BSA-3A Simulated Audit Group 2 PDF

PHASE 1 - RISK ASSESSMENT A. Preliminary Engagement Activities, Audit Planning and Understanding the Entity Activity 1 - Performance of Preliminary Engagement Activities Initially, you and your team are tasked to make a study of the possibility of accepting the engagement. Information gathered which may be relevant to this are summarized in the "Data Sheets" as follows: General Information Sheet Trend in the industry Predecessor Auditor Issue Audited/unaudited Financial Statements Organizational Chart Job Description for specific personnel Summary of significant board resolutions 1. In compliance with PSA 220 & 210, enumerate the pre-engagement activities required for this audit engagement (Vergara, Erica) Pre-engagement Activities 1. Client Acceptance and Continuance Process A.1 Client Acceptance As part of the preliminary engagement process, the firm will conduct a thorough assessment of the client’s suitability for audit in accordance with PSA and GAAS standards. This involves examining the integrity of the client’s management, including their professional reputation, ethical conduct, and commitment to transparency in financial reporting. Additionally, the firm will assess the company’s financial history to ensure consistency, reliability, and stability, with particular attention to any financial restatements, audit modifications, or unusual trends that may present risks. By also evaluating management’s openness and cooperation, the firm aims to establish the foundation of trust and transparency essential for a high-quality audit engagement. a. Self-Evaluation as an Auditor - Before accepting a new client, auditors should thoroughly assess their own readiness and capability to perform the engagement. Competence - We must evaluate whether the audit firm possesses technical skills and knowledge required to effectively conduct the audit. Capability - The client's industry, market challenges, and regulatory environment must all be understood by auditors in order to perform an efficient audit. In this situation, auditors need to become knowledgeable about the manufacturing sector's changes, the pressures from competitors, and the particular difficulties the client's industry faces. Resources - As auditors, it is our responsibility to make sure we have enough employees and time. This covers both the appropriate skills and the quantity of employees. (For instance, more seasoned team members concentrate on higher-risk areas like revenue recognition or inventory valuation, while inexperienced auditors may tackle mundane work.) Timing is also covered in this resource check to make sure the audit can be finished on time without putting too much strain on the team. b. Ethical Requirements - As auditors, it is our duty to verify if the client has committed themselves to fulfilling their ethical responsibilities in financial reporting, which may involve complying with the relevant regulations and laws (such as the Code of Ethics for Professional Accountants and Philippine Standards on Auditing). This stage is essential because it shows that the client is prepared to operate within an environment of openness and honesty. c. Integrity of Client Management - The audit firm must assess the client’s integrity by evaluating management's ethical tone, past conduct, and overall reputation within the industry, looking specifically for any history of compliance issues or legal disputes. This includes examining transparent communication with the audit team and the ethical culture promoted by management, both of which indicate the client’s commitment to ethical standards and cooperation. A.2 Independence Assessment Ensure no conflicts of interest exist, especially considering Oca Pacom’s relationship with Mega Development Bank and Jim Sesinando’s connection to Forever Mfg. Co. In the independence assessment, it’s essential to confirm that no conflicts of interest could compromise objectivity. Specifically, the audit team should consider any relationships between team members and the client that might impair independence or create the appearance of bias. In this case, Oca Pacom’s financial relationship with Mega Development Bank—a lender to the audit firm—may introduce a perceived conflict, as Mega Development Bank’s director, Jim Sesinando, has connections to Forever Manufacturing Company. This relationship could appear to affect the auditor’s impartiality; therefore, the audit firm must evaluate if safeguards, such as additional oversight, can mitigate this potential conflict to maintain an unbiased perspective. B. Engagement Letter After confirming the preconditions for the audit, the auditor formally documents the agreement with management in an engagement letter, as required by PSA 210. This letter serves as a contract that defines the terms of the audit, including the scope of work, specific auditor and management responsibilities, and any limitations that may apply to the engagement. It clarifies the objectives and procedures of the audit, outlines reporting expectations, and ensures that both parties understand their roles and obligations. By setting these expectations in writing, the engagement letter also provides a legal framework that helps manage potential misunderstandings and protects both the audit firm and the client. 2. Summarize the information gathered which you assessed as critical in making a decision to accept or not to accept the engagement. (Camacho, Kyla Ephraime) Relationship Dynamics: Oca Pacom’s borrowing from Mega Development Bank may create a perceived conflict of interest. Related Party Relationships: Key board members, including Rafael (Chairman of the Board), Ariel (Vice Chairman), Mrs. L. Ogie (Director), G. Janno (Director) and R. Jaya (Director), have significant ties to companies involved in key transactions, such as Mega Dev. Bank, Videoke Machines Unlimited, and Electronic International Supply. This raises concerns about related party transactions and potential conflicts of interest, which may impair the auditor’s ability to remain independent and objective. Jim Sesinando’s Influence: His relationship with a major stockholder raises concerns about potential bias or undue influence on the audit. Forever Mfg. Co.'s Financial Health: Assess the company’s financial stability and prior audit history to understand risks better. Reputation Risks: Consider the firm's reputation and ethical standards in light of potential conflicts. Predecessor Auditor Issues: the predecessor migrated to Australia 5 months ago Internal Control: The procurement head didn’t check the deliveries causing an over-supply of videoke machines. Tax payments: Based on a comprehensive review of Forever Manufacturing Company’s tax obligations, it has come to light that there may have been an underpayment of tax. This potential underpayment appears to stem not from any omission of reported sales or revenue but rather from possible discrepancies in the calculation process. Given the notable increase in operating expenses this year—including areas such as salaries, meals, and rental expenses—these financial adjustments may not have been fully captured in the original tax computations. Financial Statements: The company's rising inventory, decreasing cash and receivables, and increasing sales and retained earnings raise significant concerns regarding inventory valuation, cash flow liquidity, revenue recognition practices, internal control effectiveness, payables management, sustainability of profitability, and overall audit risk. Weak Internal Controls: There are inadequate segregation of duties and internal controls based on the company's job descriptions and processes (ex. lack of checks and balances in procurement, stock management, and financial reporting). Industry Risk: The company operates in an industry facing stiff competition from smuggled products, technologically advanced competitors, and shifting consumer preferences (ex. new videoke technologies, magic sing microphones). This heightens the risk of going concern issues, inventory obsolescence, and misstatement of asset values. Key considerations for deciding on this audit engagement include potential conflicts of interest, such as Oca Pacom’s borrowing relationship with Mega Development Bank and the close ties between board members and companies like Electronic International Supply and Videoke Machine Unlimited. These related party connections may affect auditor independence and objectivity. Additionally, Jim Sesinando’s link to a major stockholder would introduce bias or undue influence in the audit process. The financial health of Forever Manufacturing Co. also raises concerns, particularly with its rising inventory levels, reduced liquidity, and the issue of potential tax underpayment with the Bureau of Internal Revenue (BIR), all of which indicate potential instability and reputational risks. Internally, weak controls over procurement, stock management, and segregation of duties suggest a lack of checks and balances, further heightening the audit risk. Lastly, intense competition in the videoke industry, along with shifting consumer preferences and the risk of inventory obsolescence, casts doubt on the company’s long-term viability and presents significant operational and industry challenges. 3. Determine the preliminary assessment of Audit Risk and Engagement Risk. Quantify preliminary assessment of Audit Risk. Correlate the assessment with your answer in no. 2. (Tolentino, Ma. Andrea) Inherent Risk (High) Industry Competition: The company operates in a highly competitive industry with emerging technologies and cheaper alternatives (smuggled products and "magic sing" videoke). This makes it harder to maintain market share, increasing the risk of misstatements related to inventory obsolescence and revenue recognition. Related Party Transactions: Some of the board members are involved in businesses that directly deal with the company. For instance, the sole supplier for electronic parts is owned by R. Jaya, who is also a director. This may lead to a high risk of conflict of interest, and could result in inaccurate reporting of expenses or purchases. Predecessor Auditor Issues: The fact that the previous auditor is unavailable means that there could be issues in opening balances or comparative figures, which adds to the risk. 2. Control Risk (High) Weak Internal Controls: The company has shown significant weaknesses in its internal controls. There are signs of poor segregation of duties and ineffective checks, particularly in areas like procurement and inventory management. This increases the likelihood of errors or fraud going undetected. Revenue and Tax Compliance: The company's revenue recognition procedures and general compliance with tax regulations are under observation due to issues with tax underpayment. This underpayment raises the possibility that some financial adjustments were not properly taken into account when calculating taxes, emphasizing the importance of a thorough review to ensure accurate reporting and compliance with regulatory requirements. 