Table of content

Table of content.......................................................................................................................1
Introduction..............................................................................................................................2
Findings....................................................................................................................................3
An assessment of Second Manufacturing Limited’s materiality with respect to the
inventory valuation as well as an evaluation of the company’s audit risk by considering
the inherent risk, control risk and detection risk. ................................................................3
The issues needed to consider to determine whether the closing inventory at 31 March is
undervalued and the test that is planed to perform to quantify the amount of any
undervaluation. ....................................................................................................................8
The purpose of an audit report and the possibilities of three different types of
qualification in an audit report. .........................................................................................14
Draft of an appropriate management report to the First Company’s board of directors ...16
Conclusion.............................................................................................................................20
Reference...............................................................................................................................21

1
Introduction
Second Manufacturing Ltd is one of the subsidiaries of First Company Plc. The
Second Manufacturing Ltd has been making losses for the past year; therefore, the First
Company’s management is concerned about the accuracy of Second manufacturing’s most
recent quarter’s management accounts. As a senior partner in LKY & Co, a well establish
auditing firm in Vietnam, I will audit Second Manufacturing Ltd third quarter account
ended 31 March 2009.
In the report, an assessment of Second Manufacturing Ltd’s materiality with respect
to the inventory valuation as well as an evaluation of the company’s audit risk by
considering the inherent risk, control risk and detection risk will be planned. The issues that
are needed to consider will be explained in order to determine whether the closing inventory
at 31 March is undervalued. The test that can used to perform to quantify the amount of any
under valuation will be described. The inventory and warehousing audit cycle will be
recorded in a document flowchart. In the report, the purpose of an audit report and the
possibilities of three different types of qualification in an audit report will be explained.
After all, a draft of an appropriate management report to the First Company’s board will be
given.

2
Findings
An assessment of Second Manufacturing Limited’s materiality with respect to the
inventory valuation as well as an evaluation of the company’s audit risk by
considering the inherent risk, control risk and detection risk.
The auditing process consists of four phases: plan and design an audit approach;
perform test of control and substantive tests of transactions; perform analytical procedures
and test of detail of balances, complete of audit and issue an audit report. In order to plan
and design and audit approach, the auditor has to go through seven steps.
Accept client and perform initial planning
Firstly, the auditor will accept the client and perform initial planning. In the case, the
LKY & Co, a well established auditing firm in Vietnam, have been engaged by First
Company Plc to audit Second Manufacturing Limited. In this stage, the auditor must
consider the client's integrity, as well as the industry in which the client operates. Beside
that, the auditor may find more information about client by contacting other entities that
have had dealings with the client, in order to further assess the client's situation. After that,
the client’s reasons for the audit need to be identified. And then, the auditor can send an
engagement letter to the client.
Understand the client’s business and industry
In the second step, the auditor needs to understand the First Company Plc and
Second Manufacturing Limited’s business and industry. Second Manufacturing Ltd is one
of the subsidiaries of First Company Plc. The Second Manufacturing Ltd has been making
losses for the past year; therefore, the First Company’s management is concerned about the
accuracy of Second manufacturing’s most recent quarter’s management accounts.
Understanding of the client’s business and industry is the key to an effective and
efficient audit. It enables the auditor to alter the work to meet the individual facts and
circumstances of First Company Plc and Second Manufacturing Limited. In addition, with
the understanding of company’s business and industry, it is easier for auditor to assess
events and transactions which are likely to have significant effect on the financial
statements. From that, the areas of high risk will be identified; the information to
predictions and comparisons will also be identified for analytical procedures. Understanding
the business and industry of client is also important to assess the internal control, the
inherent and control risks.

