.

CHAPTER 4
PHASE I- RISK ASSESSMENT: PERFORMANCE OF RISK ASSESSMENT PROCEDURE

RISK IDENTIFICATION AND ASSESSMENT

What to Identify?

Two Major Classifications of Risks:

1. Business Risk
2. Fraud Risk

SOURCES OF RISKS
a. Entity objectives and strategies
b. External and Internal Factors
c. Performance Indicators
d. Accounting Policies
e. Internal Control

HOW TO IDENTIFY INHERENT RISK FACTORS

STEP 1: Gather basic information about entities.

● Forever Manufacturing Company is a pioneering manufacturer of karaoke/cassette/radio

type sound systems. They chose to grow their business through partners in order to
increase capital because of increasing demand for their product. The company dealt with
situations over time that affected the firm's position and performance. Due to
modernization, their sales tremendously decreased because a lot of competitors arose
offering products which are more innovative and convenient to the customer. As a
response, Forever Manufacturing Company switched their product from manufacturing
karaoke to producing videoke players to somehow meet the demand of their customers
and regain its status since they incurred loss for the previous year. They tried to keep up
with the trend of the industry because their competitors increased as the time went by.
Also, large numbers of illegal or pirated products are also being offered for almost half
of the Forever Manufacturing Company’s price. There are sales of inexpensive VCDs
and DVDs. Branded videoke players are being sold by some of their competitors at the
same price. The customer’s claim that their sales declined owing to an overabundance of
videoke machines, and as a result, their money became entangled with the unsold items.
 These are the essential information that may be used in assessing potential inherent risk
factors in proceeding to the designing and performing risk assessment procedures.

SOURCES OF INFORMATION ABOUT FOREVER MANUFACTURING COMPANY

Internal Sources External Sources

Financial Information ● Financial Statements ● Creditors

a. Previous Period ● Investors
b. Current Period
● Board Resolutions
● Accounting Policies
● Receipts/Invoices

Non-financial Information ● Operating Procedure ● Interview

Manual ● Suppliers
● Organizational Chart ● Customers
● Job Description of ● Official Websites
Specific Personnel
● Daily Time Records

STEP 2: Design, perform and document risk assessment procedure.

a. Risk Identification

● IDENTIFIED BUSINESS RISKS:

1. Market competition
2. Mass production
3. New products offered
4. Inflation
5. Increased taxes & licenses
6. Increase in donation & miscellaneous expenses
7. Quadruplication of invoices
8. Cut-Off time in Collection

● IDENTIFIED FRAUD RISKS

Pressures
 ❖ Shortage to cover all its running costs
❖ Too much debt incurred
❖ Tax Burden
❖ Uncollected Receivables

Opportunities
❖ Abundance of inventory
❖ Lack of segregation of duties
❖ Absence of oversight of workers' daily time records (DTR)

b. Risk Assessment Applicable to the Engagement

Inquiries

Both financial and non- financial information provided by the company

will be a great help for the performance of Risk Assessment Procedures in

identifying or assessing risk of material misstatements through understanding

the entity. Inquiries to third parties inside and outside the company would be a

stepping stone for this engagement. Seeking information for understanding the

firm from its specific personnel like from the production, sales, and

administrative managers, from the head who receives stocks from the suppliers,

and up to those in charge in compensation, in maintaining records of supplier's

account and in billings and collections can provide evidence as a response to the

auditor's questions and queries. Also, as external auditors, it is more important to

inquire to those parties outside the company like assessing their relationship

with their supplier.

Inquiring to the company on how they manage the risks will be a must.

Analytical Procedures

Checking the accuracy of the financial information provided by the

management will be the highlight in analytical procedures. Inconsistency on the

records of the position and performance of the firm must be assessed and

determined. Non-financial information provided can be used as the basis

whether the financial statements are free from any material misstatement.
 Comparing the client's prior period's financial statements to the current period's

unaudited financial statements could provide a better insight into what this risk

may possibly bring to the firm.

Comparing accounts with the same industry information like, getting the

ratios of the accounts related to each other, can be a great help to determine the

implications of the identified risks above. For Forever Mfg. Co.’s current ratio

implies two possible implications, either the firm can pay its existing debts, or

the management has an ineffective way of managing its assets. Its quick ratio

indicates that the company is in danger of meeting its currently maturing

obligations.

Ratios like these may help in assessing what aspect of the firm needs to be

monitored and kept an eye for.

Observation and Inspection

Observing and inspecting the operational procedures of the firm is a great

tool in accumulating information for identifying, analyzing and controlling

possible risks. For all the risks, whether business or fraud risk stated above, it is

essential to observe operations that are directly affecting certain accounts like

cash, inventory, fixed assets, and receivables. Physical count or inspection is

considered to be reliable and applicable in verifying whether all the transactions

related to these accounts are properly recorded and recognized.

