“EIDI FOR AUDIT STUDENTS”

ApplicAtion of professionAl skepticism in cAse studies

1. Intended sale of shares/business, or acquiring a loan:

Misstatement potential: The company may overstate the value of the shares/business to attract buyers
or secure a larger loan amount.

Example: A company announces its plan to sell a subsidiary at a significantly higher valuation than its fair
value. The management may artificially inflate the subsidiary's financial performance to attract potential
buyers.

2. Unusual growth or decrease of sales:

Misstatement potential: Management may manipulate sales figures to create an impression of strong
performance or to hide declining sales.

Example: A company experiences a sudden and unexplained surge in sales for a particular period. Upon
investigation, it is discovered that the company shipped products to a related party or recorded fictitious
sales to boost revenue artificially.

3. Management's bonuses based on financial performance:

Misstatement potential: Management might manipulate financial statements to meet performance

targets and increase their bonuses.

Example: A company's management has a significant portion of their compensation tied to achieving a
specific earnings target. To ensure the target is met, they engage in aggressive accounting practices, such
as recognizing revenue prematurely or deferring expenses.

4. Significant transactions at year-end:

Misstatement potential: There is a higher risk of improper recognition or manipulation of transactions

near the year-end to meet financial targets or manipulate financial ratios.

Example: A company accelerates sales by offering extended payment terms to customers, thereby
recognizing revenue in the current year, even though the goods or services will be delivered in the
following year.

5. Imports and Exports:

Misstatement potential: Complex import/export transactions may be used to manipulate revenue,

expenses, or inventory values.

Example: A company artificially inflates its import costs by colluding with a foreign supplier, allowing the
excess funds to be funneled back to the company as unrecorded revenue, thus overstating its profits.

6. Cash for sale or purchase received (or paid) in advance:

Misstatement potential: The company may overstate revenue or understate liabilities by recognizing
cash received in advance as revenue before earning it.

Example: A company receives upfront payments for a long-term service contract but recognizes the
entire payment as revenue immediately, without allocating it properly over the contract period.

Inconsistency between different sources of evidence:

7. Management vs. Lawyer:

Misstatement potential: Discrepancies between the information provided by management and their
legal counsel may indicate attempts to misrepresent or conceal information.

Example: During an audit, management claims that they have no pending legal disputes, while the
company's lawyer provides evidence of ongoing litigation that could have a material impact on the
financial statements.

8. Financial Statements vs. Other Information:

Misstatement potential: Inconsistencies between the financial statements and other supporting
information may indicate misrepresentation or manipulation of financial data.

Example: The financial statements report a significant increase in inventory, but external market data or
industry reports suggest a decline in demand, casting doubt on the accuracy of the reported figures.

9. Debtors' Confirmation Letter vs. Amount recorded in sales ledger:

Misstatement potential: Differences between the amount confirmed by debtors and the corresponding
sales ledger balances could indicate fictitious sales or improper revenue recognition.

Example: The auditor receives confirmation letters from customers indicating lower outstanding
balances than what is recorded in the company's sales ledger, suggesting potential overstatement of
accounts receivable and revenue.

10. Amount Estimated by auditor (through Analytical procedures) vs. Amount actually Recorded in
F/S:

Misstatement potential: Significant discrepancies between the auditor's estimates based on analytical
procedures and the amounts recorded in the financial statements could indicate misstatements.

Example: The auditor estimates that the company's bad debt provision should be higher based on
historical collection patterns, but the management records a lower provision in an attempt to overstate
profitability.

11. Going Concern Issues:

Misstatement potential: If there are indications of financial difficulties or uncertainties about the
company's ability to continue as a going concern, the financial statements may be misstated to conceal
these issues.

Example: A company facing increased competition and operating losses may overstate the value of its
inventory or understate its liabilities to present a more favorable financial position, thereby masking the
going concern risks.

12. Significant related party transactions:

Misstatement potential: Related party transactions can be used to manipulate financial results or
transfer assets or liabilities to benefit related parties.

Example: A company enters into a sale of assets with a related party at a significantly below-market
price, thereby reducing its reported profits and tax liabilities while benefiting the related party.

13. Significant income, expenses, assets, and liabilities based on estimates:

Misstatement potential: The use of estimates allows for judgment and can be manipulated to present a
desired financial outcome.

Example: A company overestimates the useful life of its fixed assets, resulting in lower depreciation
expenses and higher reported profits.

14. Identified deficiencies in internal controls:

Misstatement potential: Weak internal controls increase the risk of misstatements, such as unauthorized
transactions, errors, or fraud.

Example: A company lacks proper segregation of duties, allowing an employee to manipulate sales
records without detection.

15. Lack of competence or integrity in management or employees:

Misstatement potential: Incompetent or dishonest management or employees may intentionally

misstate financial information or make errors due to a lack of knowledge or skill.

Example: A company's financial controller lacks the necessary accounting expertise, leading to incorrect
recognition of revenue and expenses.

16. Valuation of inventory:

Misstatement potential: The valuation of inventory can be manipulated to inflate or deflate the reported
profits and assets.

Example: A company intentionally overvalues its inventory by inflating the cost of production or
including obsolete or defective items, resulting in an overstatement of assets and profits.

17. Inventory held at various locations or with third parties, or physical count not done at balance
sheet date:
Misstatement potential: Inventory held in multiple locations or by third parties increases the risk of
misstatement or theft, while failure to conduct physical counts can lead to inaccurate inventory balances.

Example: A company's inventory held at a third-party warehouse is misappropriated, but the financial
statements do not reflect the loss, resulting in an overstatement of inventory and profits.

18. Additions to fixed assets:

Misstatement potential: Significant purchases of fixed assets may be manipulated to inflate the value of
assets and subsequent depreciation expenses.

Example: A company capitalizes expenses that should be treated as repairs or maintenance costs,
artificially increasing the value of its fixed assets.

19. Revaluation of property, plant, and equipment (PPE):

Misstatement potential: Improper revaluation of PPE can result in overstatement of assets and
subsequent depreciation expenses.

Example: A company inflates the fair value of its PPE without proper appraisal or supporting evidence,
leading to an overstatement of its assets and higher reported profits.

20. Closure of a factory:

Misstatement potential: The closure of a factory can result in the recognition of extraordinary costs or
the impairment of assets.

Example: A company delays recognizing the full extent of closure-related costs or fails to impair the
carrying value of assets, resulting in an overstatement of profits and assets.

21. Provision for warranty:

Misstatement potential: The estimation of warranty provisions may be manipulated to understate

potential liabilities.

Example: A company reduces its provision for warranty expenses despite an increase in customer
complaints and product malfunctions, understating its liabilities and overstate its profits.

22. Onerous contracts:

Misstatement potential: Onerous contracts may lead to the recognition of losses or the need for
provisions that could be manipulated or omitted.

Example: A company downplays the risks associated with onerous contracts and fails to recognize the full
extent of potential losses, resulting in an overstatement of profits.

23. Dispute with a major debtor:

Misstatement potential: Disputes with significant debtors can impact the collectability of receivables and
the valuation of inventory.

Example: A company fails to recognize the risks associated with a dispute over defective goods with a
major debtor, leading to an overstatement of receivables and inventory values.
 24. Pending litigations against the company:

Misstatement potential: Pending litigations can result in potential liabilities or losses that may not be
adequately disclosed or recognized in the financial statements.

Example: A company fails to disclose pending litigations related to environmental damage caused by its
operations, leading to a potential understatement of liabilities and misleading financial statements.

TALIB E DUA: CA WALA LARKA