BAC3624

Advanced Auditing

Tutorial 7

Question 1
Distinguish between errors and fraud. Give three examples of each.
Answer to question 1
Auditing standards define errors as unintentional misstatements or omissions of
amounts or disclosures in financial statements.
Fraud is defined as intentional misstatements that can be classified into two
types: (1) misstatements arising from fraudulent financial reporting and (2)
misstatements arising from misappropriation of assets.
Examples of errors include mistakes in gathering or processing from which
financial statements are prepared, unreasonable accounting estimates arising
from oversight or misinterpretation of facts, and mistakes in the application of
accounting principles.
Fraud includes intentional manipulation, falsification, or alteration of accounting
records or supporting documents from which the financial statements are
prepared; misrepresentation in, or intentional omission from, the financial
statements of events, transactions, or other significant information; intentional
misapplication of accounting principles relating to amounts, classification,
manner of presentation, or disclosure; and theft of assets such as cash or
inventory.
Question 2
You are an audit senior in Rauther & Co and you are commencing the planning of
the audit of Alay Fertiliser Sdn. Bhd. for the year ending 31 August 2013.
Alay Fertiliser Sdn.Bhd. (Alay) is a fertiliser manufacturer and has been trading
for over twenty years. The company operates from one central site, which
includes the production facility, warehouse and administration offices.
Alay sells all of its goods to large stores, with 60% being to one large chain store
Pajakly. The company has a two year contract to be the sole supplier of fertiliser
to Pajakly. It secured the contract through significantly reducing prices and
offering a four-month credit period, the companys normal credit period is one
month.
Goods in / purchases
In recent years, Alay has reduced the level of goods directly manufactured and
instead started to import fertiliser. Approximately 60% is imported and 40%
manufactured. Within the production facility is a large amount of old plant and
equipment that is now redundant and has minimal scrap value. Purchase orders
for overseas fertiliser are made six months in advance and goods can be in
transit for up to two months. Alay accounts for the inventory when it receives the
goods.
1

BAC3624

Advanced Auditing

Tutorial 7

To avoid the disruption of a year end inventory count, Alay has this year
introduced a continuous/perpetual inventory counting system. The warehouse
has been divided into 12 areas and these are each to be counted once over the
year. The counting team includes a member of the internal audit department and
a warehouse staff member.
The following procedures have been adopted;
1. The team prints the inventory quantities and descriptions from the system and
these records are then compared to the inventory physically present.
2. Any discrepancies in relation to quantities are noted on the inventory sheets,
including any items not listed on the sheets but present in the warehouse area.
3. Any damaged or old items are noted and they are removed from the inventory
sheets.
4. The sheets are then passed to the finance department for adjustments to be
made to the records when the count has finished.
5. During the counts there will continue to be inventory movements with goods
arriving and leaving the warehouse.
At the year end it is proposed that the inventory will be based on the underlying
records. Traditionally Alay has maintained an inventory provision based on 1% of
the inventory value, but management feels that as inventory is being reviewed
more regularly it no longer needs this provision.
Finance Director
In May 2013 Alay had a dispute with its finance director and he immediately left
the company. The company has temporarily asked the financial controller to take
over the role while they recruit a permanent replacement. The old finance
director has notified Alay that he intends to sue for unfair dismissal. The company
is not proposing to make any provision or disclosures for this, as they are
confident the claim has no merit.
Required:
(a) Identify and explain the audit risks identified at the planning stage of the audit
of Alay Fertiliser Sdn. Bhd.
(b) List and explain suitable controls that should operate over the continuous /
perpetual inventory counting system, to ensure the completeness and accuracy
of the existing inventory records at Alay Fertiliser Sdn. Bhd.

BAC3624

Advanced Auditing

Tutorial 7

Answer to question 1
(a)
i Identification of risk
Alay supplies 60% of its goods to Pajakly at a significantly reduced selling price,
hence inventory may be overvalued
Explanation of risk
Per FRS 102 Inventories, inventory should be stated at the lower of cost and net
realizable value (NRV). Therefore, as selling prices are much lower for goods
sold to Pajakly, there is a risk that the NRV of some inventory items may be lower
than cost and hence that inventory could be overvalued.
ii.Identification of risk
Recoverability of receivable balances as receivables may be overstated
Explanation of risk
Alay has extended its credit terms to Pajakly from one month to four months.
Hence there is an increased risk as balances outstanding become older, that
they may become irrecoverable.
iii Identification of risk
Valuation of plant and equipment.
Explanation of risk
The production facility has a large amount of unused plant and equipment. As per
FRS 116 Property, Plant and Equipment and FRS 136 Impairment of Assets, this
plant and equipment should be stated at the lower of its carrying value and
recoverable amount, which may be at scrap value depending on its age and
condition.
iv. Identification of risk
New inventory system introduced in the year.
This could result in inventory balances being misstated.
Explanation of risk
Alay has introduced a continuous/perpetual inventory counting system in the
year. These records will be used for recording inventory at the year end.
If the records and new system have not initially been set up correctly then there
is a risk that the year end balances may not be fairly stated.

BAC3624

Advanced Auditing

Tutorial 7

v.Identification of risk
Inventory may be overstated as Alay no longer has a slow moving provision.
Explanation of risk
Previously Alay maintained an inventory provision of 1%, however, this year it
has decided to remove this. Unless all slow moving/obsolete items are identified
at the year end and their value adjusted, there is a risk that the overall value of
inventory may be overstated.
vi Identification of risk
Provisions/contingent liability disclosures may not be complete.
Explanation of risk
The companys finance director (FD) has left and is intending to sue Alay for
unfair dismissal. However, the company does not intend to make any
provision/disclosures for sums due to the FD.
Under FRS 137 Provisions, Contingent Liabilities and Contingent Assets, if there
is a present obligation, a probable outflow of resources to settle the obligation
and a reliable estimate can be made of the obligation then a provision should be
recognised. If the obligation is only possible, or if there is a present obligation but
it is not recognised as there is not a probable outflow of resources, or the amount
of the obligation cannot be measured with sufficient reliability then a contingent
liability should be disclosed, unless the likelihood of payment is remote.
(b) Controls over the perpetual/continuous inventory system.
i. Control
The inventory count team should be independent of the warehouse team.
Explanation
Currently the team includes a warehouse staff member and an internal auditor.
There should be segregation of roles between those who have day-to-day
responsibility for inventory and those who are checking it. If the same team are
responsible for maintaining and checking inventory, then errors and fraud could
be hidden.
ii.Control
Timetable of counts should be regularly reviewed to ensure that all areas are
counted.
Explanation
The warehouse has been divided into 12 areas that are each due to be counted
once over the year. All inventory is required to be counted once a year, hence if
the timetable is not monitored then some areas could be missed out.

BAC3624

Advanced Auditing

Tutorial 7

iii.Control
Movements of inventory should be stopped from the designated areas during
continuous/ perpetual inventory counts.
Explanation
Goods will continue to move in and out of the warehouse during the counts.
Inventory records could be under/over stated if product lines are missed or
double counted due to movements in the warehouse.
iv.Control
Inventory counting sheets should be pre-printed with a description or item code
of the goods, but the quantities per the records should not be pre-recorded.
Explanation
The inventory sheets produced for the count have the quantities pre-printed,
therefore a risk arises that the counting team could just agree with the record
quantities, making under counting more likely, rather than counting the inventory
lines correctly.
v.Control
A second independent team should check the counts performed by the inventory
count team.
Explanation
By counting the lines twice this should help to ensure completeness and
accuracy of the counts, and hence that any inventory adjustments are
appropriate.