STEP 3: Relate or Map the Risks Identified to Material Financial Statement Areas

Illustrative Documentation of Risk Identification and Implications to Financial Statements

Risk Event/ Sources Implication of the Risk Assertions

Factor to FS

BUSINESS RISK

1. Market competition a. Limited Sales EA

 2. Mass Production a. Lots of finished goods EV
remain unsold

3. New products offered a. The cash spent for CAEV

manufacturing may
not recover
immediately

4. Inflation a. High spending (small CAEV

amount of cash)

5. Increased taxes & a. Accumulation of C

licenses penalties

6. Increase in donation & a. Mismanagement of E

miscellaneous funds
expenses

7. Quadruplication of a. Possible AE
invoices misstatements of
amounts and other
information

8. Cut-off time in a. Possible erroneous AC

collections and untimely
recording of
transactions

FRAUD

PRESSURES

1. Shortage to cover all Affects the company’s VE

its running costs capacity to invest and finance
their operation.

2. Too much debt More apparent to harm the VE

incurred company’s revenue and
operation and turn out to be
bankrupt.

3. Tax Burden Management did not record CAV

sales on account.

4. Uncollected The sales tied up with unsold CA

 Receivables inventories, thus
management seek from legal
assistance

OPPORTUNITIES

1. Abundance of Theft/stolen/difficult to keep E

inventory track of all the items

P
2. Lack of segregation of Manipulation of records
duties

3. Weak payroll controls Inaccurate recording and

reporting of payroll expenses CAV
may lead to overstatement or
understatement of expenses
in the financial statements

Key:
P= Persuasive C= Completeness A= Accuracy E= Existence V= Valuation

Illustrative Documentation of Identification and Evaluation of Relevant Internal Control

Step 1: Risk Identification
What risks if not mitigated by internal control could result in material misstatement in the
financial statement?

Risk 1 Emerging new business competitors.

Risk 2 The company mass produced karaoke machines because of high demand.

Risk 3 The company shifts the type of products being manufactured.

Risk 4 Unanticipated changes in raw material prices and rising energy expenses.

Risk 5 Sudden increase in miscellaneous, taxes & licenses, operating and other expenses.
Risk 6 The company is over leveraged.

Risk 7 The company incurred enormous uncollected receivables.

Risk 8 Ineffective segregation of duties

Risk 9 Underdeveloped technology

Step 2: Control Design

Are there controls capable of effectively preventing or detecting and correcting the material
misstatements identified in Step 1?

Risk 1 Emerging new business competitors.

Possible Controls

a. Management continues to know the demands of the customers or target market.

b. Management understands the market condition and trends.

c. Explore strategic opportunities.

d. The company constantly innovates new products to keep up with the market.

Risk 2 The company mass produced karaoke machines because of high demand that resulted in
unsold products.

Possible Controls

a. The board approved an intensive marketing campaign under “direct selling”

technique.

b. The company can offer the unsold products for a lower price.

c. The company may repurpose some materials from the unsold products.

Risk 3 The company shifts the type of products being manufactured.

Possible Controls

a. The management may utilize an effective advertising campaign for the new product.

b. The management may limit the production based on the public demand.

Risk 4 Unanticipated changes in raw material prices and rising energy expenses.
 Possible Controls

a. Management may look for diverse suppliers to reduce the risk of raw material price

volatility.

b. Management may implement hedging strategies to lock in a price for raw materials in

advance.

c. Management should regularly review market trends and stay in touch with suppliers

to anticipate changes and take action before prices become too volatile.

Risk 5 Sudden increase in miscellaneous, taxes & licenses, operating and other expenses.

Possible Controls

a. Management should regularly review and analyze all expenses made to identify areas

where costs can be reduced or eliminated.

Risk 6 The company is over leveraged.

Possible Controls

a. Management should ensure that the debt or obligations are necessary expenses of the

business.

b. Consider the profitability or solvency of the company.

c. The company may consult a financial advisor for repayment strategies.

Risk 7 The company incurred enormous uncollected receivables.

Possible Controls

a. Businesses can minimize its uncollectible accounts by limiting their lending

operations to credit-worthy entities.

b. Offer discounts for early payments.

c. Management may create reserves that will keep them from spending

money that will most likely be uncollected.

Risk 8 Ineffective segregation of duties

 Possible Controls

a. Provide personnels with access to training and professional development programs

about their duties and responsibilities.

b. Establish procedures to prevent unauthorized access or destruction of assets, alteration

of documents and records.

Risk 9 Underdeveloped technology

Possible Controls

a. In monitoring the daily time records of the employees the management may utilize a

biometric attendance system.

Step 3: Control Implementation

Do the controls exist and is the entity using them?
Yes, see step four for documentation.

● Emerging new business competitors.

● The company mass produced karaoke machines because of high demand that
resulted in unsold products.
● The company shifts the type of products being manufactured.

● Unanticipated changes in raw material prices and raising energy expenses.

● Ineffective segregation of duties

No, so the auditor should report these significant deficiencies in control to the management.

● Sudden increase in miscellaneous, taxes & licenses, operating and other

expenses.

● The company is over leveraged.

● The company incurred enormous uncollected receivables.

● Underdeveloped technology.