3
 Assess client’s business risk
The next step will concern with the business risks of Second Manufacturing
Limited. In accordance with Edexcel HNC/HND Business (2004), there are three types of
business risks: operational risk, financial risk and compliance risk. Operational risk is the
chances of errors or mistakes being made within the operations of the company. For
instance, if there is no department controls the requirement of purchasing fixed assets,
amount of fixed assets that company does not require may be purchased. Financial risk
covers all the risk of incorrect payment which are made or not all due receipts being
collected. The compliance risk is the overall risk that company will not comply with the
entire legal requirement laid out in the Companies Act. Through assessing company’s
business, the auditor can find out which issues in the financial statements should be
considered and investigated.
Perform preliminary analytical procedures
After all of that, preliminary analytical procedures will be performed. The auditor
will consider the financial statements and find out issues which are materiality. In addition,
this step may involve comparison of the client's ratios to industry standard ratios, both to
see how the client compares to its industry, as well as to determine if the client's ratios have
changed from previous years. The possible of misstatements or complex accounting areas
may be identified in the part. The analytical procedures are the basic for following audit
tests as control test, test of detail, test of balance…
Set materiality and assess acceptable audit risk and inherent risk
Assessing materiality
According to Edexcel HNC/HND Business (2004), “material is an expression of the
relative significance or important of a particular matter in the context of financial statements
as a whole, or of individual financial statements”. A matter is considered as a materiality if
its omission or misstatement would reasonably influence the decisions of an addressee of
the auditors’ report. Due to the importance of materiality in auditing process, materiality
considerations will differ depending on the aspect of the financial statements. Therefore, it
is considered at both the overall financial statement level and in relation to individual
account balances, classes of transactions and disclosures.
Besides, the materiality will be considered in two aspects: qualitative aspect and
quantitative aspect. When a small risk occurs more than once although it is not important;
but it totals up to a big amount that can affect the financial statements; it is seen as
materiality. However, if the misstatements are small, but they are not related to each other,

4
it is hard to determine whether the matter is material or not. In another way, the
misstatement itself is a significant matter in the context of financial statements, or
individual financial statements; it is materiality. The misstatement of sales goes up to $1
million; it is considered as materiality.
The materiality is considered through the income statements for the last three
quarters in 2008 of Second Manufacturing Limited. As respect to the material (% of
revenue), it has an important role in the financial statement. If the figure of material is
wrong, it will affect the value of inventory. Therefore, the whole financial statements will
be influenced due to the inventory. Thus, in the qualitative aspect, material is a significant
matter, thus it can be seen as materiality. Based on the financial statements of the last three
quarters in 2008 and 2009, in 30th September 2008 and 31st December 2008, the percentage
of material was the same of 70%. However, in 31st March 2009, it increased to 78.3%. The
difference goes up to 8.3% which is a big amount. Therefore, material (% of revenue) is
considered as the materiality.
In the financial statements, it is seen that the labor (% of revenue) decreased
gradually. In 30th September 2008, the labor took 21.6%; it decreased to 16.2% in 31 st
December 2008 and 14.5% in 31st March 2009. However, the direct wages increased from
$54,000 in 31st December 2008 to $62,000 in 31st March 2009. Hence, the labor matter
needs to be considered whether it is materiality; though, it is not a very important matter.
Assessing audit risk and inherent risk, control risk and detection risk
The audit risk is defined as the risk that auditors may give an inappropriate opinion
on the financial statements (Edexcel HNC/HND Business, 2004). It might be the risk that
financial statement contains material misstatements or risk that auditors fail to detect any
material misstatements. Audit risk comprises of three components: inherent risk, control
risk and detection risk.
Inherent risk
According to Edexcel HNC/HND Business (2004), inherent risk is “the
susceptibility of an account balance or class of transactions to material misstatement, either
individually or when aggregated with misstatements in other balance or classes, irrespective
of related internal control”. The risk that items will be misstated due to characteristics of
those items; for example, they are important items in the accounts. In order to assess the
inherence risk, the auditors must use professional judgments and all available knowledge.
On the other hand, inherent risks can be seen as the outside risks which influence on
the company’s operation. In current situation, Second Manufacturing Limited produces

