3 More AFRC Inspection Deficiencies to Resolve Today
We have provided AFRC Inspection consultancy and monitoring reviews to many CPA Practices in Hong Kong, and we have familiarized ourselves with dozens of potentially significant audit deficiencies that are prevalent in over half of the reports we have reviewed.
Deficiency #1: Lack of Procedures on Unrecorded Liabilities
Background
What are your typical audit procedures on liabilities? What are the most relevant assertions on liabilities? As auditors, we should be concerned with the risk of understatement of liabilities. Audit confirmations alone may not confirm the completeness of liabilities and this is one of the key areas focused on by AFRC Inspectors – the adequacy of in every selected audit file.
Many CPA practices may have a working paper template to perform the search for unrecorded liabilities but often would just document that there is no material payment subsequent to the end of the reporting period. While this AFRC Inspection finding on itself would not normally lead to a disciplinary action, however, multiple of these minor breaches of the Hong Kong Standards on Auditing can potentially lead to a complaint on the auditor’s level of professional competence and due care expected of a practising accountant.
What should be done
Your team should understand the concepts of how a search for unrecorded liabilities is performed. By sample checking to material payments after the end of the reporting period, you may trace to the related invoices for which these payments are settling and assess whether accruals or provisions made as at year-end date were recognised in the proper accounting period. It is also important to select material payments directly from a variety of source documents, such as payment vouchers, bank statements and unprocessed suppliers’ invoices.
For example, ABC Company Limited has a financial year-end date on 30 June 2021, and in July 2021, its bank statement recorded a material payment. Through inquiry and tracing to the ledger of the Company, you may find that the payment is for a settlement of supplier’s invoice for the trading of goods that was issued on 15 June 2021, and the risks and rewards relating to the purchased goods have already been transferred to the company in June 2021. If you find that the liability was recorded in July 2021, then account payables would be understated.
Deficiency #2: Fraud Risks not Considered in Addressing Management Override of Controls
Background
What are your standard procedures in addressing management override of controls? Would you identify this as a presumed fraud risk, and if yes, then what unpredictable procedure would you adopt to address the risk of management using creative journal entries, or biased accounting estimates to perform window-dressing accounting?
Fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively. Some common techniques to commit fraud include recoding fictitious journal entries, inappropriately adjusting estimates and judgements, omitting and delaying the recognition of certain transactions, or even concealing facts that could affect amounts recorded in the financial statements.
What should be done
Your audit team should make inquiries of senior management of your audit clients, who are involved in the financial reporting process about any unusual activity relating to the processing of journal entries and adjustments and document your findings of these inquiries. In addition, you should consider significant transactions that are outside the normal course of business for that entity, and those that are made at the end of the reporting period and consider whether the business rationale of the transactions suggests that any fraud has been committed to conceal the misappropriation of assets.
By identifying characteristics of journal entries that may indicate a higher fraud risk, you may then trace to source documents of those journal entries displaying such fraud risk characteristics to help you assess the business rationale of these transactions. In addition, by performing retrospective reviews of accounting estimates and significant accounting judgements to assess if there is a risk of material misstatement due to fraud.
Case Study #1 Proceedings No. D-19-1529P
Date of Disciplinary Order: 13 May 2021
Penalty: HK$100,000
Costs: approximately HK$70,000
Cancellation of Practising Certificate for 6 months
#1 Case Study Details
In this case, the respondent failed to perform inquiries of the client’s management during the planning phase of the audit regarding fraud risk assessment and determine whether the management has knowledge of any actual, suspected or alleged fraud affecting several of the selected clients’ audit engagement by the QAD in a inspection.
Case Study #2 Proceedings No. D-19-1463P
Date of Disciplinary Order: 30 December 2020
Penalty: HK$50,000
Costs: approximately HK$164,448
Cancellation of Practising Certificate for 20 months
#2 Case Study Details
In this case, the respondent failed to perform audit procedures and consider fraud risk in revenue recognition and management override of controls, including testing of non-standard journal entries with fraud risk characteristics and the testing of biased accounting estimates.
Deficiency #3: Improper Procedures on Sales Cut-off Testing
Background
In many AFRC Inspection engagements that we have provided consultancy services in assisting the replies to the Institute, we have noticed that many practices have only performed substantive tests on sales to address their occurrence and completeness but not on cut-off of sales. How do you determine the proper extent of sample size on sales cut-off tests, and what are the correct source documents to trace to ensure that revenues are recognised in the proper accounting period.
What should be done
It is a common practice to select the last 3 to 5 sales transactions of the reporting year, followed by the same number of the first sales transactions in the following year. However, many practices do not sufficiently document the reasons for selecting this sample size. It is crucial for your audit team to consider the normal “operating cycle” of your client’s entities and the frequency of control activities that help to oversee the correctness of sales transactions.
For example, if a company operates in the trading of goods, and a normal operating cycle from issuance of sales invoices to the delivery of goods and posting of sales entries is approximately 1 month, and the sales manager and director would review the sales transactions on a weekly basis. On these assumptions, it may be justifiable to only select samples within the 1 month around year-end date, and the sample size can be determined based on the average number of sales transactions in any representative week.
Another example of a frequent common finding on the sales cut off is the checking of improper source documents to ensure that performance obligations have been fulfilled. It is important to remember that the issuance of sales invoices or the settlement of invoices should not act as the primary indicator on whether sales should be recognised. For a company that is engaged in the trading of goods, delivery or shipping terms should be examined and actual departure / arrival dates when the risks and rewards are transferred to the customers should be documented in your tests of details. These departure / arrival dates are often only found on delivery notes or bills of lading.
Case Study #3 Proceedings No. D-18-1372F and D-18-1407F
Date of Disciplinary Order: 31 August 2021
Penalty: HK$300,000
Costs: approximately HK$3,600,000
#3 Case Study Details
In this case, the respondents submitted working papers of an audit of a group’s revenues with 19% represented by retail sales. Part of these retail sales were made with deposit received in advance. The audit client should recognize revenue from the sales of goods upon the transfer of risks and rewards of ownership of the goods to the customers, which should coincide with the time when the goods were delivered to the customers. However, the audit work showed that the audit client recognised the revenues on a cash basis, i.e. on the dates when the deposits were received, rather than the dates when the goods were delivered.
While the CPA practice performed inquiries of the management regarding the revenue cycle, performed walkthrough tests, sequential tests as well as cut-off tests, the documentation on how cut-off was ascertained as inadequate, as the practice mistakenly accounted certain delivery of goods from warehouses to the retail shops as delivery to customers.