3. Detection Risk (Low) Due to the high inherent and control risks, the chance of not detecting material misstatements (detection risk) is low. The auditor will have to carry out more detailed and thorough procedures to catch any potential issues, but the risk still remains elevated due to the company’s situation. Audit Risk = Inherent Risk x Control Risk x Detection Risk Audit Risk = 80% x 70% x 10% Audit Risk = 5.6% This implies a 5.6% likelihood that the auditor could provide an inaccurate opinion on the financial statements as a result of material misstatements. Considering the high inherent and control risks, this percentage is significant, indicating that comprehensive audit procedures and detailed review of financial reporting practices are crucial to reducing this risk. A high inherent risk suggests that the nature of the business or industry has a greater chance for misstatements. We assumed that 80% of the risk of material misstatements will occur in an assertion before considering any related controls. A control risk of 70% indicates that there is a significant chance that the controls may fail. The risk that a material misstatement will not be prevented or detected by the company's internal controls. Which results in a lower detection risk indicates that the auditor is willing to accept a higher level of risk that their procedures may not catch errors. It is the risk that the audit procedures will not detect a material misstatement that exists. Therefore, with an overall audit risk of 5.6%, it suggests that there is a moderate level of risk that the financial statements may be materially misstated despite the audit procedures. Engagement Risk (Very High) Engagement risk refers to the potential exposure of the auditor to reputational or legal issues because of their association with the client. In this case, the engagement risk is very high because: Independence Issues: Oca Pacom, one of the partners at the audit firm, has a loan from Mega Dev. Bank, where some of the board members (Rafael and Ariel) are directors. This presents a significant threat to auditor independence and conflicts of interest. Related Party Transactions: The presence of related party transactions, particularly with board members, increases the risk of misstatements and makes it difficult to ensure objectivity during the audit. Tax and Legal Risks: The company’s potential tax underpayment raises the possibility of penalties or legal consequences if not promptly addressed. Additionally, if the auditor issues an incorrect opinion based on this underpayment, they could face reputational damage or even legal repercussions. Due Diligence: The necessity of thorough due diligence before engagement. Before accepting an engagement, auditors need to gather comprehensive information about the potential client. This includes understanding the industry, business operations, and financial health. Knowing the client helps assess risks that may impact the audit. Quantifying Audit Risk Based on the information provided, the overall audit risk is high. Here’s how it breaks down: Inherent Risk: High (due to the industry, related party transactions, and financial instability). Control Risk: High (due to weak internal controls and poor oversight). Detection Risk: Low (the auditor will need to do extensive work, but there is still a risk of missing something). Correlation of Assessment with number 2: Independence Concerns: The close relationships between the auditor and key company figures (Oca Pacom’s loan and Jim Sesinando’s influence) present a major risk to independence. Related Party Transactions: The involvement of board members in related entities adds complexity and increases the risk of misstatement, particularly in areas like procurement. Internal Controls: The lack of strong internal controls makes it difficult to rely on the company’s processes, which increases the likelihood of errors or fraud going unnoticed. Financial Health: The company’s financial difficulties, such as declining cash reserves and rising inventory, contribute to a high inherent risk, as do industry challenges like smuggled products and cheaper alternatives. Legal and Tax Issues: The potential tax underpayment introduces significant risks, particularly concerning revenue recognition and tax liabilities. The assessment of engagement risk highlights several critical concerns that impact the auditor's independence and the integrity of the financial statements. Close relationships between the auditor and key company figures, such as Oca Pacom’s loan and Jim Sesinando’s influence, pose significant risks to independence. Additionally, the involvement of board members in related entities adds complexity and heightens the risk of misstatement, especially in areas like procurement. The company's lack of strong internal controls further complicates the situation, making it difficult to rely on existing processes and increasing the likelihood of undetected errors or fraud. The company’s financial difficulties, evidenced by declining cash reserves and rising inventory—contribute to a high inherent risk, compounded by industry challenges such as smuggled products and cheaper alternatives. Together, these factors create a multifaceted risk landscape that the auditor must navigate carefully. 4. How did you assess the following factors as precondition requirements in accepting this audit engagement? Auditor related: Appropriate technical competency required by this engagement (Valencia, Christine Joy) We can identify the appropriate level of technical competency required by assessing factors such as the specific industry knowledge needed to understand the nature of the Forever Manufacturing Company– if they operate in an industry that needs specific technical expertise– so we can identify and understand their manufacturing processes and regulatory requirements. Also, assessing the engagement team’s expertise– if they have the necessary knowledge and experience to address and understand the client’s business. Lastly, is having professional judgment to develop an appropriate audit opinion and related audit report Capability to mitigate possible risk of material misstatement in the financial statement to lower audit risk (Valencia, Christine Joy) To assess the capability to mitigate the possible risk of material misstatement, we consider our capability to do our investigation and research for sufficient appropriate evidence and to work together with the team, having open communication channels to prepare for the comprehensive field audit. Transparency on each member of the audit team is also important and collaboration in working on the audit, like clarifying and answering questions during a regular meeting and giving out clear instructions. This helps in lowering the audit risk, knowing where the potential risk and the team can make an informed judgment on the process of finding and responding to such risk. Compliance with the ethical requirements (Dela Rosa, Kriztine Gail) The code of ethics requires auditors to practice integrity, objectivity,confidentiality and professional competence. Auditors are expected to maintain the highest levels of professionalism and personal integrity while working for the public, since this will enhance the confidence that the public has placed in them. They also have to be polite, respectful, fair, and unbiased to everyone, whether they are a client, public official, or member of the general public. They must be diligent in identifying the public's actual needs and seek to effectively meet them. In addition, they are urged to provide relevant information and services as required, with the objective of enhancing value and satisfying the needs of the communities they serve. Sufficient resources to successfully carry out the engagement (manpower, time & capital) (Dela Rosa, Kriztine Gail) Given the situation, there ought to be enough staff for the engagement if the current team can be divided up wisely without compromising their work for other clients. However, more temporary workers might be required if workloads are particularly heavy right now. There should be plenty of time if the firm can commit enough time and resources to handle this audit well, as well as capital, there should be enough capital available if the engagement's budget is reasonable and yields a profit. But it's crucial to make sure that every expense is covered. Client related: Auditability and Financial Reporting Framework (Tela, Maria Angela) Based on the financial data provided by the Forever Manufacturing Co., there seems to be sufficient documentation, such as a balance sheet and income statement. However, there are some discrepancies found between the audited and unaudited figures. These discrepancies should be investigated. Additionally, the departure of the predecessor auditor without proper handover raises questions about the continuity of records. Moreover, It is essential to confirm that the company follows a recognized financial reporting framework, such as the Philippine Financial Reporting Standards (PFRS). There is no explicit mention of this, so clarification is needed before engagement. Based on Forever Manufacturing Co.'s structure and scope, they seem to require compliance with general accounting standards, but more detail is needed. Management Integrity (Tela, Maria Angela) The board includes individuals, Oca Pacom and Jim Sesinando, involved in related businesses, which could cause potential conflicts of interest. This should be indicated