Step 4: Control Documentation

Illustrative Documentation of Control Deficiencies and Impact on Audit Response

Risk 1

Risk factor/Assertion affected Emerging new business competitors

Auditor, Thought Process

a.) Deficiency identified Emerging new business competitors can

potentially erode the market of established
businesses, leading to a loss of revenue and
profits.

b.) Potential on the financial statements To stay competitive, Forever Manufacturing

Company may need to increase their marketing
expenses to promote their products or services.
This could increase operating expenses and
impact profitability.

c.) Is deficiency considered significant? Yes

d. Audit response Review current marketing strategies if they are

effective in reaching the target audience.

Risk 2

Risk factor/Assertion affected The company mass produced karaoke machines

because of high demand that resulted in unsold
products.

Auditor, Thought Process

a.) Deficiency identified The management failed to accurately predict and

manage the supply and demand of karaoke
machines.

b.) Potential on the financial statements If the company is unable to sell the excess
inventory, they may have to dispose of it, which
can result in significant losses. This can also
impact the company's financial statements, as it
may result in a decrease in assets and an increase
in expenses.
c.) Is deficiency considered significant? Yes

d. Audit response Evaluate the company's ability to manage excess

inventory, including assessing its ability to sell
the products

Risk 3

Risk factor/Assertion affected The company shifts the type of products being
manufactured.

Auditor, Thought Process

a.) Deficiency identified There is a lack of clear product development and

manufacturing strategy since this can lead to
inefficiencies in the production process, which
may result in higher costs and lower quality
products.

b.) Potential on the financial statements Forever Manufacturing Company stops

manufacturing a particular product, it may
result in excess inventory, which can lead to
write-downs or write-offs. This can impact the
company's financial statements.

c.) Is deficiency considered significant? Yes

d. Audit response Implement any necessary changes to its

manufacturing processes, quality control
procedures, or other systems

Risk 4

Risk factor/Assertion affected Unanticipated changes in raw material prices

and rising energy expenses.

Auditor, Thought Process

a.) Deficiency identified Unanticipated changes in raw material prices is

an increase in the cost of goods sold (COGS).
This can lead to a decrease in profit margins.
Similarly, rising energy expenses can
 significantly increase a company's operating
costs which can decrease profits too.

b.) Potential on the financial statements Unanticipated changes in raw material prices
and rising energy expenses can have a significant
impact on a company's financial statements,
potentially leading to lower profitability and
reduced liquidity.

c.) Is deficiency considered significant? Yes

d. Audit response Test the company's internal controls related to

the procurement of raw materials and energy
expenses to ensure that they are effective and
can mitigate the impact of any unanticipated
changes. In addition, it is essential to perform
analytical procedures to identify any significant
fluctuations or trends in the company's raw
material and energy expenses.

Risk 8

Risk factor/Assertion affected Ineffective segregation of duties

Auditor, Thought Process

a.) Deficiency identified Ineffective segregation of duties may increased

risk of fraud, errors and mistakes going
undetected.

b.) Potential on the financial statements Ineffective segregation of duties can create
potential risks in financial statements, including
inaccuracies and misstatements.

c.) Is deficiency considered significant? Yes

d. Audit response Reassign certain responsibilities to different

individuals or departments. Also, conduct
periodic reviews and assessments of the
segregation of duties policies and procedures to
ensure they remain effective and up to date.
CONCLUDING THE RISK ASSESSMENT PHASE
1. How much assurance can be obtained regarding audit risk when internal control is
present and working?
When internal controls are present and working effectively, the auditor can
obtain a higher level of assurance regarding audit risk. Effective internal controls reduce
the risk of material misstatements in the financial statements, which in turn reduces the
risk of the auditor issuing an incorrect opinion.
If the auditor determines that the internal controls are effective, they can rely on
those controls to reduce the assessed level of control risk. This allows the auditor to
reduce the extent of substantive testing they perform, as they can rely on the internal
controls to detect and prevent material misstatements. However, it’s important to note
that even with effective internal controls, the auditor still needs to perform some level of
substantive testing to obtain reasonable assurance that the financial statements are free
from material misstatements.

2. If control activities within major processes are working properly throughout the year,
what is the residual risk that remains that an account balance can still be misstated?
● Human error - even with effective control activities, there is still the possibility of human
error. Employees may make mistakes or may not follow procedures correctly.
● Fraud - control activities may not be able to prevent or detect fraud.
● Changes in the business environment - changes in the business environment such as
new technology, new product or services, may render existing control activities
ineffective.

3. What is the risk that the auditor’s evaluation of internal controls might be incorrect?
● Inadequate understanding of the client’s business - If the auditor does not have a
thorough understanding of the client’s business, they may not be able to assess the risks
and design appropriate audit procedures.
● Failure to identify material weaknesses - if the auditor fails to identify material
weaknesses in the internal control system, they may provide an incorrect evaluation of
controls.
● Time constraints - if the auditor is under pressure to complete the audit within a limited
timeframe, they may not be able to conduct a thorough evaluation of the internal
controls.

