Auditing - Semester 2 2016

Solutions to Homework Tutorial Questions Week 4 Tutorials

Review Questions
8.15

Discuss the steps involved in the audit planning process.

Planning an audit involves establishing the overall audit strategy for the engagement
and developing an audit plan, in order to reduce audit risk to an acceptably low level
(ASA 300). Planning starts with an understanding of the entity and its environment.
Planning also involves (1) setting materiality levels, (2) assessing audit risk and its
components, (3) obtaining an understanding of the internal control structure and then
(4) developing a preliminary audit strategy for significant assertions. Auditors should
also perform analytical procedures as part of the planning process as well as
consider the risk of fraud.
8.18

What are the auditors responsibilities in relation to fraud?

The activities that the auditor will carry out include procedures to:
Identify and assess the risks of material misstatement due to fraud.
Ensure the audit team is aware of the risks of fraud and their responsibilities
in response to those risks.
Design and implement appropriate responses to the fraud risks identified.
Respond to any fraud or suspected fraud identified during the audit.
8.20

Identify the benefits of preparing audit documentation.

Assists the audit planning processes.
Demonstrates the audit was performed in accordance with auditing standards.
Ensures the appropriate direction and supervision of the audit team.
Facilitates the appropriate review of audit work ensuring the accountability of
audit team members.
Proves evidence is sufficient and appropriate to support the audit opinion.

Professional Application Questions

8.21 Risk of fraud
Following are a number of factors recognised by the auditor as having an
effect on the risk of fraud.
1.
The company is vulnerable to interest rate fluctuations.
2.
Management has significant financial interests in the entity.
3.
Employees express dissatisfaction with the company and its treatment of
staff.
4.
Many asset values are based on significant estimates that involve
subjective judgements.
5.
Management does not place a high priority on ethical standards.
6.
Inadequate systems of authorisation and approval of purchase

transactions.
7.
Management shows an excessive interest in increasing the entitys share
price.
8.
There is a high turnover of internal audit and information technology
staff.
9.
Employees ignore internal controls and do not focus on reducing risks of
misappropriations of assets.
10. The entitys industry is highly competitive.
11. Employees anticipate future redundancies.
12. Management attempts to justify marginal or inappropriate accounting on
the basis of materiality on a recurring basis.
Required
For each of the foregoing risk factors, use the following codes to identify the risk
component that is most directly related to (a) fraudulent financial reporting or
misappropriation of assets and (b) incentives/pressures, opportunity or
attitude/rationalisation.
FFR = fraudulent financial reporting
MA = misappropriation of assets

I/P = incentives/pressures
O = opportunity
A/R = attitude/rationalisation

Note: some of these may have more than 1 correct answer. Attempt has been made
to include the best answer in the table below.
Factor

(a) FFR or MA

(b) I/P, O or A/R

FFR

I/P

FFR

I/P

MA

A/R

FFR

FFR

A/R

MA

FFR

A/R

FFR

MA

A/R

10

FFR

I/P

11

MA

I/P

12

FFR

A/R

8.23

Client evaluation

Dinfal Ltd is a company that manufactures a range of products for the

electronics industry. You work for a medium-sized firm of accountants, Ejo,
Gam & Step. It is now 29 May 2015 and you have been approached by Dennis
Launch, one of the directors of Dinfal Ltd, to perform the financial report audit
for the year ended 30 June 2015.
From your brief conversation with Dennis you establish the following:
Dinfal Ltd was set up by Dennis and his cousin Berty Drip, who are both
directors and each own 50% of the shares. Both Dennis and Berty consider
themselves to be entrepreneurs and have a range of experience in different
industries. Since creating Dinfal Ltd six years ago, the profits have increased
very quickly, sales having nearly doubled each year.
Dennis mentions that they left their previous two auditors due to differences
of opinion about accounting policies and accounting treatments for various
transactions including research and development expenditure.
Your firm has wide experience of the industry but no previous connection to
the company. You have explained to Dennis that there are certain procedures
that need to be followed before you can accept appointment as auditors.
Dennis has indicated that Dinfal Ltd is seeking additional financing and would
like the audit to be completed as soon as possible so that the audited financial
report can be provided to the potential financiers to prevent any delay in
accessing additional funds.
Required
Highlight the issues that your firm should consider before accepting the appointment
as the auditor of Dinfal Ltd.
Before accepting a client, an audit firm should:
Evaluate the integrity of management
Identify special circumstances and unusual risks
Evaluate independence
Assess competence to perform the audit
Determine ability to use due care
Some more specific issues to consider with regard to this include:

The client has gone through 2 auditors in <6 years; this does not reflect well
on managements integrity.
Permission should be sought to contact the previous auditors, the audit
should not be accepted if this is not received.
We should communicate with the previous auditor to establish if there are any
reasons why weshould not accept appointment.
We should also ensure that the previous auditor has properly resigned.
We should obtain further details of the issues with the previous auditors,
including the details of accounting policies being followed.
We should review prior year financial reports and obtain copies of the most

8.26

recent financial information.