for further scrutiny. Nevertheless, the fact that these individuals have significant business experience suggests some level of professionalism. Moreover, the company has faced challenges (such as decreased sales due to smuggled products and competitive technologies), this might impact the transparency and accuracy of financial disclosures. Additionally, the fact that the previous auditor migrated and is unreachable could indicate poor transition planning or other underlying issues. This raises concerns about management’s commitment to sound auditing practices. Engagement Risk (Barrientos, Catherine) We assess a variety of factors to decide whether the risk level for a client is acceptable. Forever Manufacturing Co. faces a variety of inherent risks due to its competitive and constantly evolving market. These issues include decreasing sales, obsolete items, losing market share, and probable noncompliance with tax and customs laws. Furthermore, their recent unaudited financial accounts reveal a decrease in profitability over the prior year. This raises concerns about financial misstatements, since management may feel prompted to present a more favorable financial image. Overall, these indicators suggest an increased risk of financial mistakes. Agreement of Management Responsibility (Barrientos, Catherine) Forever Manufacturing's management must acknowledge that they are responsible for preparing financial statements and for designing and implementing internal controls. Since there is no direct mention of this agreement in the provided information, this should be clearly established in the engagement letter to ensure the audit is conducted effectively. Additionally, management should understand their obligation to provide access to all necessary records and respond to inquiries truthfully. 5. Are you going to accept the engagement or not? Explain the critical factors considered in the decision. (Lupango, John Rey) Upon assessing the risk factors, financial statements, and other pertinent details regarding the audit, we have decided to accept the engagement, subject to specific conditions and mitigations to address the identified risks. While there are concerns related to the predecessor auditor's unavailability and potential independence and ethical issues, we are willing to proceed with the engagement given the management's commitment to transparency and cooperation. Specifically, we require access to all relevant records, agreement on the scope of the audit, and a mutual commitment to acknowledge and address any key audit findings that may arise during the process. The following factors have significantly influenced our decision to accept the audit: Industry position Forever Manufacturing Co. has a long-standing presence in the karaoke and videoke industry. Despite facing current challenges, their established client base and adaptability to market innovations provide a solid foundation for potential recovery and growth, making this audit a worthwhile endeavor. Initial financial outlook At first glance, the company's financial statements appear promising. Although there are suspicious details—such as the significant increase in meals expense, double value of revenue with minimal increase in COGS—overall, the financials are less complicated than those of other cases we have encountered, which allows for a more manageable audit process. Our issuance of opinion is highly objective and dependent on the audit Initial outlook of the company does not matter because our issued opinion will all be based on the thorough audit procedures that we are going to conduct. Upon arriving at a result of no discrepancies, we can issue an unqualified opinion. On the other hand, if we encounter lack of evidence, or severe material misstatements, we can issue a qualified or disclaimer of opinion. Presence of preliminary data Management has demonstrated a drive to improve financial transparency by providing relevant information necessary for the audit, including: 1. General Information Sheet 2. Industry Trends 3. Predecessor Auditor Issues 4. Audited/Unaudited Financial Statements 5. Organizational Chart 6. Job Descriptions for Specific Personnel 7. Summary of Significant Board Resolutions In summary, these factors contribute to our decision to accept the audit engagement, with the understanding that we will implement necessary measures to mitigate risks effectively. 6. Prepare an engagement letter (Dizon, Rynnylle Dricx) Engagement Letter BPSU CPA's & Associates Balanga City, Bataan October 09, 2024 Mr. Rafael Santos Chairman of the Board Forever Manufacturing Company 5 km West from Commercial District, [City] Dear Mr. Santos, The very purpose of this letter is to inform you that we agreed to engage, operate, and conduct audit procedures on your entity (Forever Manufacturing Company) relating to the Financial Statements which are composed of the Balance Sheet,Income Statements and so the other statements upon request. The objective of our audit is to deliver an expressed opinion whether your consolidated Financial statements are fairly presented in accordance with accounting principles that is generally accepted in the Philippines. Together with the application of the generally accepted accounting principles, considering the accounting evidence that will be the basis in forming an opinion. If we express our opinion other than an unqualified opinion, We will inform you as soon as possible. Also, we would like to emphasize that efforts on contacting the predecessor auditor, even with exerting reasonable efforts, conclude that obtaining information to his/her will be out of the list, previous works and findings relating to the entity are clearly not within the scope. Also, this will be a factor resulting from additional procedures and planning. Our Responsibilities We will conduct our audit in line with the Philippine Standards on Auditing (PSA). These standards mandate that we adhere to ethical guidelines and plan and execute the audit to provide reasonable assurance that the financial statements are free from material misstatement. The audit process includes carrying out procedures to gather evidence related to the amounts and disclosures within the financial statements. The choice of procedures will be based on our professional judgment, including an assessment of the risk of material misstatement, whether arising from fraud or error. Additionally, the audit will involve assessing the suitability of accounting policies applied, the fairness of management's accounting estimates, and the overall presentation of the financial statements. Due to the inherent limitations of an audit and internal controls, there is an unavoidable risk that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with PSA. In making our risk assessments, we will consider internal control relevant to the preparation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of your internal controls. However, we will communicate in writing any significant deficiencies in internal controls relevant to the audit that we identify during the course of the audit. Unless unforeseen difficulties are encountered, our report will be substantially in the following form: [Form and content of the auditor's report will be provided based on our findings.] Management’s Responsibilities Our audit will be conducted on the basis that management and those charged with governance acknowledge and understand that they have responsibility: For the preparation and fair presentation of the financial statements in accordance with Philippine Financial Reporting Standards; For implementing internal controls as management deems necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; and To provide us with: ○ Access to all relevant information necessary for the preparation of the financial statements, such as records, documentation, and other matters; ○ Any additional information we may request for the purpose of the audit; and ○ Unrestricted access to personnel within the company from whom we need to obtain audit evidence. As part of our audit process, we will request written confirmation from management and, where applicable, those charged with governance concerning representations made to us during the audit. We look forward to full cooperation from your staff during the course of the audit. Fees Our fees for the audit engagement will be based on actual time charges incurred by the individuals assigned to the project. The fee structure is as follows: Daily Rate: Each team member will be charged at a per diem rate, depending on their role and level of responsibility. Out-of-Pocket Expenses: In addition to the daily rates, any out-of-pocket expenses incurred during the audit process will be billed separately. All charges will be invoiced as work progresses, and detailed records of time and expenses will be maintained for your review. This engagement letter will remain in effect for future audits unless terminated, amended, or superseded by a new agreement. Please sign and return the attached copy of this letter to confirm your acceptance of the terms outlined for our audit engagement with Forever Manufacturing Company. Yours sincerely, BPSU CPA's & Associates By: John Rey Lupango Audit Manager Acknowledged and agreed on behalf of Forever Manufacturing Company: By: _____________________ Rafael Santos, Chairman of the Board Date: ____________________ Activity 2 - Planning the audit to develop an overall audit strategy and audit plan Related to audit planning you are required to establish the overall audit strategy for the engagement and develop an audit plan to reduce audit risk to an acceptable level. 