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Topic 3 Audit planning I

The purpose of this topic is to cover audit planning including the stages of the audit, gaining
an understanding of the client, fraud risk, going concern, corporate governance information
technology and closing procedures.

Learning Objectives:
After studying this chapter you should be able to:

1. Identify the different stages of an audit

2. Explain the process used in gaining an understanding of the client
3. Define fraud risk
4. Explain the going concern assumption
5. Describe corporate governance
6. Explain how a clients information technology (IT) can affect risk
7. Explain how client closing procedures can affect reported results

Set readings for this topic

Chapter 3 Moroney, Campbell and Hamilton 1st Edition.

What you need to do this week

1. Read this Topic Guide
2. Complete the set reading for this topic from Moroney, Campbell and Hamilton with
reference to the listed learning objectives of the topic. Make sure you achieve ALL the
listed learning objectives after reading the chapter.
3. Complete the Interteaching Questions before attending your tutorial class. You should
be prepared to discuss the answers to these questions in class without making
reference to your notes. In the Interteaching Session you will also be expected to apply
the information you have learnt from your reading to address a real world issue.

Interteaching Questions - To be completed before class

Question 1

What are the purposes of an audit plan?

The main purposes of an audit plan includes:

- Perform a risk and materiality of material misstatements (material misstatements are

the errors in the financial statements that are caused by errors or frauds). This risk
assessment helps identify the areas (financial accounts/transactions) that need more

- Perform a materiality assessment (this is introduced in more detail in the next topic)

- Develop an audit strategy based on the above risk and materiality assessment (to be
able to identify the most appropriate and efficient audit procedures to be carried out in
the execution stage).

Question 2

Discuss (with examples when appropriate) the outcomes (or objectives)

the auditors gained from understanding the client at the industry and
entity level.

- Two main outcomes auditors would gain from understanding the

client at an entity and industry level:
o Assess the clients going concern ability (or risk of failures)
o Identify the financial assets accounts that are exposed to
higher risks of being misstated (thus requires closer

Specific examples of the specific procedures and outcomes:

o Assess whether the client has provided adequate provision of

doubtful debts, by identifying the clients major customers to
assess their ability to pay.
o Assess the going-concern ability of the business, by, for
example assessing the clients reliance on major customers,
the stage of development in the industry, the position
economic condition, the position of the client company within
the industry (and how it would be affected by the economic
o Determine (if appropriate) how effective the client is in
managing the foreign exchange risk exposure to assess the
volatility of the profit figures as well as a going concern ability
of the client, through identifying and assessing the clients
exposure to the risk of currency fluctuations.
o Through the assessment of clients capacity to adapt to
changes in technology and other trends, to assess the
volatility of profits as well as going concern-ability of clients.
o Assess the adequacy of provisions such as for warranties, from
the quantity and frequencies of goods returns.
o assess the going-concern ability of clients through other
factors such as clients bargaining power, sources of finance
(and the conditions in the debt covenant) to assess clients
going-concern ability.

Question 3

Briefly list out some common information that an auditor may be

interested in when performing an understanding of clients at the industry

- Clients position in the industry
- Nature of business/nature and types of products in the industry
- Level of competition in the industry
- Clients reputation relative to other companies in the same industry
- Level of government support for the industry
- Level of demand for goods sold or services provided by the
companies in the companies in the clients industry.

Question 4

Corporate Governance is the set of rules, systems and processes within

companies that are used to guide and control.


- Guidance on how to set up the structure of the Board e.g different

- Guidance on promoting ethical and responsible decision making
- Guidance on policies and procedures needed to safeguard the
integrity in financial reporting

Question 5

The auditor needs to understand where the risk of inaccurate processing lies within the IT
system and whether the client has other controls (e.g. manual controls or other automated
controls) over processing systems which would provide greater assurance that the reported
figures are accurate.