5
motorbikes and supplies to Vietnamese market. Therefore, the increase of number of
customers is one of inherent risks. Because the demand for motorbike increases, Second
Manufacturing Ltd has to produce more. Thus, it leads to the increase of goods, inventory
and materials. Moreover, company has to purchase quality materials with affordable price
because of the competition in the market with other motorbike manufacturers as Honda,
Yamaha, and Chinese manufacturers.... Besides, if company wants to attract the investors,
they need to have good financial statements. Therefore, the revenue should increase
compared with the previous years. Due to the financial crisis, every business is affected.
Thus, as respect to Second Manufacturing Limited, with a good revenue and high material
cost, the auditor will consider it as the inherent risk to investigate.
In addition, the inventory itself also influences the company as a whole. Inventory in
company is a list of goods or products that is held in stock. Having no inventory or having
wrong inventory can lead to many problems. Because inventory is reflected in the
company’s books and company’s management board may make decisions based on the
inventory numbers. If the number is wrong, they just made a wrong decision that could be
costly. Thus, auditing inventory is an important step of auditing process.
Internal control and control risk
Understanding company’s internal control will help auditor to assess the control risk
easily. Control risk is the risk that a misstatement could occur in an account balance or class
of transaction. It could be material, either individually or when aggregated with
misstatements in other balances or classes. In addition, it would not be prevented or
detected and connected on a timely basis, by the accounting and internal control systems.
Overall, the control risk is the risk that company fails to detect material misstatements.
In the case of Second Manufacturing Limited, the high material consumption as a
percentage of revenue for the quarter to 31st March 2009 is due to some of the following
reasons.
(1). Under – counting or under – valuation of closing inventory
(2). High volume of goods
(3). Wastage of materials
(4). Material being stolen by employees or other individual
(5). High price during purchase
Regard with the first reason, the closing inventory may be under counted or under
valuated. It may due to the treatment of customer orders. The analysis of purchase invoices
for materials between customers’ orders has not been done; therefore company can not

6
control the material which is correlative with the customer’s orders. The misstatement in
Customer Order may lead to the mistakes in sales and in the record profit from sales. In
addition, company does not maintain perpetual inventory records and full physical count is
to be carried out at every financial year end. Therefore, the auditor must consider these
control risk, and look at records to see what happened.
Second Manufacturing Limited has the high material consumption because of high
volume of goods. With the increase of customers and demands, company may produce
more goods. In addition, the production department normally produces 30% more of the
finished goods to anticipate the future demand. Thus, the labor cost should be increased;
nevertheless, it decreases from 16.2% to 14.5% in 31st March 2009. The decrease of labor as
a percentage of revenue may come from the reduction of productivity.
The third reason for high material consumption is wastage of materials. The weak
skills of workers can lead to the wastage of materials. Moreover, the staff may not be
responsible for using materials in manufacturing products. If the material has inferior
quality, it may cost than others. Thus, company has to buy more materials for
manufacturing purpose. In addition, if Second Manufacturing Limited uses old equipments,
they may require more materials than new ones. All of this belongs to the control risk which
auditors should consider.
If materials are stolen by employees or other individuals, it will cause to the high
consumption of materials. All the material will be kept in store and the storekeeper will
record and issue to the production. The storekeeper undertakes a lot of responsibilities, thus,
it is difficult to control the material.
Besides, the higher price during purchase will cause to high material consumption.
Goods were delivered from a number of suppliers chosen by management, and then, each
supplier will submit their quotation to the management before included in the company
supplier list. Hence, the management may collide with the suppliers. In addition, the price
of goods and supplier list has not been updated for the last 3 years; so that, the price did not
follow the market failure. From that, the quality of product will be affected. These control
risk should be considered carefully by the auditors.
Detection risk
After identifying the inherent risk and control risk, the auditor needs to find out the
detection risk. The detection risk is defined as the risk that the auditors’ substantive
procedures do not detect a misstatement that exists in an account balance or class of
transactions that could be material, either individually or when aggregated with

7
misstatements in other balances or classes (Edexcel HNC/HND Business, 2004). Detection
risk relates to the inability of the auditors to examine all evidences. Therefore, the auditor
has to consider the assessed levels of inherent and control risk in determining the nature,
timing and extend of substantive procedures to reduce detection risk as well as audit risk.