1. Prepare an overall audit strategy to set the scope, timing, and direction of the audit and to use as basis in the development of the more detailed audit plan by following the steps below. Explains how each will affect the overall audit strategy. A. Determine the scope of the audit by the identifying the characteristic of the engagement (Camacho, Kyla Ephraime) Overall Audit Strategy a. Identifying the characteristics of the engagement that define its scope. The financial framework - The financial framework determines how transactions are recognized, measured, and reported. It influences the accounting policies of the entity and affects the auditor's approach to evaluating compliance with these standards. Understanding the financial framework is crucial for assessing whether the financial statements provide a true and fair view of the entity's financial position. Industry specific reporting requirement - Industry-specific requirements can dictate the format and content of financial reports or additional reporting obligation, influencing areas such as disclosures, risk management practices, and internal controls. The auditor must be aware of these requirements to ensure that the financial statements are compliant and that the audit addresses these specific aspects. The location of the components of the entity. - The location affects logistical aspects of the audit, such as the accessibility of records, the need for travel, and the consideration of local regulations. Additionally, it may impact the auditor's evaluation of risks related to specific locations, particularly in jurisdictions with different regulatory environments. The audit will focus on financial statements and compliance with relevant regulations. Key areas include revenue recognition from sales, procurement processes, and related-party transactions, particularly given the board members’ connections with Mega Dev. Bank. Understanding these elements is important to assess the company’s financial health and risks. B. Ascertain the reporting objectives to plan the timing of the audit , the nature of communication with the client and report submission (Vergara, Erica) 1. Deadlines for interim and financial reporting - Objective: To ensure timely preparation and submission of financial statements to stakeholders, including regulatory bodies and investors. - Explanation: Establishing clear deadlines helps the audit team align their work with the client's reporting schedule. For interim reports, these deadlines may require audits or reviews to be completed in a shorter time frame, influencing the nature and timing of audit procedures. The auditor must communicate these deadlines effectively to ensure compliance. 2. Key dates and organization of meetings with management and those charged with governance to discuss the nature and extent of audit work. - Objective: To facilitate effective communication and coordination between the audit team and management/board members regarding audit scope, expectations, and findings. - Explanation: Scheduling meetings at key dates, such as the start of the audit, mid-audit progress updates, and post-audit discussions, is essential for ensuring that management and those charged with governance are informed and involved. These meetings help clarify expectations, address issues in real time, and ensure that both parties are aligned on the audit's objectives and progress. 3. Discussion with management regarding the expected communication on the status of audit work throughout the engagement. - Objective: To set expectations for regular updates on the audit's status and findings throughout the engagement. - Explanation: Regular communication between the audit team and management is vital for addressing any emerging issues, understanding management's concerns, and facilitating timely responses to audit inquiries. This can include formal updates at scheduled meetings or informal check-ins as needed. Establishing a communication protocol ensures that both the auditor and management remain engaged throughout the audit process. The audit will aim to provide clear and accurate financial information of Forever Mfg. Co. We will plan the timing around key reporting dates, ensuring that we communicate findings effectively with the management and board, leading up to the submission of our final report. C. Determination of factors that will provide the focus and direction of the audit as follows: 1). Determine Overall Planning Materiality. Quantify and justify your answer. (Lupango, John Rey) In order to determine the overall planning materiality in the audit of Forever manufacturing company, we use the rule of thumb, which is using 1-3% of the revenue or expenditures. This is because we cannot use the profit from continuing operations as a basis for materiality for a reason that it is unstable. (It is provided in the income statement of forever manufacturing corporation that they incurred a loss of P191, 551.23 last year and a profit of P542, 403.32 this year, which sufficiently provides that it will be unstable due to the huge leap in the values) Due to the overwhelming suspicious areas in the company’s details, the overall materiality we have set is 1% of the revenue this year. The revenue from this year is approximately P 8,897,450 and multiplied with 1%, which will arrive at a materiality value of P 88,974.50. This means that we are going to examine transactions up to this extent. This level of materiality is appropriate because it reflects the significance of transactions and balances in the context of the overall financial statements. It allows the audit to focus on areas where misstatements could influence decisions made by users of the financial statements. 2). Identify the possible areas with a higher risk of material misstatement (Dizon, Rynnylle Dricx) Accounts Receivable: There was a recorded uncollectible receivables amounting to which is P365,365.00 but there was a statement where in collections of AR clerk are larger so it is really possible that these uncollectible receivables may result in an overstatement if the recorded uncollectible accounts are not accurate or recorded efficiently. Revenue Recognition: The billing operations for both the wholesale and outlet divisions are intricate, encompassing numerous steps, from preparing dispatch orders to issuing invoices. The Accounts Receivable Clerk is responsible for sending collection letters and visiting customers in person to collect payments. Dependence on manual processes can result in delays and increase the risk of errors and inaccuracies, which could lead to the overstatement or understatement of revenue if not carefully monitored. Manual invoicing and collection handling can significantly slow down the billing cycle, affecting cash flow. Human errors are more common in manual systems, leading to incorrect billing or recording of amounts. For instance, failing to record a payment could result in overstated revenue, while billing errors could lead to underreported earnings. Inventory Valuation: An Increased inventory levels may indicate the risk of obsolescence or overstatement if not properly accounted for, especially in a competitive market facing cheaper imports.A sudden increase in inventory might be skeptical at some point. Expense Recognition: At the first glance of the income statement at the operating expenses section, the meals expense can also be questionable in a fact that it almost duplicated the amount of the preceding year records compared to the current year. From a meal expenses of P351,000.00 to P643,000.00 which declares an increase of P292,500.00 based on the presented statements. Related-Party Transactions: We found out that the Board of Directors present in the company do have other businesses engaged with. There were directors that are engaged with the Mega development bank and Riverside Rural Bank which may be subject to possible material misstatement.Also Purchases made from R.Jaya’s company which is the Electronic International Supply and other parties may be looking for a non-compliance on fair-market value principles that may lead to possible misstatement especially R.Jaya was revealed as one of the Directors of the Tax Compliance: As for BIR Assessment, the ongoing scrutiny from the Bureau of Internal Revenue regarding potential underreporting raises concerns about the accuracy of the company’s tax filings.The complexity of tax regulations can increase the risk of non-compliance, leading to possible fines and penalties.Underreporting of taxable income due to improper revenue recognition or failure to report certain transactions. Payroll including the manual in and out of the employees: Potential misstatements in payroll and labor costs include overstated payroll expenses due to inaccurate time records or falsified employee signatures, leading to payments for unauthorized or non-existent employees. Manual payroll calculations may result in errors, causing incorrect payroll expenses, while unauthorized approvals could result in unapproved payments. Cash handling risks may lead to missing or misappropriated funds, creating discrepancies between actual and recorded payroll amounts. Misreporting labor hours on time tickets can cause improper cost allocation, affecting job cost accuracy and inventory valuation. Duplicate records or mishandled documents could lead to incomplete or duplicate labor cost reporting, and cash payroll distribution is susceptible to theft or fraud, further distorting recorded expenses. Effective internal controls are necessary to prevent these misstatements. 