4. Which account balances contain more than an acceptable amount of risk that a material
misstatement could occur?
 ● Cash - a manufacturing company may be at risk of fraudulent activities related to cash,
such as theft of cash or fraudulent financial reporting.
● Accounts Receivable - accounts receivable can be overstated or understated as it may
cause discrepancies, such as having quadruplicate copies of sales invoice and the
company does not properly write off uncollectible accounts.
● Inventory- a manufacturing company that shifted outputs or products inherently have
complex inventory management, as there are also unanticipated changes in raw
materials and unsold products.

5. How could a misstatement in a material amount account balance most likely occur?
● Misappropriation of assets - assets may be misappropriated through theft or
embezzlement, resulting in a misstatement of the account balance. Inventory may be
stolen, but the accounting records may continue to reflect the missing inventory, leading
to an overstatement of inventory.
● Inadequate internal controls - weaknesses in internal controls can lead to fraudulent
activities, errors, or omissions in financial reporting.
● Errors in recording transactions - transactions may be recorded incorrectly due to
human error or misunderstandings.
● Misstatements in financial reporting by third-party service providers - third party
service providers, such as payroll processors, may make errors or engage in fraudulent
activities that result in a material misstatement of account balances.
● Lack of segregation of duties - having an inappropriate segregation of duties can
increase the risk of material misstatement.

6. What are the most effective substantive tests of account balances to determine whether
there is a misstatement in the account balance?
● Physical inspection - physical inspection of account balances and related transactions,
such as checking of inflows and outflows of the inventory, and checking of receipts and
records, can help verify their existence and condition.
● Analytical procedures - auditors may perform analytical procedures, such as comparing
the current financial information from the prior year’s financial statements, to identify
unusual relationships in account balances that may indicate a misstatement.
● Direct testing of transactions - auditors may directly test transactions, such as reviewing
entries of transactions from journals to ledgers, to verify the accuracy and completeness
of account balances.
● Cut-off testing - this involves examining supporting documentation, such as invoices
and receipts, and any other shipping or receiving documents, to verify that the
transaction has been recorded in the correct period.
 ● Evaluating presentation and disclosures - auditors may perform a proper examination of
the financial statements to determine if presentation and disclosures are in accordance
with the standards.

CHAPTER 5
PHASE II- RISK RESPONSE: DESIGNING OVERALL RESPONSES AND FURTHER
AUDIT PROCEDURES

ILLUSTRATIVE COMPREHENSIVE CASE STUDY ON RISK ASSESSMENT AND RISK

RESPONSE

CASE FACTS:

Introduction

Forever Manufacturing Co. is a pioneer company that manufactures sound systems like
karaokes, radios and cassettes which are to be sold to their markets like households and other
small establishments. It started in the early 90's after the founders got married. Due to the
increasing demand of their supply, they decided to expand their company through their
partners in order for them to maximize capitalization. Over the years, the company faced
circumstances that had bearing on the position and performance of the firm. They even shifted
their products in order for them to adapt to major changes present in their industry. Their
primary objective is to reacquire and remain their standing in the market.

The BPSU CPA's & Associates, audits the financial statements of Forever Manufacturing Co. for
the first time. For this year’s audit, the staff of the firm has prepared audit planning working
papers.

Read through the information for you to obtain an understanding of the nature of the
information that is important to planning an audit engagement.

The selective audit planning working papers include:

● The statement of financial position and statement of comprehensive income for the
company for 20X1
● The analytical ratios working paper that is partially completed. (The ratios for 20X2 have
been left off.)
 ● The audit plan for the audit of the financial statements for the year ended December 31,
20X2.
● A fraud risk assessment.

FOREVER MANUFACTURING COMPANY

STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 20X1

ASSETS

Current Assets

Cash on Hand and in 444,393.95

Bank

Accounts Receivables 864,107.00

Finished Goods 278,913.80

Inventory

Work in Process 150,258.00

Materials Inventory 1,077,155.25

Total current assets 2,814,828.00

Fixed assets

Building 3,755,174.30

Depreciation- building 468,756.84 3,286,417.46

Equipment 2,061,792.00

Depreciation- 460,579.20 1,601,212.80

equipment

Furnitures and Fixtures 1,525,800.00

Depreciation- fur. & fix. 204,020.00 1,321,780.00

Other factory 251,620.00

equipment
 Depreciation- Other 50,248.00 201,372.00 6,410,782.26
factory equipment

Total Assets 9,225,610.26

LIABILITIES AND STOCKHOLDERS EQUITY

Liabilities

Accounts Payable 830,687.53

Loans payable 2,500,000.00

Total liabilities 3,330,687.53

Stockholders Equity

Capital Stock 5,011,250.00

Retained Earnings 883,672.73 5,894,922.73

Total Liabilities and 9,225,610.26

Stockholders Equity

FOREVER MANUFACTURING COMPANY

STATEMENT OF COMPREHENSIVE INCOME
YEAR ENDED DECEMBER 31, 20X1

REVENUE

Total Sales 6, 730,800.00

COST OF SALES

Total Cost of Sales 3,450,650.00

GROSS PROFIT 3,280,150.00

LESS: OPERATING EXPENSE

Salaries & Wages 2,555,100.00

 Meals Expense 351,000.00

SSS, Medicare & EC Expense 76,500.00

Office Supplies 21,681.00

Repairs & Maintenance 39,644.00

Traveling 88,334.53

Representation 27,383.50

Rental Expense 23,000.00

Taxes & Licenses 8,040.00

Depreciation Expense 236,270.00

Donation 4,850.00

Miscellaneous 39,898.20 3,471,701.23

NET LOSS (191,551.23)

