Darfield

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Electronics in order to increase the total current liabilities for showing a goods short-
term liquidity position. This needs to be considered by the auditor (Hooda, Bawa and
Rana 2018).
4. Darfield Electronics has registered an increase in the inventory days along with
inventory in 2020 as compared to 2021. Given the large mismatch between the
increases in inventory and cost of sales, it can be said that there is a risk due to the
potential presence of insufficient provision for outdated inventories by the
management of Darfield Electronics. Another possibility is that the management of
Darfield Electronics has not transfer the inventories to the cost of sales that should
have been done. This needs to be considered by the auditor (Wang and Cuthbertson
2015).
5. Earlier analysis shows that both the current ratio as well as quick ratio of Darfield
Electronics have largely fallen in 2021 as compared to 2020. This indicates that
Darfield Electronics is facing major issues in paying off the current business
obligations in the absence of adequate current assets and quick assets. This aspect is
in line with the large increase in trade payable and trade payable days. All these
aspects indicate towards the presence of going concern risk in Darfield Electronics
(Hooda, Bawa and Rana 2018).
Audit Response
1. It is needed for the auditor to undertake cut-off test of sales through obtaining and
acknowledging sales invoices issued by Darfield Electronics in order to check the
customers’ dates of acknowledgement so that it can be assured that the sales invoices
are of same accounting period when the company has recognized the sales (Byrnes et
al. 2018).

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2. Darfield Electronics uses certain valuation process for inventory in order to determine
the values of inventories. It is required for the auditor to verify the fact that the
method mentioned in the financial statements has been followed by the accounting
system of the company. This also helps in determining associated costs with
inventory.
3. In case of trade receivables, the auditor needs to compare trade receivable days to the
last year’s data, review the appropriateness of allowance for doubtful debts by
discussing with the management. Moreover, the auditor is required to examine the
large customer accounts in trade receivables while comparing them with previous
year’s balance (Abdullatif 2013).
4. It is needed for the auditor of Darfield Electronics to test the allocation assertion of
expenses. This requires the auditor to verify whether the expenses have been properly
classified as well as presented in the financial reports of the company.
5. The auditor of Darfield Electronics is needed to assess that whether there is any
material uncertainty in the company that can cast significant doubt on the ability of
the company to continue as a going concern in future. Moreover, the auditor is also
needed to undertake analysing the management’s assessment on the presence of any
material uncertainty, events or circumstances (Daniela and Attila 2013).
Conclusion and Recommendations
The above analysis shows that business organizations have certain factors that
increase the risk of material misstatements and there are certain factors that reduce the
possibility of the risk of material misstatements in the financial statements. For example, high
competitiveness of industry, complex accounting judgment, less profitability and others are
the factors that increase the risk of material misstatements; and factors like effective internal
control, governance mechanism and others reduce the risk of material misstatement. The

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above discussion also shows that analysis of financial information helps the auditors in
identifying the audit risk which is required to undertake the appropriate audit procedures by
them.
On the basis of whole discussion, it is recommended to the auditors that they should
design the audit based on the outcome of the analysis of the unaudited financial statements of
the clients. This is helpful for the auditors in identifying the areas that are of high audit risk
and require additional audit attention. Moreover, the auditors are recommended to consider
both types of factors responsible for increasing and decreasing the risk of material
misstatements.

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