3). Identify material components (transaction cycle) and account balances a). Divide the audit into components by preparing summary transaction cycles and determining account balances. Use the following format. You are required to prepare for the Revenue Cycle & Expenditure Cycle. (Lupango, John Rey) Name of Transaction Cycle: Revenue Cycle Description of Transaction Cycle: The Revenue Cycle at Forever Manufacturing Corporation involves a sequence of processes that begin with receiving customer orders and end with collecting payments. The Sales Department initially handles order intake, passing each order to Product Engineering for a review of specifications, materials, and labor costs. Once approved, production proceeds under the guidance of the Plant Supervisor, who coordinates scheduling and materials requisition to meet order requirements. When production is complete, the Sales Department arranges dispatch through either the Wholesale or Outlet division, depending on the customer type. In the wholesale segment, a Dispatch Order, issued in triplicate, guides the AR Clerk in creating a quadruplicate sales invoice. This invoice serves as a record for the sales journal, with additional copies sent with the goods. Outlet sales follow a similar process, but involve a weekly delivery summary that the AR Clerk uses to collect payments on-site from various outlets, which are a mix of cash and on-account sales. The collection process involves the AR Clerk sending collection letters to wholesale customers five days after delivery. If payment is still pending after 15 days, the AR Clerk follows up in person. Collections, including those made by the AR Clerk and direct customer payments, are managed by the Cashier. With a 2:00 PM cutoff each day, the Cashier prepares and deposits collections, recording late-day receipts as next-day transactions. To ensure accuracy, validated deposit slips are added to the cash collection book, and official receipts move to the Accounting Head for Cash Receipt Journal entries and AR ledger updates. Account Balances: Sales: ₱8,897,450 Accounts Receivable: ₱458,417.25 Cash on Hand and in Bank: ₱250,625.45 Finished Goods Inventory: 378, 551.15 Name of Transaction Cycle: Expenditure Cycle Description of Transaction Cycle: The Expenditure Cycle at Forever Manufacturing Corporation includes the stages of procurement, receiving, inventory control, and payment processing. When stock reaches its reorder level, the Procurement Department prepares a purchase requisition, reviewed and approved by the Procurement Head, and forwarded to suppliers. Supplier representatives manage these orders, ensuring that all required goods are delivered promptly. Upon delivery, the Procurement Department inspects goods against the requisition and prepares a receiving report. These items are then handed over to the Stockroom, where the Stockroom Clerk logs inventory details in the stock card. To manage inventory issuance, the Stockroom Head authorizes the release of materials to production as requested by the Production Department, documenting each issuance through supply slips that the Production Cost Clerk uses to update cost records. Supplier payments are processed by the AP Clerk, who forwards invoices to the Cashier. The Cashier then prepares checks, securing final approval from the Administrative Manager before issuance. Paid invoices are recorded in the Cash Disbursement Journal by the Accounting Head, providing a complete record of disbursements. Payroll preparation also falls within this cycle, as the Accounting Head reviews employee DTRs, organizes payroll checks, and distributes cash through the cashier. Account Balances: Accounts Payable: ₱685,850.58 Materials Inventory: ₱1,686,233.33 Work in Process (WIP) Inventory: ₱175,288.00 Salaries and Wages Expense: ₱3,060,480 Depreciation Expense: ₱236,270.81 4). Identify the accounts (within the transaction cycle) which you are not planning to conduct a test of controls. Explain. (Dizon, Rynnylle Dricx) 1. Cash on Hand and in Bank - Reasons for Not Testing Controls: Direct Verification: Cash balances can be verified through direct bank confirmations and reconciliations. Auditors compare bank statements with the company’s records to ensure accuracy. Since cash handling usually involves stringent internal controls and oversight, the risk of material misstatement is generally low. Most companies have structured processes in place to document cash transactions. By emphasizing substantive procedures, such as reconciliations, auditors can effectively confirm cash balances without reviewing every control related to cash management, allowing them to focus on higher-risk areas instead.. 2. Depreciation Expense - Reason for Not Testing Controls: Depreciation is typically calculated using standardized methods like straight-line or declining balance, making it routine and compliant with accounting standards. The base data, such as asset cost and useful life, is generally reliable and less prone to manipulation, reducing the need for extensive control testing. Auditors can rely on substantive analytical procedures by analyzing trends, asset changes, and performing recalculations to verify depreciation without testing every control. 3. Cost of Goods Sold (COGS) - Reason for Not Testing Controls: Since COGS is directly linked to inventory and purchases, auditors focus more on inventory management than on specific COGS controls. Auditors verify COGS by conducting physical inventory counts and analyzing the flow of goods, ensuring accuracy without testing every COGS-related transaction. By comparing COGS to sales trends and historical data, auditors can identify any inconsistencies that might indicate errors.Auditors also review inventory valuation methods (e.g., FIFO, LIFO) for consistency and check for inventory obsolescence, which could affect COGS. 4. Sales Revenue - Reason for Not Testing Controls: Due to the large number of straightforward sales transactions, it’s impractical to test all controls, so auditors use statistical sampling to examine a representative sample. Significant sales transactions can be independently confirmed with customers to verify accuracy and validity. Auditors assess sales trends against industry benchmarks and historical data to identify unusual patterns for further investigation. Auditors also evaluate revenue recognition policies to ensure compliance with accounting standards and that revenue is properly recognized in the correct period. 5. Accounts Payable - Reason for Not Testing Controls:Auditors can verify accounts payable through direct vendor confirmations, which provide reliable evidence of liabilities without the need to test the internal controls over the entire accounts payable process. Supplier statements are typically trustworthy, making them useful for confirming account balances. Instead of assessing controls, auditors may focus on reviewing processes for entering and recording accounts payable transactions, particularly in high-risk areas. Additionally, they can identify unusual vendor payments or changes in payment terms that could signal potential fraud. For inventory management, auditors can verify accuracy through physical inventory counts rather than testing internal controls. They also review established valuation methods for consistency and adherence to accounting policies, analyze inventory turnover ratios against industry benchmarks, and evaluate inventory reserves and aging to identify potential obsolescence or slow-moving stock. 6. Accounts Receivable - Reason for Not Testing Controls: Since the account receivable co-relates to the uncollectible accounts and the uncollectible accounts is deemed high in value as stated at the given information, a test of control wouldn’t be an option anymore for a reason that the control risk is too high and cannot be assess at less than maximum level. So instead of testing controls, it would be directly subjected to substantive testing. 5). Identify recent significant entity-specific, industry, financial reporting or other relevant developments (if any). (Lupango, John Rey) 1. Entity-Specific Developments: Factory Repairs and Machinery Upgrade: Major repairs are planned to install new machinery from Germany to enhance product quality. Research and Development (R&D) Initiative: The company allocated ₱2 million for the R&D of a new product to stay competitive and innovative. Board Resolution for Stock Issuance: The company approved issuing an additional ₱10 million in capital stock, with ₱6 million subscribed by the board members. Intensive Marketing Campaign: The company approved an intensive marketing campaign under direct selling method that has an estimate of 200% increase in sales. 2. Industry-Specific Developments: Growth of Videoke Machine Assemblers: There has been a notable increase in the number of videoke machine assemblers, especially in Raon, Manila. Technological Advancements by Competitors: Competitors like Promac, LG, and Pioneer have released videoke players with advanced features, including built-in songs and large storage capacities. Smuggling of Videoke Players: A significant portion of the market is now filled with smuggled videoke players offered at almost 50% lower prices. Pirated Media: The sale of low-cost pirated videoke discs continues to affect the market, with prices as low as ₱25 per disk. 3. Financial Reporting Developments: Unaudited Financial Statements: The current year's financials are unaudited, reflecting a net income of ₱542,403.32 compared to a prior year’s audited net loss of ₱191,551.23. 4. Other Relevant Developments: Emergence of new products: New products such as magic sing is being introduced in the market which is highly advance and portable than the videoke D. Identify the information (if any) in the pre-engagement activities that will be considered in the preparation of the audit plan. (Tolentino, Ma. Andrea) 1. Predecessor Auditor Issues: The migration of the predecessor auditor raises concerns regarding the continuity of the audit trail. The lack of contact with them suggests potential gaps in documentation and understanding of prior audit findings. We will need to gather any available audit reports and internal control assessments to identify unresolved issues or areas of concern that may require special attention. 2. Financial Statement Trends: A review of the financial statements indicates fluctuations in sales, a shift in product lines, and changes in cost structures. These trends will guide the risk assessment process, particularly in areas such as revenue recognition and inventory valuation. 3. Market Conditions: The competitive landscape described highlights potential pressures on pricing and market share, which may influence revenue and cost forecasts. We will assess how these external factors could affect financial performance and identify related risks. 4. Management’s Strategy: The decisions regarding product development and expansion into new markets indicate management's response to market challenges. Understanding these strategic directions will help identify key operational areas that might require closer examination during the audit. 