FOREVER MANUFACTURING COMPANY

WORKING STATEMENT OF FINANCIAL POSITION
YEAR ENDED DECEMBER 31, 20X2

Balance 12/31/20X1 Unadjusted Trial Balance

Account # Account Name Dr Cr Dr Cr

101 Cash on Hand and in 444,393.95 250,625.45

Bank

102 Accounts Receivables 864,107.00 458,417.25

103 Finished Goods 278,913.80 378,551.15

Inventory

104 Work in Process 150,258.00 175,288.00

105 Materials Inventory 1,077,155.25 1,686,233.33

201 Building 3,286,417.46 3,192,666.09

 202 Equipment 1,601,212.80 1,509,096.96

203 Furnitures and Fixtures 1,321,780.00 1,280,976.00

204 Other factory equipment 201,372.00 191,322.40

301 Accounts Payable 830,687.53 685,850.58

311 Loans payable 2,500,000.00 2,000,000.00

501 Capital Stock 5,011,250.00 5,011,250.00

517 Retained Earnings 883,672.73 1,426,076.05

9,225,610.26 9,225,610.26 9,123,176.63 9,123,176.63

FOREVER MANUFACTURING COMPANY

WORKING PROFIT AND LOSS
YEAR ENDED DECEMBER 31, 20X2

Balance 12/31/20X1 Unadjusted Trial Balance

Account Account Name Dr Cr Dr Cr

#

601 Sales 6,730,800.00 8,897,450.00

701 Cost of Sales 3,450,650.00 3,899,073.75

702 Salaries & Wages 2,555,100.00 3,060,480.00

703 Meals Expense 351,000.00 643,500.00

704 SSS, Medicare & EC 76,500.00 92,400.00

Expense

705 Office Supplies 21,681.00 27,426.47

706 Repairs & Maintenance 39,644.00 84,276.29

707 Traveling 88,334.53 58,141.79

708 Representation 27,383.50 78,308.59

 711 Rental Expense 23,000.00 65,200.00

712 Taxes & Licenses 8,040.00 27,738.00

751 Depreciation Expense 236,270.00 236,270.81

761 Donation 4,850.00 8,041.30

771 Miscellaneous 39,898.20 74,198.68

6,922,351.23 6,730,800.00 8,355,055.68 8,897,450.00

191,551.23 542,394.32

6,922,351.23 6,922,351.23 8,897,450.00 8,897,450.00

FOREVER MANUFACTURING COMPANY

ANALYTICAL REVIEW RATIOS
YEAR ENDED DECEMBER 31, 20X2

Ratio Ending Ending Industry

12/31/20X2 12/31/20X1

Current Ratio 3.389 2.14

Quick Ratio 1.575 1.41

Days’ sales in accounts receivable, computed 36 days 67.00

with average accounts receivable

Inventory turnover computed with average 1.842 10.00

inventory

Days inventory on hand computed with 198 days 96.00

average inventory

Total liabilities / net worth 0.565 0.99

Return on total assets -0.021 0.006

Return on net worth 0.032 0.006

Return on net sales 0.028 0.036

Gross profit / net sales 0.487 0.328

Selling, operating, and administrative 0.516 0.016

expense / Net Sales

FOREVER MANUFACTURING COMPANY

AUDIT PLAN
DECEMBER 31, 20X2

Date

Prepared by: Rene Gayle Isip (senior) December 10, 2022

Reviewed by: Mariane Manalili (manager)

Audit Objective

Audit of the financial statements of Forever Manufacturing Company for the year ended
December 31, 20X2.

Business and Industry Environment

Forever Manufacturing Company is a manufacturer of many sorts of sound systems for the
general market, such as a simple household and a small company. The firm began as a sole
proprietorship, and as it grew, other parties joined as owners and members of the
management team in order to maximize capitalization and market share. The company's
revenues have decreased as a result of modernization. Numerous industry developments are
emerging, including the sale of large amounts of illegal videoke players to videoke machine
makers for roughly 50% less money, the sale of low-cost VCD and DVD players everywhere,
and the introduction of a new product dubbed "magic sing" videoke microphones. The firm
also competed with some other companies that offered considerably more advanced
technology at the same price as them. To successfully compete, they shift to other products or
outputs in order to offer better/innovative products, meet the demands of their target
customers, and remain relevant in the market.