Practical exercises

Question 1

Katie Gardner is the audit senior in the audit of Honza Ltd, an existing
client of her firm which is an importer of scooters and other low-powered
motorcycles. In doing the audit plan, Katie has been investigating certain
aspects of Honza Ltds business given the change in economic conditions
over the last 12 months. She has found that Honza Ltds business, which
experienced rapid growth over its first five years in operation, has slowed
significantly during the last year. Initially, sales of scooters were boosted
by good economic conditions and solid employment growth, coupled with
rising petrol prices made the relatively cheap running costs of scooter
seem very attractive. In addition, the low purchase price of a small motor
cycle of scooter, at between $3,000 and $8,000, meant that almost
anyone who had a job could obtain a loan to buy one.

However, Katie has found that the sales of small motorcycles and scooters
have slowed significantly and all importers of these products, not just
Honza Ltd, are being adversely affected. The onset of an economic
recession has restricted employment growth and those people who still
have jobs are less certain of continued employment. In addition, the
slowdown in the world economy has made petrol prices fall, further
reducing demand for this type of economical transport. Katie has also
discovered that, due to the global financial crisis, the finance company
used by Honza Ltds customers to finance the purchase of scooters and
motor cycles has announced that it will not be continuing to provide loans
for any type of vehicle with a purchase price of less than $10,000.


1) What are the issues that may affect the audit of Honza Ltd.
Clearly state whether the issues identified are at industry level or
are company specific?

2) Identify the risks (and the financial report accounts that are
exposed to that risk) that require closer examination in the audit.

1) Issues:

Change from good economic conditions (solid employment growth, rising petrol
prices, easy access to credit for consumers) to financial crisis (recession with lower
employment growth, falling petrol prices, difficult access to credit).

Changing conditions such as lower petrol prices and lower employment growth have
slowed consumer demand for scooters. Consumer demand is also likely to be affected
by less access to consumer credit for scooter purchases.

The changed economic conditions also likely adversely impact Honza Ltds access to
finance (tighter finance market, slower cash flow to service debt).

2) Potential risks:
Greater risk of fraudulent financial reporting because of pressure on Honza Ltd
management to meet performance targets (either for bonuses or to satisfy bank
The issues likely have impacts on profit
Sales revenue. Consider risk of fraudulent transactions, cut-off (sales from future
period back-dated to the current period), revenue recognition issues (e.g. scooters
loaned to potential customers recorded as sales despite generous rights of return)
Risk associated with finance company scooter price inflated to be above
$10,000 with allowance granted later to customer.

Expenses: Consider risk that expenses post-dated to next period to improve
current period profit.
Going concern risk is business able to pay its debts as they fall due? What are
the terms of finance between Honza Ltd and its banks? Is Honza Ltd locked into a
lease on premises that are now too large?
Risk associated with staff layoffs poor sales could lead to staff sackings not in
accordance with relevant awards, risk of successful case for unfair dismissal.

Question 2

GreenScope Steel Company has grown from its beginnings in the steel
fabrication business to become a multinational manufacturer and supplier
of all types of packaging, including metal, plastic and paper based
products. It has also diversified into a range of other businesses including
household appliances in Europe, the United States and Asia. The growth of
the size of the business occurred gradually under the leadership of the
last two CEOs, both of whom were promoted from within the business.

At the beginning of last year, the incumbent CEO died of a heart attack
and board took the opportunity to appoint a new CEO from outside the
company. Despite the companys growth, returns to shareholders have
been stagnant during the last decade. The new CEO has a reputation of
turning around struggling businesses by making tough decisions. The new
CEO has a five year contract with generous bonuses for improvements in
various performance indicators, including sales/assets, profit from
continuing operations/net assets and share price.

During the first year, the new CEO disposed of several segments of the
business that were not profitable. Very large losses on the discontinued
operations were recorded and most non-current assets throughout the
business were written down to recognise impairment losses. These actions
resulted in a large overall loss for the first year, although a profit from
continuing operations in the United States increased dramatically, and
combined with various cost-saving measures, the company made a large

The auditors have been made aware through various conversations with
middle management that there is now an extreme focus on maximizing
profits through boosting sales and cutting costs. The attitude towards
compliance with accounting regulations has changed, with greater
emphasis of pleasing the CEO than taking care to avoid breaching either
internal policies or external regulations. The message is that the company
has considerable ground to make up to catch up with other companies in
both methods and results. Meanwhile, the share price over the first year
and a half of the CEOs tenure has increased 65 per cent, and the board

has happily approved payment of the CEOs bonuses and granted the CEO
additional options over the companys shares in recognition of the change
in the companys results.