5. Internal Controls: Evaluating the existing internal control systems, particularly around procurement, sales, and inventory management, is essential. This will help us identify weaknesses that could impact the financial statements. E. Ascertain the nature, timing, and extent of resources necessary to perform the engagement (Tolentino, Ma. Andrea) Nature: Audit Team Composition: We will assemble a team with expertise in manufacturing and knowledge of relevant regulations. This will include auditors with experience in financial reporting, internal controls, and industry-specific practices. Nature of Audit Procedures: Given the complexities in the production and procurement processes, we will employ a combination of substantive testing and control testing. This dual approach ensures that we assess the effectiveness of internal controls while also verifying transactions and balances. Timing: Timing of Audit Activities: Initial meetings with management will help establish a timeline for the audit engagement. We will propose a phased approach to the audit, starting with planning and risk assessment, followed by fieldwork that aligns with key financial reporting periods. Communication: Ongoing communication with the company’s management and the board will be essential throughout the audit process. Regular updates will help ensure that any emerging issues are addressed promptly. Extent: Extent of Resources: The engagement will require adequate resources, including time for fieldwork, meetings with key personnel, and analytical procedures to assess trends and variances. We will allocate resources to address potential issues related to accounts receivable collections and inventory management, given the identified risks in these areas. 2. Prepare the Audit Plan that relates to the following factors in accordance with PSA 315 & 330 by: 1) Description of the Company Forever Manufacturing Company started in the early 1990s, producing karaoke, cassette, and radio sound systems for homes and small restaurants. The company was founded by Regine and Ariel after their marriage. During the mid-90s the demand increased, prompting the company to expand to mass production. The company decided to incorporate formally with Rafael joining as a 35% shareholder. Richard also became part of the company, managing marketing. The board of directors consists of industry professionals and business leaders, including Engr. O. Ogie, Mrs. L. Ogie, G. Janno, and R. Jaya. While the company initially did well, the rise of VCDs and videoke machines in the late 90s caused sales to drop, leading them to shift to producing videoke players in 2001. Their factory is located 5 kilometers from the commercial district, and they face tough competition from other videoke assemblers and smuggled players. 2) Audit Objectives (Tela, Maria Angela) The primary objective of the audit is to provide reasonable assurance that the financial statements are free from material misstatements, whether due to fraud or error. This process is guided by PSA 315, which emphasizes the importance of identifying and assessing the risks of material misstatement through a thorough understanding of the entity and its environment. It involves performing risk assessment procedures, such as inquiries, data analysis, and observations, to detect potential areas of misstatement. Once risks are identified, PSA 330 comes into action by guiding the design and implementation of appropriate audit procedures to address these risks. This includes evaluating the effectiveness of internal controls and conducting detailed testing to detect any material misstatements. Additionally, the audit aims to ensure the accuracy and completeness of financial records, assess compliance with applicable laws and regulations, and provide recommendations for improving internal processes. By focusing on high-risk areas where errors are most likely, the audit enhances the overall reliability and credibility of the financial reporting process. 3) Description of the nature and extent of other services such as tax returns preparation, etc. (Barrientos, Catherine) BPSU CPA’s audit firm is an organization that primarily provides assurance services, such as financial audits, to assure the integrity and reliability of financial statements. Other services are the following: A. Operation Audit - The operation audit mainly focuses on identifying and evaluating the effectiveness of the operation of the firm on the basis of achieving their goals and objectives, The work done by the auditor is to evaluate if their strategy is inline with their goals and objectives and if it is implemented properly by assessing the progress of their goals. B. Compilation Services - This service mainly focuses on preparing the financial statements of the firm. It also includes bookkeeping and other services that are incidental to the preparation of the financial statements. The auditor will be the one who will prepare those financial statements thus the extent of the services is exclusive only to preparation of the financial statements. C. Compliance Services - This service mainly focuses on the verification if the firm is complying with the applicable laws and regulations. This service will also cover the tax services or the preparation and filing of taxes by the auditor on behalf of the firm. D. Advisory services - These services mainly focus on reviewing prior and current strategy and the firm if it results in achieving the firm’s goal and giving strategy advice on improvements and changes on the strategy. The service will focus on giving advice on the management and monitoring the implementation of the strategy. E. Other Assurance services - Other assurance services include the review of the financial statements. The difference of the review of financial statements from the financial Audit is that review focuses on finding the misstatements while financial audit seeks supporting evidence to ensure that the financial statement is free from material misstatements. The work to be done by the auditor in financial statement review is to only perform analytical procedures and limited testing on the individual transaction and balances. 4) Table Below (Valencia, Christine Joy) 5) Work to be done by the client's employee (Valencia, Christine Joy) a. Schedule meetings with the client’s employee The client’s employee has to provide information and overview about the company's production and operations, especially during the observation and investigation of the audit team. This can help on understanding the nature of the client’s business and how they process or work, that could help in highlighting the importance of some specific and special processes and systems that we need to focus on, and where can we find potential misstatements during the planning of audit and risk assessment b. Client’s employees provides information about the existing risk, their internal control, and internal documentation They also are gonna be required to inform and discuss what are the existing risks that the audit team must be aware of, and explain what and how they implement and monitor their internal control. They will also be required to provide internal documents, receipt and supporting documentation related to the cash flows, revenue recognition and inventory management. This could help the audit team to assess if the internal control implemented is strong or poses a risk. Thus, the employee’s coordination with the audit team would help in the assessment of audit risk and setting the materiality level during the audit planning. 6) Assignment of Audit Staff (Dela Rosa, Kriztine Gail) Employees in auditing have duties and tasks to attempt to complete in a way that is both accurate and efficiently. Many of the audit staff's responsibilities include assisting in the creation and implementation of audit programs, conducting audits of the company's finances, operations, and compliance with regulatory requirements, evaluating and suggesting improvements to business processes and controls, upholding good working relationships with management and audit teams, completing assigned audit activities promptly and effectively, conducting informational interviews with business units to gather audit-related data, promptly advising managers of audit issues, preparing reports of audit findings and proposals to management, and keeping all audit instruments and reports for reference. 7) Target completion dates of the major segments of the engagement (Dela Rosa, Kriztine Gail) The main components of the engagement have target completion dates that are usually two to four months long, including two weeks of planning, six weeks of fieldwork, and three weeks of report compilation. In addition to your audit, the auditor projects. The auditors' time will be divided among all of their projects, with some weeks heavily focused on your audit and other weeks less focused on your audit. 8) Preliminary evaluation and judgment about materiality level for the engagement a). Determine Performance or Planning Materiality. Explain. (Lupango, John Rey) The overall planning materiality for this audit has been set at 1% of revenue for the year, which amounts to approximately P88,974.50. Planning materiality represents the threshold for what is considered a material misstatement at the financial statement level. If misstatements in the financial statements accumulate to P88,974.50, the financial statements may be materially misstated, and users of the statements might be misled. To calculate performance materiality, we apply a stricter standard at the individual account balance level. Performance materiality is typically calculated as a percentage of overall planning materiality, in this case, 50%, resulting in a performance materiality of P44,487.25. This lower threshold ensures that undetected or uncorrected misstatements in individual accounts do not accumulate to a material amount at the financial statement level. If the difference between the audited and unaudited account balances reaches P44,487.25, that specific account would be considered materially misstated. However, the sum of immaterial misstatements across different accounts can still exceed the overall planning materiality, in which case the financial statements could be materially misstated. This approach ensures that material misstatements are identified at both the financial statement and account balance levels. b). Determine the accounts involved in the transaction cycle given in Activity 2 (Number 1.c.3). (Lupango, John Rey) Use the following format: Name of Transaction Cycle: Revenue Cycle (Sales Cycle) Account Name & Amount Materiality Level Account Name Account Specific Explanation Balance Materiality (Tolerable Misstatement) Cash on hand P250, 625.45 P12, 531. 