Planning Meetings
On November 2, Mariane Manalili and I met with Rafael, chief operating officer of Forever
Manufacturing Company to discuss the planning of the audit for the current year. On
November 20, a planning meeting was held in our office with all members of the engagement
team assigned to the audit.

Audit Approach

The company’s sales decreased resulting in a loss and surplus of inventory, we plan to
perform both tests of control in their internal control and substantive tests for the possible
high risk areas like inventory and cash as it helps to detect errors and fraud and verify
accuracy and completeness.

Several factors affect the risk of this engagement, including:

● As described above, Forever Manufacturing Company is in a very competitive

business that is sensitive to economic conditions.
● Oca Pacom, CPA, one of our partners (BPSU CPA's & Associates), Mega Development
borrower Jim Sesinando, one of Mega Development's Directors and a relative of
Regine, one of Forever Manufacturing Co.’s major stockholders.
● The company's sales declined resulting in a loss due to modernization.

● The previous auditor is currently outside the country, with that, reaching him will

take our best efforts.

These factors indicate that the engagement to audit Forever Manufacturing Company has

moderate risk.

Significant Accounting and Auditing Matters

Since the company is a manufacturer, we need to understand the client's inventory system,
including how inventory is valued, how inventory transactions are recorded, and how
inventory is physically counted and verified. Furthermore, we may evaluate the client's
internal controls related to inventory to determine whether they are designed effectively and
operating as intended. This may include reviewing policies and procedures related to
inventory, testing controls such as segregation of duties, and assessing the client's inventory
tracking and management systems.

Forever Manufacturing Company major repair will be undertaken to ready the factory for the
installation of new machineries to improve product quality making it more technologically
competitive. We need to ensure that the new machinery is properly classified as a fixed asset
and is capitalized and needs to verify that the depreciation method used for the new
machinery is appropriate in accordance with accounting standards . PAS 16 Tangibles
Planning Materiality

Since the client obtained a loss from the previous year and a profit for the current year, the
risk is quite high due to the volatility of the account balances, especially in the income
statement. Furthermore, the client firm is a manufacturer, it may have a higher inherent risk
due to the complexity of their operations, including inventory management and production
processes. We believe that total assets is the most appropriate basis for estimating planning
materiality as described on the next page:

Computation of Planning Materiality

Base Amount Percentage Materiality Estimate

Total Assets 9,123,177 1% 91,232

The range for planning materiality is up to 91,232 in order to reduce the risk to an acceptable
level.

Scheduling and Staffing Plan

Based on the discussions with Mr. Rafael, the following are dates for the audit:

Pre-engagement engagement activities November 26, 2022

Information gathering & Risk Assessment By December 3, 2022

Preparation of Audit Program By December 10, 2022

Sampling Plan for Test of Controls By December 17, 2022

Submission of Report - Planning & Test of December 24, 2022

Controls

Quality Review for Test of Controls By December 31, 2022

Sampling Plan for Substantive Testing January 1, 2023

 Evaluation of test results and preparation By January 8, 2023

of Audit Report

Submission of Report - Substantive Audit By January 15, 2023

& Report

Quality Review for Substantive Test & By January 22, 2023

Audit Report

Staffing time requirements for the engagement are described below:

Manager Senior Staff/Assistant Total

Interim 1 5 5 11

Final 1 5 5 11

2 10 10 22

Fraud Risk Assessment

Client: Forever Manufacturing Company

Financial Statement Date: 12/31/X7

Procedure Performed by Comments

1. Consider the results of the discussion Audit Manager

among engagement personnel about
the risk of material misstatement due
to fraud.
2. Consider results of inquiries of Audit Manager
management about the risks of fraud
 and how they are addressed.
3. Consider the result of planning Senior Auditor
analytical procedures
4. Consider any other information that Staff Auditor
might be relevant to the risk of
material misstatement.

Risk of material misstatement due to fraud

Overall Responses

Professional skepticism is used in document

gathering and evaluation to ensure the
appropriateness and sufficiency of audit
evidence. Risks were considered when
assigning significant responsibilities, and the
appropriate level of supervision is used for
each situation. The element of
unpredictability is considered in the selection
of auditing procedures to properly address
potential areas of fraud.

Risks were considered in staffing the

engagement and determining the
appropriate level of supervision.

Alterations of the Nature, Timing and

Extent of Procedures

Risk was considered when developing

procedures for auditing cash, accounts
receivable, and inventories.

Audit procedures are designed to reduce the

possibility of misstatements and
management override of internal controls.

Requirement 1. Analysis of Audit Plan for Forever Mfg. Co

Section Purpose Content

OBJECTIVES OF THE To describe the services that The objective is (1) audit of
ENGAGEMENT are to be rendered to the the financial statements of
client. Forever Mfg. Co for the year
ended 12/31/X2.

BUSINESS AND INDUSTRY To describe the nature of Forever Mfg. Co. is a

CONDITIONS Forever Mfg. Co.’s business manufacturer of sound
and industry. systems for the general
market. The company’s
revenues have decreased due
to modernization. To
successfully compete, they
shifted to other products or
outputs in order to offer
better innovative products,
meet the demand of their
target customers, and remain
relevant in the market.