The issues needed to consider to determine whether the closing inventory at 31 March is
undervalued and the test that is planed to perform to quantify the amount of any
undervaluation.
As said above, inventory has an important role in the financial statements and
auditing process. Therefore, identifying factors that may affect closing inventory is
necessary for auditor to determine whether the closing inventory at 31st March is under
value. The closing inventory is measured by the formula:
Opening Inventory + Purchased – Consumption = Closing Inventory
Therefore, closing inventory is influenced by the opening inventory, purchased and
consumption including sales, cost of goods sold and scraps. The auditor must consider these
factors to assess the closing inventory. If one of the factors is undervalued, it will lead to the
under valuation of the closing inventory. For example, if the scrap material value not
included in the stock, it makes the closing stock undervalued. The auditor also needs to
consider whether the cut off is right, the goods in transit or not and if goods from April
excluded from count. In addition, from the below model, we can see that raw material,
direct labor, manufacturing overhead, work-in-process and finished goods are also the
factors that can affect the closing inventory.

Raw material work-in-process finished goods cost of goods sold

Direct labor
Manufacturing overhead

Inventory and warehousing audit cycle in a document flowchart

The flowchart below shows the document movement of the inventory and
warehousing of Second Manufacturing Limited.

8
 Production Shipping
Warehouse
Department Department

Storekeeper Delive
r
M.R.N. goods
M.R.N.
Material
Requisition
Note
Make Receive
purchas and Clients
e for inspect
material goods
s
Purchase
Order

Good
Received Updated
Note computerized
N
system

Operating
Manager

S.R.
GRN File Stock
Record
Choose
supplier
s
1

Accounting
Department

9
 Test of control
After understanding the document movement, the auditor will conduct the test of
control. There are two aspects that the auditor should seek to obtain audit evidence for test
of control. The first aspect is design which means the accounting and internal control
system are designed so as to be capable of preventing or detecting material misstatements.
Another aspect is operation: the systems exist and have operated effectively throughout
relevant period.
According to the case of Second Manufacturing Limited, the auditor will consider
each step of the document movements.
In the first stage, the material purchase requisition note and purchase order will be
issued. The production department will identify the production requirement and submit 2
copies of material requisition note to the storekeeper. Issuing two copies of material
requisition note is good; but, sending both of them to the storekeeper will create problem. In
the case that the storekeeper looses both of the requisition notes, it will be difficult to
examine. Therefore, the auditor will check whether two copy of material requisition note
has adequate information and will be transferred to storekeeper. The number of material
requisition note will be examined whether it is correlative with received materials. The
purchase order is issued by storekeeper and will be submitted to the operating manager for
approval. Therefore, the auditor will consider how many purchase orders are issued, where
they are kept…
After that, the storekeeper will receive raw materials. Receiving report and vendor’s
invoice are required in this stage. Goods delivered to the warehouse will be inspected by the
storekeeper and Good Received Note is issued and kept in file. Only the storekeeper
inspects the received materials and the supplier’s invoice is given to storekeeper. Hence, he
can not check the number and also the quality of materials. In this stage, the auditor will
check whether the storekeeper received good receive note and the vendor’s invoice. The
auditor also checks whether the figures in Good Received Note is correlative with the
supplier’s invoice.
The third stage is about putting material in storage. For the related documentation,
the raw materials perpetual inventory master file is required. When the materials are kept in
store, the storekeeper will update the computerized store system and reconcile the balance
of the stock. However, the storekeeper does not give any document for the production
department after reconcile; thus, the production department can not update to the material