27 Cash transactions and in bank are sensitive to errors and potential fraud, so tolerable misstatement is set to 5% of its account balance. Reconciliations make errors easier to detect. Accounts 458, 417.25 22, 920.86 Receivables Receivable impact cash flow, so a lower tolerance ensures accurate recording, particularly with the risk of doubtful accounts or revenue timing. Sales 8,897,450.00 44,487.25 Sales directly impact revenue, so a lower threshold for misstatement is set to ensure that revenue recognition is accurate and timely. Gross profit 4,998,376.25 45,615.89 Gross profit is influenced by sales and cost of sales, both of which require strict tolerances to prevent material misstatements in profitability. Finished goods 378,551.15 18, 927.56 Finished goods inventory valuation affects the cost of sales and profitability, so setting tolerable misstatement to 5% of its account balance ensures correct recognition of inventory values. Name of Transaction Cycle: Expenditure Cycle Account Name & Amount Materiality Level Account Name Account Specific Explanation Balance Materiality (Tolerable Misstatement ) Work in process 150,258.00 7, 512.9 Since WIP is part of inventory production, tolerable misstatement of 5% of its account balance is applied to capture valuation and timing errors without impacting profitability too much. Materials 1,686,233.33 44,487.25 Inventory errors Inventory directly affect the cost of sales, so 50% of overall planning materiality is acceptable, considering potential errors in valuation and obsolescence. Accounts 685,850.58 34,292.53 Payables reflect Payable outstanding obligations; a lower tolerance ensures timely and accurate recognition of supplier payments and reduces cash flow risks. Loans Payable 2,000,000.00 44,487.25 Loans payable affect long-term obligations, so the 50% of overall planning materiality set ensures accurate reporting of loan balances and interest obligations. Salaries & 3,060,480.00 44,487.25 Payroll is one of the Wages largest expenses, so the 50% of overall planning materiality set ensures that payroll misstatements do not materially affect the financial statements. Meals Expense 643,500.00 32,175 Even though meals are low-risk, discretionary expenses, it has a significant increase during the current year, so the specific materiality is set to 5% of its account balance. SSS, Medicare 92,400.00 4, 620 Compliance-related & EC expense expenses require moderate tolerance to ensure accuracy in reporting benefits and avoid regulatory penalties, that is why its amount of tolerable misstatement is set to 5% of its account balance. Office supplies 27,426.47 1,371.42 Office supplies are routine and minor in nature, however, setting the materiality with the rule of thumb will disregard its value, considering the detection risk is set to low, 5% of its account balance is set as its specific materiality. Repairs and 84,267.29 4, 213.36 Repairs are essential Maintenance for maintaining assets; setting materiality at 5% of account balance ensures that errors in recording are captured without significantly affecting the financials. Traveling 58,141.79 2, 907.09 Travel expenses are routine and flexible, however, setting the materiality with the rule of thumb will disregard its value, considering the detection risk is set to low, 5% of its account balance is set as its specific materiality.. Representation 78,308.59 3, 915.43 Representation is generally discretionary, however, setting the materiality with the rule of thumb will disregard its value, considering the detection risk is set to low, 5% of its account balance is set as its specific materiality. Rental Expense 65,200.00 3, 260 Rental expenses are typically fixed; 5% of its account balance as tolerance ensures that any deviations or errors in adjustments are captured appropriately. Taxes and 27,738.00 1,386.9 Although the tax Licenses expenses are small in value, we find it suspicious that it is lower than it should be, since the gross profit is about 5 million pesos. So, we have set the materiality level to 5% of its account balance. Depreciation 236,270.81 11, 813.54 Depreciation affects Expense long-term assets, so 5% of its account balance as tolerance helps ensure accurate expense recognition without overstating net income. Donation 8,041.30 402.05 Donations are small, discretionary expenses, however, for the sake of its balance not getting disregarded, we have set its specific materiality level to 5% of its account balance. Miscellaneous 74,198.68 3, 709.93 Miscellaneous expenses are smaller in value, however, getting the materiality with the rule of thumb will disregard its value, considering the detection risk is set to low, 5% of its account balance is set as its specific materiality. c). Determine the specific materiality or tolerable misstatement to the accounts by completing the schedule above. Explain your answer. (Lupango, John Rey) Because of the assessment of moderate to high inherent and control risk of the entity, the audit team had concluded that it is better to set specific performance materiality to 50% of overall planning materiality which is P44,487.25 (8, 897,450 x 1% x 50%). This value will apply to accounts with balances of a million and up, while those accounts with balances of a million and below will be using 5% of their respective account balances. 9) Any special problems to be resolved during the engagement - those revealed by analytical procedures (if any) (Dizon, Rynnylle Dricx) 1. Acid test ratio issue: A result of 0.47 means that the company has only ₱0.47 in liquid assets (cash, receivables, etc.) to cover ₱1 of current liabilities. This indicates a potential liquidity problem, as the company may struggle to meet its short-term obligations without selling inventory or securing additional financing. A healthy acid-test ratio is typically 1 or higher, depending on the industry. 2. Accounts Receivable issue: The accounts receivable turnover improved significantly, increasing from 7.79 times to 19.41 times. While this might seem like a positive trend, such a large increase could indicate that the company is either collecting payments more aggressively or offering less favorable payment terms to customers, which might hurt future sales growth or customer relationships. 3. Increased Expenses:Operating expenses have risen sharply, particularly in categories like salaries and wages (up by 20%) and meals expense (up by over 80%). While some increase is expected with revenue growth, the rise in expenses is outpacing the revenue growth rate. This could squeeze future profits if not managed properly.The total operating expenses grew from ₱3.47 million to ₱4.46 million, a 28.4% increase, which closely matches revenue growth. However, if this trend continues without further revenue growth, it could reduce profitability in future years. 4. Inventory Management: The company's inventory turnover ratio has declined from 2.28 to 1.68 times, suggesting that inventory is moving more slowly than before. This could lead to higher storage costs, potential obsolescence, or cash flow issues if the inventory isn't sold quickly enough. 5. Net Income Margin Still Low: Although the company turned its net income from a loss of ₱191,551.23 last year to a profit of ₱542,403.32, the net income margin of 6.1% is still relatively low. This margin indicates that after accounting for all expenses, the company is only retaining a small portion of its revenue as profit. Low net margins can make the company vulnerable to cost increases or revenue fluctuations. 6. Tax Computation issue: Based on our professional judgment, we declare a misstatement on the tax computation for a reason that based on recomputation, the amount encoded in the Financial statements are understated. 10) Conditions that may require changes in audit test (if any) (Dizon, Rynnylle Dricx) a. Unexpected alteration in key personnels and policies - A sudden change in both key personnels and policies can greatly affect the tests that will be conducted in an audit. A change in key personnel will affect tests such as authorization procedures which have required specific employees or persons that if not contacted will definitely increase the inherent risk. Also new key personnels might implement new policies which will give rise to adjustments to tests such as comparison to the new policies if it is required by the standards etc. b. A sudden flop of same course of business industry - A new emergence of new industry trends or technology affecting financial transactions may affect the risk assessment procedures. New industry means new competitors that might have great value to offer to the consumers which is a great factor in the audit process for reducing the risk. c. Unexpected findings of past audit report authorized by the past predecessor that can’t be contacted - Information coming from the predecessor auditor will help the current auditor to make an easy plan on how the audit team will handle the audit. But if the predecessor auditor cannot be contacted in any ways, a plan starting from zero shall be implemented. But if a sudden finding on the predecessor auditor's report occurs, it might make a conflict to the test that is currently in progress which will affect the audit itself. d. Gathered information during test of controls - Information gathered during the test of controls can significantly influence the nature, timing, and extent of further audit procedures. If the test results indicate that internal controls are effective, auditors may reduce the extent of substantive testing needed, as there is more reliance on the entity's internal processes to prevent or detect material misstatements. Conversely, if the tests reveal control deficiencies or weaknesses, auditors must adjust their approach by increasing the scope and detail of substantive tests to gain sufficient audit evidence. This could involve more comprehensive transaction testing or additional procedures to address higher risks of misstatements, ensuring that the financial statements remain accurate and reliable. e. Existence of non-routine Transactions - The existence of non-routine transactions increases inherent risk due to their complexity, infrequency, and potential for significant judgment or errors. Auditors must adapt their approach by conducting