PLANNING MEETINGS To indicate meetings held At this point, two meetings

with the client and with have been held: (1) the chief
CPAs engagement team. operating officer of the
Forever Mfg. Co with the
audit manager and a senior
auditor, and (2) with all
members of the engagement
team assigned to the audit.

AUDIT APPROACH To describe the overall The CPAs plan to perform

approach to be taken on the both substantive tests for
audit. high-risk areas as it helps to
detect errors and fraud, and
it also verifies accuracy and
completeness, and tests of
controls in the internal
control.

RISKS To describe factors affecting The engagement has

the risk of the engagement. moderate risk. The primary
risk factors are: (1) sensitivity
to economic conditions, (2)
conflict of interest on client
referral, (3) incurred losses
 due to modernization, and (4)
predecessor auditor issue.

SIGNIFICANT To describe particular Two particular concerns exist:

ACCOUNTING AND accounting and auditing (1) inventory analysis and
AUDITING MATTERS matters of concern. valuation, and (2) assessment
on installation of new
machines.

PLANNING MATERIALITY To identify an amount to be Based on an analysis of total

used as a measure for assets, an amount of 91,232
planning materiality. will be used as a measure of
planning materiality.

SCHEDULING AND To provide the schedule for This section includes major
STAFFING PLANNING major portions of the audit, dates beginning interim audit
and the staffing requirements work through the issuance of
for the engagement. an updated management
letter. A total of 12 weeks are
budgeted for the audit.

Requirement 2. Research made on Inventory Analysis and Valuation.

FOREVER MANUFACTURING COMPANY

DECEMBER 31, 20X2

Memorandum Accounting Issues - Accounting for Inventory

Forever Manufacturing shifted their product due to the tremendous decrease in their sales
because they have a lot of competitors. We must determine how inventory is being valued,
and we must know how inventory transactions are recorded, physically counted, and verified
as well. PAS 2 is the accounting treatment for inventories. It provides guidance for
determining the cost of inventories and for subsequently recognizing an expense, including
any write-down to net realizable value.

According to PAS 2, inventories include assets held for sale in the ordinary course of
business(finished goods), assets in the production process for sale in the ordinary course of
business (work in process), and materials and supplies that are consumed in
production (raw materials.) Moreover, According to IAS 2, in a manufacturing business,
inventory can be evaluated using First-In, First-Out (FIFO) method, Last-In, First-Out (LIFO)
 method, Weighted Average Cost method, Specific Identification method (in some cases).
Forever Manufacturing Company applied the First-In, First-Out (FIFO) method in evaluating
the inventory.

Inventory transactions in Forever Manufacturing Company are recorded in the same way as
any other business. When raw materials, work-in-progress, or finished goods are received,
they are recorded as an increase in inventory and a corresponding increase in accounts
payable or a decrease in cash, depending on the payment terms. When inventory is used or
sold, it is recorded as a decrease in inventory and an increase in cost of goods sold, which
ultimately affects the company's gross profit margin.

To physically count and verify inventory in this manufacturing business, the process may be a
bit more complex than in other businesses due to the variety and complexity of the inventory.
This may include identifying the inventory to be counted whether it is raw materials,
work-in-progress, and finished goods to be counted. Then, make sure the area where the
inventory is located is clean and organized, and that all items are easily accessible. Next is to
physically count each item of inventory on hand and record the quantity on a count sheet or
in a handheld device. Then, verify the count by comparing the physical count to the recorded
quantity in the accounting system, and investigate any discrepancies.

Camila P. Alvarez
Donna Jane L. Chico
(September 30, 20x2)

Requirement 3. Research made on installation of new machineries

a.

FOREVER MANUFACTURING COMPANY

DECEMBER 31, 20X2

Memorandum Accounting Issues - Installation of New Machineries

With the recommendation, FMC major repair will be undertaken to ready the factory for the
installation of new machineries to improve product quality making it more technologically
 competitive and a budget for research and development costs. PAS 16, states that intangible
items that are held for use in the production or supply of goods or services, for rental to
others, or for administrative purposes; and are expected to be used during more than one
period. It should be clear that the nature of the activity for which the machinery is being
developed should be considered in determining whether the new machinery should be
included in the asset. PAS 16, costs directly attributable to bringing the asset to the location
and condition necessary for it to be capable of operating in the manner intended by
management. Examples of these costs are: maintenance,professional fees, initial delivery and
handling, installation and assembly, etc.

Useful life and asset’s residual value (input to depreciable amount) shall be reviewed at least
at the end of each financial year. If there is a change in the expectations compared to previous
estimates, then change shall be accounted for as a change in an accounting estimate in line
with PAS 8 (no restatement of previous periods). Review the company's policies and
procedures related to capitalization and depreciation to ensure that they are consistent with
accounting standards.

Depreciation shall be recognized in profit or loss unless it is capitalized into the carrying
amount of another asset. PAS 16 prescribes that the carrying amount of an item of equipment
shall be derecognized on disposal; or when no future economic benefits are expected from its
use or disposal.