10
for manufacturing. In this phase, the auditor will consider if storekeeper maintains the raw
materials perpetual inventory in master file.
In stage of process the goods; the materials will be put in production. The auditor
will check the raw materials requisition and cost accounting records for this stage. The
figures in raw materials requisition and the cost will be calculated to decide whether it
march with the products.
The stock of finished goods will be kept in the warehouse. In this phase, the finished
goods perpetual inventory master file and cost accounting record will be checked. Finished
goods perpetual inventory master file is separate perpetual timely records of inventories are
normally kept for finished goods. It includes the information about the units of inventory
acquired, sold, and on hand and also information about unit costs. The auditor will see if the
storekeeper keeps all these documents and the figures on the documents tally with the real
number of finished goods.
In order to ship finished goods to clients, the storekeeper is required to have
shipping document, finished goods perpetual inventory master file and cost accounting
record. The auditor will check based on the documents.
Analytical procedure
After finishing test of control, the auditor will conduct analytical procedures.
Analytical procedures are typically used to determine whether a financial statement contains
relationships and items that are unusual. It also consist of reviewing financial statements for
comparable prior periods, comparing financial statements with anticipated results, and a
study of the relationships of the elements of the financial statements that would be expected
to conform to a predictable pattern based on the company's experience.
In the case of Second Manufacturing Limited, the analytical procedures will base on
the financial statements of last three quarters 30th September 2008, 31st December 2008 and
31st March 2009.
As we can see in the financial statements, the opening inventory alters fluctuantly.
In 30th September 2008, the opening stock is $203,000; it decreases to $163,000 in the
second quarter. However, in 31st March 2009, the opening inventory increases $17,000 to
$180,000. The figure may be recorded higher, thus, it breaches the existence. The increase
of opening stock can come from the break of obligation and rights.
As respect to direct wages, it also fluctuates among three quarters. It changes from
$74,000 in 30th September 2008 to $54,000 in second quarter; then it increases again to
$62,000 in last quarter.

11
 In contrast, the material increases gradually from $200,000 to $251,000 and
$318,000 in three quarters respectively. The break of valuation may lead to the changes of
materials.
It is also the same with the revenue when the revenue increases from $334,000 in
31st December 2008 to $429,000 in 31st March 2009.
Based on the financial statements of the last three quarters in 2008 and 2009, in 30th
September 2008 and 31st December 2008, the percentage of material was the same of 70%.
However, in 31st March 2009, it increased to 78.3%. The difference goes up to 8.3%.
In the financial statements, it is seen that the labor (% of revenue) decreased
gradually. In 30th September 2008, the labor took 21.6%; it decreased to 16.2% in 31 st
December 2008 and 14.5% in 31st March 2009.
Overall, we see that, all of the factors revenue, opening inventory, materials, direct
wages, material (% revenue) and labor (% revenue) increase in third quarter, thus, the
closing inventory should be increased. However, it reduces $180,000 and $162,000;
therefore, it may be undervalued.
Test of detail of balance
Due to the undervaluation of the closing inventory, a test of detail of balance will be
conducted to quantify the amount of undervaluation. The auditor will implement the test of
detail to check whether the inventory balance is true and fair.
In order to check the closing stock, the auditor needs to consider the raw materials,
work – in – progress and finished goods. To check the raw materials, the auditor will
examine the purchase orders, material receive notes, and good receive notes. It will also be
checked whether the raw material break completeness, obligations and rights. Beside that,
the auditor will consider the percentage of completion in checking work – in – progress.
Whereas, with the finished goods, the auditor will inspect the total cost. With these two
tests, the direct materials, direct labor and production cost will be checked.
To investigate the direct material, the auditor may apply FIFO or LIFO method.
FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as
sold first. LIFO stands for last-in, first-out, meaning that the most recently purchased items
are recorded as sold first. With the direct labor cost, the presumed records will be checked;
while, expenses and overhead are use to verify production cost. The auditor will
recalculated the total cost to ascertain the reasonable cost being charged to the inventory
and to ensure the accuracy of the closing inventory.