more detailed substantive testing, reviewing supporting documentation, and verifying that proper accounting treatments are applied. Standard analytical procedures may be less effective, necessitating more customized procedures and enhanced professional judgment. Auditors also need to assess and test the effectiveness of internal controls surrounding these transactions, considering risks such as management override. Additionally, comprehensive documentation and communication with management are essential to ensure transparency and proper financial statement presentation, particularly if related parties are involved or unique disclosures are required. f. A discovery of errors in account balances - The discovery of errors in account balances signals potential weaknesses in internal controls and increases the risk of material misstatements in the financial statements. When such errors are found, auditors need to modify their audit approach by expanding the scope of substantive testing and selecting larger or more targeted sample sizes to identify the extent and nature of the discrepancies. This condition may also prompt auditors to reassess their risk assessment and control testing, potentially leading to increased testing of related accounts or processes to ensure the errors are not systemic. Additionally, auditors need to evaluate whether the errors indicate broader issues such as management bias, fraud, or control deficiencies, and ensure that corrections are made and properly disclosed in the financial statements. To facilitate the answers for no. 4, 6 & 7, fill up the table below: Activity Target Due in 1. Pre-engagement activities October 9, 2024 2. Information gathering & Risk Assessment October 13, 2024 3. Preparation of Audit October 16, 2024 4. Sampling Plan for Test of Controls October 18, 2024 5. Submission of Report - Planning & Test of Controls October 20, 2024 6. Quality Review for Test of Controls October 23, 2024 7. Sampling Plan for Substantive Testing October 25, 2024 8. Evaluation of test results and preparation of Audit Report October 30, 2024 9. Submission of Report - Substantive Audit & Report November 4, 2024 10. Quality Review for Substantive Test & Audit Report November 13, 2024 1. Pre-engagement engagement activities: This includes initial meetings, defining the audit scope, and agreeing on timelines. 2. Information gathering & Risk Assessment: During this stage, auditors gather data, identify key risks, and understand the business environment. 3. Preparation of Audit Program: Drafting the audit plan based on the gathered information and identified risks. 4. Sampling Plan for Test of Controls: Developing a sampling strategy to test internal controls. 5. Submission of Report - Planning & Test of Controls: Writing and submitting the initial findings and plans for the next steps. 6. Quality Review for Test of Controls: Reviewing the quality of work done on testing the controls before proceeding. 7. Sampling Plan for Substantive Testing: Designing a plan for detailed testing of transactions or account balances. 8. Evaluation of test results and preparation of Audit Report: Analyzing the findings from the tests and compiling them into a draft report. 9. Submission of Report - Substantive Audit & Report: Submitting the detailed report based on substantive testing. 10. Quality Review for Substantive Test & Audit Report: Reviewing the final report for accuracy and completeness before final issuance. Members of the Audit Team: 9 Position 1. John Rey Lupango Team Leader 2. Rynnylle Dricx Dizon Assistant Team Leader 3. Catherine Barrientos Audit Associate 4. Kyla Ephraime Camacho Audit Associate 5. Kriztine Gail Dela Rosa Audit Associate 6. Angela Tela Audit Associate 7. Andrea Tolentino Audit Associate 8. Christine Joy Valencia Audit Associate 9. Erica Vergara Audit Associate b. Based on the information you gathered at this point, what will be your plan related to the nature, timing and extent of risk assessment procedures at financial level and assertion level appropriate for the engagement. (Lupango, John Rey) Financial Statement Level Nature of Risk Assessment Procedures Competitive Market Pressures: Forever Manufacturing is exposed to significant competition, with lower-cost imported products and shifting consumer preferences for advanced technology. This environment increases pressure to meet revenue targets and maintain profit margins, which could lead to aggressive financial reporting or misstatements. Reliance on Affiliated Businesses: The company’s board includes individuals affiliated with related businesses, which increases the risk of transactions that may not be conducted at arm’s length. These related-party transactions need to be examined to ensure fair value and proper disclosure. Regulatory Issues: The recent BIR tax assessment indicates potential regulatory concerns, possibly linked to incomplete sales reporting. This risk suggests a need to evaluate compliance with tax and financial reporting regulations. Related Party Transactions: Due to the involvement of affiliated entities, transactions with these parties present a high risk of misstatement. These transactions need careful examination to verify arm’s length pricing, proper classification, and full disclosure. Timing of Risk Assessment Procedures Conduct initial risk assessments at the beginning of the audit to identify high-risk areas and direct audit efforts appropriately. Revisiting these assessments closer to year-end will be crucial, especially to detect any significant changes, unusual adjustments, or trends that could affect reporting. Interim testing may be conducted on controls over inventory, payables, and receivables, which could provide early insights into risk levels and lessen the year-end testing burden. Extent of Risk Assessment Procedures In-depth Analysis: Due to moderate-to-high inherent risks from competitive pressures, regulatory issues, and related-party transactions, extensive audit procedures will be applied to key accounts and high-risk areas. This includes reviewing major transactions and significant balances to detect any management bias or unusual activity. Control Testing and Substantive Procedures: Since control risk is not assessed at maximum, tests of controls over revenue, procurement, and inventory processes will be implemented. If controls are deemed effective, the extent of substantive testing may be reduced. Substantive Procedures: Where control weaknesses are noted, such as in cash flow or related-party transactions, substantive testing will be more extensive. This includes confirmation procedures, detailed transaction reviews, and cutoff tests to ensure accurate reporting. Assertion Level Nature of Risk Assessment Procedures Key Assertions for Major Accounts: ○ Revenue: Due to the competitive environment, there is a risk of overstatement. Assertions of existence, completeness, and cutoff are crucial to ensure that revenue is accurately reported for the correct period. ○ Inventory: With increased inventory levels in a competitive market, there’s a risk of overvaluation. Assertions of existence, valuation, and allocation will be essential to verify that inventory levels are genuine and appropriately valued. ○ Accounts Payable: Potential cash flow management concerns suggest a risk of understatement in accounts payable. Assertions of completeness and cutoff will be prioritized to ensure all liabilities are recorded. ○ Expense Recognition: The significant increase in meals and miscellaneous expenses poses a risk of misclassification or overstatement. Assertions of accuracy, classification, and completeness are essential to confirm the validity and proper categorization of these expenses. Timing of Risk Assessment Procedures Key assertion risk assessments will be conducted early to guide the overall audit approach. These assessments may be updated as additional information is gathered, especially near year-end, to confirm the final balances for high-risk accounts. Interim assessments of high-risk assertions, such as for revenue and inventory, may be conducted to determine if further, more targeted procedures are necessary before year-end. Extent of Risk Assessment Procedures High-Risk Assertions: Extensive substantive testing will be performed for high-risk assertions in revenue, inventory, and related-party transactions. Procedures will include transaction testing, cut-off analysis, and reconciliations to verify existence, valuation, and accuracy. Medium-Risk Assertions: For expense accounts such as meals and miscellaneous, testing will focus on classification and accuracy assertions, with documentation reviews to verify the legitimacy of recorded expenses. Low-Risk Assertions: Low-risk areas, such as cash and bank accounts, will require standard verification procedures, focusing on existence and valuation assertions to ensure reliability. Activity 3 - Performance of Risk Assessment Procedures to Identify/ Assess Risk of Material Misstatement Through Understanding the Entity 1. Based on the answer you gave in the last question, explain the circumstances of which the following risk assessment procedures are applicable to the engagement: (Dizon, Rynnylle Dricx) A. Inquiries Circumstances: Understanding Processes: Inquiries are used to gain insight into how processes work within an organization and to confirm that controls are in place and functioning as described. This is particularly applicable when assessing the classification of transactions and how management ensures compliance with financial reporting requirements. Identifying Risks: Inquiry helps auditors understand management’s perspective on risk factors, such as potential areas for fraud, significant judgments, or estimates that might affect the financial statements. Evaluating Internal Controls: By asking questions of management and staff, auditors can assess whether internal controls are effectively designed and implemented to prevent or detect material misstatements. Early Phase: Inquiries are often performed early in the audit process during the planning and preliminary assessment stage to guide the overall audit strategy. Specific actions: Asking management and staff about the procedures for classifying financial state

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