Financial Statements are prepared to show the true and fair view of the state of affairs of the company.Balance Sheet to show the position of assets and liabilities and Statement of profit and loss to show the net result of operations over a period. Relating to Financial Statements, the risk that we would be concerned is of risk of material misstatement. Risk of Material Mistatement may arise due to;
(i) Recording of revenue item as capital or a capital item as a revenue item. By doing so the profits for the period do not reflect at their true value. (ii) Overstating or understating of receivables/payables, on doing this actual payable or receivable might be substantially different from the one really due to or by us. (iii) not following the accrual policies of accounting, leading to which expenses or incomes of one period get recognized in another period affecting the true and fair view. (iv) recording cash transaction as a credit one and showing artificial debtors/creditors hence misappropriating cash(using cash for some other purpose for the remaining credit period). (v) Recording of an expense of personal nature as business expense to reduce business profits so as to lower tax burden. (vi) Creation of bogus workers at the year end and making more payouts and thus increasing expenditure as at the year end. (vii)Booking huge amounts of sale on the year end to show a better GP.
Adressing the risk of window dressing
Window Dressing is a technique employed by enterprises to cover up the weak status of operations or present a better looking set of financials that what actually is. Overstating of closing stock is an example of how one can boost Gross Profit. Even Charging of depreciation at lower rates shows higher profits and stonger backing by fixed assets in the balance sheet. The motive behind window dressing might be to
1)show a better picture of the financials especially in the case of listed companies so as not to affect the price of shares or induce favourable movement in the share price 2) attract investors 3)to manipulate certain ratios for the purpose of obtaining loans from a financial institution 4) or it can also be to reduce tax burden.
Window dressing can be checked up in various ways:
(i) External confirmations from debtors and creditors can help us know whether the balances represented in our books are correct. (ii) Intra company and Intercompany comparison can be made for various industry standards.Various accounting ratios can be compared with PY and also with standards for that particular industry. (iii) In case of income recognition, Cut off procedures can be applied to see whether actually income accrued during the period. In case of sales cut off it should be particularly observed that double recognition does not take place, that is an item does not find place in both sales and closing stock.
(iv)Bank Balances and Deposits can also be confirmed to see whether actually the company has got such deposits. Another thing to be checked here can be whether any lien has been marked on these deposits or BG given out by banks against these deposits and the appropriate disclosure of the same. (v)Fixed Assets can physically be verified to see whether they actually exist or are in a working condition.
Window Dressing in accounting refers to fudging the financial statements to throw a sound financial position and rosy picture about a company An adjustment made to a portfolio or financial statement to create a more positive appearance than is actually the case. For example, a manager may decide to provide window dressing to a portfolio by selling stock that has declined in value and replacing it with stock that has increased in value. Such activity creates the impression of successful portfolio management. Likewise, a firm might adjust its current assets and liabilities prior to the release of its financial statement
The American Heritage® Dictionary
This phase of the audit process is not just a planning tool, but an integral part of evidence gathering. Since risk assessment directs the auditor’s attention to issues that merit further consideration, it should be based on the inquiries, observations and audit evidence gathered by the auditor; this gathering and documentation of evidence is important. Generally, simple inquiries of management are an insufficient basis for this assessment. In addition, according to SAS no. 109, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement,risk assessment procedures alone are not a sufficient basis for rendering the audit opinion. As part of the risk assessment process, the engagement team should hold a brainstorming session to consider the nature and magnitude of possible misstatement risks.
This session may be combined with the brainstorming session on fraud risks required by SAS no. 99, Consideration of Fraud in a Financial Statement Audit. To meet this requirement, a sole practitioner might challenge himself or herself to be objective and critical when updating past risk assessments and documenting changes in the business environment. While not intended as a checklist of all factors, appendix C to SAS no. 109 provides specific examples of risks for consideration. This list, plus other factors identified in the standards, may facilitate productive discussions during the brainstorming session. These factors have roots in business risks that in the past have led to audit issues. It is expected that on every audit the auditor will identify one or more significant risks before considering related controls.
For example, a significant inventory of precious metals or gems might be a significant risk in an audit of a jewelry business. In other businesses, such risks may arise due to unique transactions, adjustments or critical accruals, such as the estimation of highly subjective allowances. For significant risks, the auditor should (1) consider the design and implementation of related controls, (2) avoid reliance on analytical procedures alone and (3) rely on evidence gathered only in the current period for controls assurance. By their nature, some risks may have especially pervasive effects on financial reporting. For example, one risk may be associated with the weak business background of those charged with governance (that is, the owners or a group such as the board of directors).
This type of overall risk can affect many accounts and measures, but others relate more to specific accounts and assertions. For example, a risk of misstatement of inventory amounts due to obsolescence risk in a line of inventory products would be related to the valuation assertion for that account. Both these types of risks—overall and assertion-based—may affect auditors’ actions and procedures, but in different ways. An overall audit risk might require a more experienced engagement team, while the obsolescence risk in inventory may require specific, directed procedures, such as a more detailed analysis of product demands and inventory turnover.
LINKING RISKS AND PROCEDURES
An important requirement in these standards is the need to link identified risks to relevant controls and to the audit actions designed to respond to these risks. Such a linkage helps the audit team determine whether the risks are addressed, assists in communication on the audit and helps reviewers, including peer reviewers, follow the implementation of the audit strategy. In practice, simpler audits may accomplish this linkage through careful cross-referencing of audit documentation. For more complex situations, this linkage may be supplemented by a planning or engagement strategy memo or matrix.
In heightening the importance of using assertions to link risks, the standards also have revisited the assertions in the literature and expanded them to articulate presentation and disclosure issues. The specific assertions listed in SAS no. 106, Audit Evidence (see exhibit 2 , below), do not have to be used if auditors employ assertions that are essentially equivalent.