12
 On the other hand, the undervaluation of closing inventory will be assessed based on
the classes of transactions. The closing stock may be unevaluated because it breaks the
existence. In order to check that, the auditor will attend and observe a physical inventory
count or perform the physical count by himself. In addition, the auditor can get the
confirmation for inventories held by third parties. The auditor may get more information by
calling and questioning the third parties.
In case, the auditor wants to examine if the closing inventory breaks the
completeness or not, the cut off procedures will be carried out. The auditor needs to make
sure that no movements of the inventory during the count. And then, auditor will check
whether inventory movements are properly identified and recorded in the inventory records
at the cut – off date. The last Good received notes (GRNs) will be recorded and dispatched
before to the count. In addition, the auditor will record the first GRNs and also dispatch
notes after to the count. In this situation, the auditor will vouch and trace the documents of
inventory movements to check the figures of closing stock.
In order to verify the valuation of the closing stock, the auditor has to check the
vendor’s invoices to determine that correct prices have been used to value raw materials.
The method to valuation for raw material will be reviewed for consistency and
appropriateness. The auditor also considers the direct wages to check the direct labor costs.
In addition, the allocation of overheads will be inspect to see whether it is consistent with
previous period and calculated on the normal level of production activity. The net realizable
value will be considered to make sure that the raw material’s price follows market value.
From that, the auditor will review and checked the Second Manufacturing Limited
system for identify slow moving, obsolete or damaged inventory during the count. The
inventory records for slow moving items should be inspected; the production reports needs
to be reviewed. Furthermore, the auditor may make inquiries to the production department
to get more information. Prices of finished goods sold and the sales report after year end
will be examined. To determine the inventory is realizable, the quantities of goods sold will
be reviewed.

13
The purpose of an audit report and the possibilities of three different types of
qualification in an audit report.

An audit report is usually of the financial records and accounts of a company. In

accordance with CBS Interactive Inc (2009), “an auditor's report normally takes one of the
forms approved by the accountancy professional organizations to cover all requirements
imposed by law on the auditor”. Therefore, the purpose of the audit report is to report on
whether the accounts show a true and fair view to the shareholders (Edexcel HNC/HND
Business, 2004).
There are four types of qualification in an audit report: unqualified opinion,
qualified opinion, disclaimer of opinion and adverse opinion.
Unqualified opinion
An unqualified opinion is the expression of the independent auditor when he/she
concludes that the financial statements give a true and fair view. It also means that the
auditor has formed the opinion “on the basis of an examination made in accordance with
generally accepted accounting principles, applied in a consistent basis and includes all
informative disclosures necessary to make the statements not misleading” (Credit Research
Foundation, 2009).
Qualified opinion
Beside that, a qualified opinion report is issued when the auditor faced one of two
types of situations which do not comply with generally accepted accounting principles,
however the rest of the financial statements are fairly presented. On the other hand, a
qualified opinion should be expressed when the auditor concludes that an unqualified
opinion can not be expressed but the misstatements, the disagreement with manager or
limitation on scope is not so material and pervasive. In addition, these disagreements or
limitations can not be charged as adverse opinion or a disclaimer of opinion. For instance, a
company dedicated to a retail business that did not correctly calculate the depreciation
expense of its building. Although, this expense is considered material, since the rest of the
financial statements are not affected, then the auditor qualifies the opinion by describing the
depreciation misstatement in the report and continues to issue a clean opinion on the rest of
the financial statements.
As regard to limitation of scope, it occurs when the auditor could not audit one or
more areas of the financial statements, and although they could not be verified, the rest of
the financial statements were audited and they conform GAAP (Credit Research