Verify that the new machinery has been installed correctly and is functioning properly. They
should review installation records and perform tests on the machinery to ensure that it meets
the company's specifications and is operating as expected. Also the company's maintenance
records for the new machinery to ensure that it is being properly maintained and serviced.

Joan Shine Dimple M. Butcon

Jameela Rae E. Guevarra
(September 30, 20x2)

l
b.
Forever Manufacturing Co. is a pioneer company that manufactures sound systems like
karaokes, radios and cassettes which are to be sold to their markets like households and other
small establishments. Due to the increasing demand of their supply, they decided to expand
their company but as the competitors arose the company's revenues have decreased as a result
of modernization. The situation leads the company to changing products which requires
acquiring new machinery. The major audit issue involved will be the installation of new
machineries. Depending on the size and configuration of the new equipment, installing it can
require you to move existing components. As a result of the stock of old products before
shifting , their money will become entangled with the unsold goods, and the inventory account
will be impacted.

Requirement 4. Forever Mfg. Co. Ratio Analysis

Forever Manufacturing Company

Analytical Review Ratios
For the Period Ended December 31, 20x2

12/31/2022 Ending Industry

12/31/20X1

Current Ratio 4.300 3.389 2.14

Quick Ratio 1.034 1.575 1.41

Days’ Sales in Accounts 27 days 36 days 67.00

Receivable, Computed with
Average Accounts Receivable

Inventory Turnover Computed 3.481 1.842 10.00

with Average Inventory

Days’ Inventory On Hand, 105 days 198 days 96.00

Computed with Average
Inventory

Total Liabilities to Net Worth 0.417 0.565 0.99

Return on Total Assets 0.059 -0.021 0.006

Return on Net Worth 0.084 0.032 0.006

Return on Net Sales 0.061 0.028 0.036

Gross Profit/ Net Sales 0.562 0.487 0.328

Selling, Operating, and 0.501 0.516 0.016

Administrative Expense
Supporting Computation for 20x2 Ratios

Current Ratio ● Current Assets/Current Liabilities: 2,949,115.18/

685,850.58= 4.30

Quick Ratio ● Quick Asset/ Total Current Liabilities= 250,625.45+

458,417.25= 709,042.7/ 685,850.58= 1.03

Debt Ratio

Days’ Sales in Accounts ● Sales per day= Sales/365 = 8,897,450/365= 24,376.575

Receivable, Computed with ● Average Accounts Receivable= A/R Beg+ A/R End/2=
Average Accounts (458,417.25+ 864, 07)/2= 661,262.125
Receivable ● Days’ Sale= Average Accounts Receivables/ Sales Per Day=
661,262.125/ 24,376.575= 27.127

Receivable Turnover ● Net Sales/ Average Receivable= 8,897,450/ 661,262.125= 14

days

Inventory Turnover ● Ave Inventory= Finished goods + Work in process+

Computed with Average Materials/ 2 = (378,551.15+ 175,288+ 1,686,233. 33) /2= 2,
Inventory 240,072.48/ 2= 1,120,036.24
● Cost of Goods Sold/ Ave Inventory= 3,899,073.75/
1,120,036.24= 3.481

Days’ Inventory On Hand, ● Cost of Goods Sold per day= COGS/365= 3,899,073.75/365=
Computed with Average 10,682.384
Inventory ● Ave Inventory/ COGS per day= 1,120,036.24/ 10,682.384=
105 days

Total Liabilities to Net ● Total Liabilities/ Total Shareholders Equity= 2,685,850. 58/
Worth 6, 437, 326. 05= 0.417

Return on Total Assets ● Net Income/ Total Assets= 542,403. 32/ 9, 123,176. 63= 0.059

Return on Net Worth ● Net Income/ Total Shareholders Equity= 542,403. 32/
6,437,326. 05= 0.084

Return on Net Sales ● Net Income/ Net Sales= 542,403. 32/ 8,897,450= 0.061

Gross Profit/ Net Sales ● Gross Profit/ Net Sales= 4,998,376. 25/ 8,897,450= 0.562
Selling, Operating, and ● Expenses/ Net Sales= 4,455,972.93/ 8,897,450= 0.501
Administrative Expense

Current Ratio
● Changes in credit policy
● Better economic conditions
Quick Ratio
● Changes in credit policy
● Better economic conditions
● Increasing sales and inventory turnover
Days sales in Accounts Receivable
● Changes in credit policy
● Better economic conditions
● Change in customer mix
Inventory Turnover
● Increasing sales
● Changes in credit policy
● Better economic conditions
● Reduction of cost
● Change in sales mix
● Increase in sales pricing
Days in Inventory on Hand
● Better economic conditions
● Change in inventory policy
● Inventory Obsolesce
● Overstatement of Inventory
Return on Total Assets
● Reduction of cost
● Better economic conditions
● Understatement of payables
Gross Profit / Net Sales
● Change in sales mix
● Reduction of cost
● Increase in sales pricing
● Understatement of cost of goods sold