1. Preliminary analysis to understand the client‘s business and risk - Understanding the auditee’s business, environment, and risks
- Mature company, has been around for more than 15 years, simple business structure – manufacturing and merchandising, heavily based on inventory sales, however it is highly prone to competition in this industry. The intensity of rivalry is very high in this industry.
- MIT is taking initiative in differentiating their products as they are seeking out new opportunities, such as importing from Italy. This would most likely allow MTI to be differed from the competitors in the industry, and improve brand image and gain customer loyalty. This industry has very high threat of substitute products as well as the barriers to entry are very low for this industry. These high level threats in the industry due to competition chip away the sales of the existing companies. These are business risks that MTI face due to the nature of the company and the industry.
- The newly implemented sales strategy (importing from Italy) creates a new product line, and the business risks related to this addition are: getting familiar with the legal policy requirements for imported product requirements, exchange rate risks. The customers are newly introduced to this product line as well therefore the company is unfamiliar with the demand and needs of the Canadian customers with regards to internationally imported products. The uncertainty of the demand in the Canadian market may hinder the company’s performance
- Users of the financial statement: shareholders (3 in total), creditors (banks who provided loans to the company), major suppliers and major customers – not a complex audit
- There may be entity risks related to the implementation of the new IT and accounting system. Risk of material misstatement is very high
- Sales are highly credit based therefore there are risks related to the collectability of receivables and the valuation of allowance for doubtful accounts and bad debts.
2. Perform preliminary analytical procedures to identify significant audit issues
- Ratio Analysis: three ratios were calculated – (1) Days Sales Outstanding: 2010 – 99.85 days (2009 – 65.80 days); (2) Inventory Turnover: 2010 – 4.04 times (2009 – 6.26 times); (3) Debt-to-Equity: 2010 – 2.29 (2009 – 1.18) o MTI is taking longer to collect their accounts receivables as the days sales outstanding has increased drastically. This is an indication of poor accounts receivables collection process as it is taking longer for the company to collect their revenue on their sales. This poses a risk in hindering sales from the company and future company performance. o MTI’s inventory turnover has slowed down, this is also supported by the decrease in sales from 2009 to 2010, indicating a decrease in performance of the company o Lastly, the debt-to-equity ratio has increased significantly. Per every dollar of equity, there is 2.29 times of debt related. This is a bad indication that the company may be taking on too much debt and would result in liquidity risks and credit risks in the company. Especially that management has put in personal collateral in for the loan, this increases the overall risk of the business
- Horizontal analysis: the most significant change that was noted from the horizontal analysis was the 89% increase in bank indebtedness from 2009 to 2010. Per the financial statement note 3, this was the loan that was secured with inventories, receivables and personal guarantees from the shareholder. This is significantly risky for the company if they were not able to meet their obligations as it may result in liquidity issues. Sales also decreased by $1.1 million in 2010 compared to 2009; financial expenses increased by 74% compared to 2009. The decrease in sales in addition to the effect from taking on new financial loans resulted in the 2010 net loss.
- Vertical analysis: the only two changes that are noteworthy through the vertical analysis is the increase in bank indebtedness as a proportion to total liabilities and shareholders’ equity by 11%, as well as a 7% increase in cost of goods sold as a proportion of total sales. There were no other issues that may pose risks onto the audit.
3. Perform preliminary materiality and justify you conclusion;
- MTI is experiencing a net loss in 2010. The net income has fluctuated significantly from 2009 to 2010, thus the net income or operating profit are not appropriate bases to determine materiality on.
- Revenue would be the new base that would be used to determine materiality. Total assets is another good alternative, however this company does not have many operating assets (only inventory and PPE are the significant accounts)
- Materiality is then determined as 1% of total 2010 revenue/sales: $61,159. This would be the overall materiality for the entire financial statement.
4. Set your Audit Risk assessment and why
- Business risk evaluation – possible and moderate = medium business risk. The threat of new entrants and substitute products are very high, in addition to the high level of competition in the industry. Therefore, the business risk that MTI faces – losing customers due to lack of product differentiation, profit decrease due to increase in competition in the industry are likely possible to occur. In addition, the effects from new companies entering the industry will have a moderate effect on MTI’s revenue stream. As a conclusion, MTI faces medium business risk.
- A reasonable assurance level would be around 90-95% for such business (having lowest 5% as overall audit risk). An assurance level of 93% is selected due to the medium risk nature of the company. In result, an acceptable audit risk would be 7%
5. Assess the Risk of Material Misstatement (IR and CR)
- Inherent Risk – medium to high o AR collectability risk – due to the nature of sales transactions of MTI – sales on account o Default risk on the bank indebtedness loan that MTI took on. There may be personal shareholder liability in case of default o Exchange rate fluctuations in the global economy would affect MTI’s cost of goods sold, as well as revenue levels o Revenue recognition is most vulnerable for errors, especially for a company that is highly dependent on sales on account o Budgets are not created – lack of accounting competency in accounting department – no benchmark for performance
- Control Risk - High o Weakness in the accounting process and accounting system from prior year o Implementation of the new accounting system – unfamiliarity with the new system may result in human error and incompatible design of the system to the company’s needs. The parallel system was only used for a month and the company forced the new system to go live. This may result in mistakes in accounting records during the transition period o Management override issues o There are no controls on reconciling computer prepared input data to the output o There are no master file controls

A lot of substantive procedures should be used to lower detection risk to lower the audit risk as a whole.