14
Foundation, 2009). For example, an auditor was not able to observe and test a company’s
inventory of goods. If the auditor audited the rest of the financial statements and is
reasonably sure that they conform to GAAP, then the auditor simply states that the financial
statements are fairly presented, with the exception of the inventory which could not be
audited. There are two situations that might be a limitation on scope: the limitation of the
auditor’s work may sometimes be imposed by the entity or by the circumstances.
Disclaimer of opinion
The third type of qualification in audit report is disclaimer of opinion. The
disclaimer is issued when the possible effect of a limitation on scope is so material and
pervasive; thus the auditor has not been able to obtain sufficient, appropriate audit evidence.
This type of report is issued when the auditor tried to audit an entity but could not complete
the work due to various reasons and does not issue an opinion.
According to Robert, R. D. (2009), a disclaimer of opinion is appropriate in the
circumstances: lack of independence; scope limitations which mean inability to obtain
sufficient competent evidential matter; when the auditor concludes that there is substantial
doubt about the entity’s ability to survive; and matters involving uncertainties.
Adverse opinion
The auditors will express an adverse opinion if the statements are so lacking in
fairness that a qualified opinion would not be warning enough. An adverse opinion is an
opinion that the financial statements do not present fairly the financial position, results of
operations, and cash flows of the company, in accordance with generally accepted
accounting principles. In this situation, the auditor will conclude that a qualification of the
report is not adequate to disclose the misleading or incomplete nature of the financial
statements. It is considered the opposite of an unqualified opinion, essentially stating that
the information contained is materially incorrect, unreliable, and inaccurate in order to
assess the auditor’s financial position and results of operations.

15
Draft of an appropriate management report to the First Company’s board of directors
From: LKY & Co
Date: June, 3rd 2009

To: First Company Plc

Cc: Second Manufacturing Limited

Member of the board,

FINANCIAL STATMENT FOR THE YEAR ENDED 31ST MARCH 2009
According to our normal practice we said out in this letter certain matters which
arose as a result of our review of the accounting systems and procedures operated by
company during our recent interim audit.
We would point out that the matters dealt with in this letter came to our notice
during the conduct of our normal audit procedures which are designed primarily for the
purpose of expressing our opinion on the financial statement of your company.
Consequently, our work did not encompass a detail review of all aspects of the system and
can not be relied on necessarily to disclose defalcations or other irregularities or to include
all possible improvement in internal control.

1. Managing estimated costs and actual costs.

Present system
Through our work, we discovered that the estimated costs are not compared with the
actual costs. The analysis purchase invoices for materials between customer’s orders has no
been done.
Implication
Without the comparison, it is impossible to know the variance between budget and
actual, thus, company will not know the reason of high consumption material, whether
materials are used appropriately. Therefore, setting up the budget becomes useless. In
addition, because company did not analyze the purchase invoices for materials between
customer’s orders, the amount of materials as well as inventory process can not be
controlled.
Recommendation

16
 We recommend that company should prepare budget to plan and control the
inventory system. The comparison between actual cost and estimated cost is necessary.
Moreover, the analysis purchase invoices for materials between customer’s orders should be
carried out frequently.
2. Inventory control.
Present system
Under your present system, a physical inventory count is carried out at the end of
each quarter. Items of the inventory are entered on stock sheets and valued manually.
Company does not maintain perpetual inventory records a full physical count is to be
carried out at every financial year end.
Implication
Because the items of inventory are entered on stock sheets and valued manually;
thus, the misstatements easily occur. The figure may break one of classes of transaction -
the accuracy. In addition, the perpetual inventory records were not maintained and the full
physical count is to be carried out at every financial year end; hence, company can not
control the inventory. There would create opportunities for people to steal.
Recommendation
It is suggested that company should use computerized system to control the items of
inventory. The manual record can be carried out concurrently with the computerized
system. Therefore, at the end of each quarter, the storekeeper can compared two figures.
The perpetual inventory records are required for inventory control. Furthermore, company
needs to carry out full physical count at the end of each quarter to control the inventory.
3. Ordering system
Present system
Goods were ordered from a number of suppliers chosen by the management. Each
supplier submits their quotation to the management before been included in the company
supplier list. The price of the goods will then charge to the company based on price listed in
the quotation. The supplier list has not been updated for the last 3 years.
Implication
The management chooses the suppliers and each supplier submits their quotation to
the management before been included in the company supplier list; thus, it is easily for
management to collide with the suppliers. On the other hand, the supplier list has not been
updated for 3 years; therefore, the price of materials does not followed market value. It is
one of the reasons for high material consumption.