The client has indicated that the audit needs to be finished as soon as
possible; we need to consider if this allows us time to complete the audit with
due care and whether appropriate staff will be available at what is likely to be
a busy time for our firm.
The current financial year is almost over; this will limit the interim testing which
can be done and may affect the overall audit strategies adopted.
We should also consider whether our firm has staff with appropriate skills to
carry out the audit.
We should obtain further details of the finance being sought; i.e. who the
potential financiers are and how the financial report will be presented to them
as part of any funding application. The financial report users are particularly
relevant when considering potential legal liability.
A check will need to be performed to ensure the firm has no connections with
the firm that would affect independence.
The firm has clients in the same industry and should therefore ensure there
are no conflicts of interest.
The client has been experiencing rapid business expansion which can
represent a business risk.
Planning the audit; analytical review

Tirthe Ltd sells a range of indoor and outdoor furniture by recycling and
reinterpreting old furniture and other wood, metal, glass and plastic products
obtained from a variety of sources such as derelict buildings, deceased estate
auctions and so on. Revenue comes from sales to the general public and
businesses such as hotels and restaurants. Some small items are collected by
customers but generally goods are delivered by Tirthe Ltd. The directors have
reported that it has been another good year for the organisation and that they
expect the coming year to be successful.
The draft income statement for 2015 together with audited figures for 2014
are given below:
30 June
30 June 2014
2015
(draft)
(actual)
Revenue
Cost of sales
Gross profit

536 994
(322 187)
214 807

617 140
(302788)
314 352

Other income

7 186

(95 438)
(50 575)
(7 434)

(92 064)
(79 933)
(7 623)

Operating expenses
Administration
Selling and distribution
Finance costs

Profit/(loss) before tax

61 360

141 918

Required
You are planning the audit of Tirthe Ltd for the year ended 30 June 2015, discuss the
issues to be considered in your audit planning from the information contained in the
income statements.
Note: There were many different ways to approach this question; below is an
example only. Analytical procedures were required in order to answer the question
well, but you do not need to have used the exact same ratios and analysis as below.
Many of your overall comments, however, should be similar to those given below.
Trend analysis

Income statement items

Revenue
Cost of sales
Gross profit
Other income
Operating expenses
Administration
Selling and distribution
Finance costs
Profit/(loss) before tax
Ratio calculations
Ratio
Gross profit
margin

30 June
2014
(actual)
617 140
(302 788)
314 352
7 186

30 June
2015
(draft)
536 994
(322 187)
214 807

(92 064)
(79 933)
(7 623)
141 918

(95 438)
(50 575)
(7 434)
61 360

Formulae
Gross profit Net sales

Profit margin

Profit Net sales

Times interest
earned

Profit before income taxes

and interest expense
interest expense

Change
%
(13)
6
(32)
(100)
4
(37)
(2)
(57)

2014
51%

2015
40%

(314,352/617,140)

(214,807 / 536,994)

23%

11%

(141,918/617,140)

(61,360 / 536,994)

20%
((141,918 + 7,623) /
7,623)

9%
((61,360 + 7,434) /7,434)

Net profit (decrease of 57%)

The change in net profit is a much a greater fall than the levels of turnover would
suggest. The profit margin has dropped from 23% to 11%. The reasons for this fall
needs to be investigated. A review of each item on the income statement, as
discussed below, should provide those answers.
Sales revenue (decrease of 13%)
There needs to be some investigation to the directors assertion that it has been
another good year given that the draft income statement shows a fall in revenue.
Specific attention may be devoted to sales testing for completeness (for possible

understatement of sales) and cut-off for receivables to ensure sales have been
recorded in the correct period.
Cost of sales (increase of 6%)
Cost of sales have increased when sales revenue has fallen. This may indicate
occurrence problems for purchases (overstatement) or cut-off problems relating to
payables and inventory. It may also indicate completeness problems for inventory
quantities (understatement).
Gross profit (decrease of 32%)
Gross profit margin has fallen from 51% to 40% this may indicate difficult trading
conditions which contradict the directors assertion about it being a good year.
Investigations into the causes of the change are required, it maybe that there has
been an adjustment to pricing policy leading to reduced profit percentages.
Other income (none this year)
There is no other income this year, this may refer to interest income, or other
investment income. In which case this would indicate the downturn in trade has
reduced cash balances or other investment balances. A review should be conducted
to establish the ability of the company to meet liabilities as they fall due to assess the
possible going concern risk - it should be noted that it usually takes more than one
year of reduced performance to create going concern problems.
Administration (increase of 4%)
Admin costs are likely to be fairly fixed (or stepped) and therefore it might be
expected that admin costs do not change much unless there is a significant change
in volume of trade.
Selling and distribution (decrease of 37%)
There has been a decrease in sales which may suggests fewer deliveries, it may
also be the case that reducing spend on marketing may have led to the fall in sales.
There is a possibility that some costs have been incorrectly allocated to cost of sales
- given the increase in cost of sales referred to above.
Interest payable (decrease of 2%)
A small decrease in the amount paid would not indicate any significant risk. Levels of
cash balances, loans and overdraft levels would indicate the extent to which this
expense appears realistic.