17
 Recommendation
We recommend that the suppliers list should be updated regularly. The price of
materials needs to be determined based on the market value. Choosing suppliers has to be
suitable with the current situation of company and should be checked frequently.
4. No segregation of duties
Present system
During the course of our work, we find out that there is no segregation of duties. The
storekeeper has to take a lot of responsibilities. Purchases for raw material are made by the
storekeeper. He also acted as purchasing officer will reconcile the balance of the stock in
the warehouse and the production department requirement. He will then prepare the
purchase order and submit to the operating manager for approval. The storekeeper inspects
the goods delivered to the warehouse and issued Goods Received Note. All material
received will be kept in store and storekeeper update the computerized store system every
timer goods received and issued to the production. And then, the storekeeper will monitor
the movement of the goods and also in charge of finished goods delivery to the clients.
Implication
This will influence on the operation of the company. The production department will
identify the product requirement each month and submit to the storekeeper. If the
storekeeper has budget for materials, he will know what to buy unless production
department needs a special material. The storekeeper also reconciles the balance of the
stock in the warehouse and the production department requirement. In addition, company
does not compare budget and actual. Therefore, if the storekeeper steals the materials,
nobody will know. The physical stock count is conducted by the storekeeper; it is also an
opportunity for storekeeper to steal or create misstatements.
Recommendation
It is recommended that the physical count should be conducted by the storekeeper
and other people from other department. On the other hand, a person from other department
or an account should come and check the inventory every month. When the goods are
delivered to the warehouse, there should be two people together with storekeeper to inspect
the goods.
We have reviewed the income statements of Second Manufacturing Limited at 31st
March 2009, and we have not been able to obtain sufficient, appropriate audit evidence.
Therefore, we would express the disclaimer of audit opinion.

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 Our comments have been discussed with your finance director and the chief
accountant and these matters will be considered by us again during future audits. We look
forward to receiving your comments on the points made. Should you require any further
information or explanation do not hesitate to contact us.
This letter has been produced for the sole use of your company. It must not be
disclosed to a third party, or quoted or referred to, without our written consent. No
responsibility is assumed by us to another person.
We should like to take this opportunity of thanking your staff for their cooperation
and assistance of during the course of our audit.

Yours faithfully,
LKY & Co

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Conclusion
In the report, an assessment of Second Manufacturing Ltd’s materiality with respect
to the inventory valuation as well as an evaluation of the company’s audit risk by
considering the inherent risk, control risk and detection risk was planned. The issues that are
needed to consider were explained in order to determine whether the closing inventory at 31
March is undervalued. The test that was used to perform to quantify the amount of any
under valuation was described in the report. The inventory and warehousing audit cycle
were recorded in a document flowchart. The purpose of an audit report and the possibilities
of three different types of qualification in an audit report were explained. After all, a draft of
an appropriate management report to the First Company’s board was given.

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Reference
1. BPP Professional Education (2004) Financial System and Auditing Supporting
Foundation Degrees, Great Britain: BPP Professional Education.
2. Millichamp, A. H. (2002) Auditing, London: Continuum Publisher.
3. Robert, R. D. (no date) Using disclaimers in audit reports [online] CPA
Journal, Available from:
http://www.nysscpa.org/cpajournal/2004/404/essentials/p26.htm [Accessed: 29
May 2009]
4. Credit Research Foundation (no date) Understanding the auditor’s report
[online] CRFOnline.com, Available from: http://www.crfonline.org/orc/cro/cro-
11.html [Accessed: 29 May 2009]
5. Sift Media (2002) Accounting concepts and conventions [online]
Accountingweb, Available from: http://www.accountingweb.co.uk/cgi-
bin/item.cgi?id=69109 [Accessed: 1st June 2009]

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