1) Identify the factors may give rise to fraud risk in the facts of the
above company, clearly indicating whether each creates an
incentive, pressure, opportunity to commit fraud or an attitude
and rationalisation to justify the fraud.
2) What potential financial report frauds would be potentially
occurring at the company?

1) Incentives: The board has shown through their selection of a new CEO with a
reputation for toughness and turning around businesses that they want a change in
the companys results. The board has given the new CEO a 5 year contract with
incentives for growth, profit and share price. The CEO also has the incentive to
preserve his reputation.

Opportunities: The new CEO has a bonus that is tied to profit from continuing operations.
This means that any write-offs that can be labelled as discontinuing operations will not
affect his bonus. There is the opportunity to take a bath by writing down assets more than is
required without affecting the bonus. In future periods, bonus payments will be higher
because a lower amount of depreciation will be charged to continuing profits. In addition,
selling off certain divisions reduces recurrent depreciation charges and provides a cash
resource to invest in other areas that are favoured by the CEO. The new CEO also has a 5
year period to make these changes without risking termination.

Attitudes/rationalisations: The focus is now on maximising profits through boosting sales and
cutting costs. There is less emphasis on compliance and more on pleasing the CEO. This
suggests that efforts to boost profit will be received favourably and any attempt to obstruct
the CEO, such as questioning accounting policies or business decisions, will not be received
favourably. Increasing share prices also seem to say that the market approves the new actions.
The CEO has been rewarded by the board, further encouraging this type of behaviour.

2) Potential frauds consider risk of fraudulent financial reporting greater than risk of
asset misappropriation.

- Backdating sales to current period, post dating expenses to next period (consistent with
reported growth in sales, lower costs in latest results)
- Reclassifying assets and expenses as part of discontinued operations, overstating asset
impairments, overstating losses on disposal of discontinued operations
- Inappropriate classification of revenues and expenses in current period to accentuate
reported growth in profit, greater capitalisation of expenses in current period as assets
(also to increase profit), understating liabilities (nonrecognition of accruals etc)

Question 3

The Hiltin Hotel is located close to the main railway station in a large
regional city. Its main client base is business people visiting the city for
work-related purposes. The second largest group of clients consists of
groups of (mainly) women visiting the city for its great shopping. All major
department stores have a presence in the city and there are also lots of
specialty shops and factory outlets. Another large group of clients are
groups of (mainly) men visiting the city for annual international cricket
match in the summer plus several important football games (soccer and
rugby league) during the winter.

Occupancy rates have been reasonable but stagnant for several years,
providing a steady but unsatisfactory rate of return for the owners of the
hotel. Revenues have been sufficient to cover operating costs but not
substantial progress has been made on replying the large, long-term loans
used to finance the hotel. In an effort to increase the hotels profitability, a
major renovation program was undertaken and completed earlier this
year. The renovation was predicted to increase the relative attractiveness
of the hotel to guests. It was also undertaken to earn additional revenue
from the rent of a new coffee shop on the ground floor. The coffee shop is
run by a separate company that has purchased a franchise of a major
international brand.

The global financial crisis has hit the hotel business very hard this
financial year. Business travel is down by 25% across the country. Further,
discretionary retail spending is down by 40%, particularly in the regions.
Several specialty shops in the city have already shut and others are
cutting their opening hours. In addition, the international cricket match
this year was won by the visiting team in two and a half days (instead of
the scheduled five days). Thousands of visitors left the city early once the
match was over. Just before the cricket match the coffee shop owners
went bankrupt and closed down, breaking their lease. The hotel owners
are seeking legal advice on whether they can claim penalty fees on the
broken lease.

Finally, the hotel owners bank is warning that the short-term finance
obtained for the renovations will not be renewed when it is due (one
month after year end). The hotel managers had expected to repay the
debt from this years bookings and the coffee shop lease. The hotel
owners are still hopefully that the winter will bring a large lift in occupancy
(and revenue) as the local football teams are doing well and several key
games are scheduled for the city. This expected winter trade is essential
to meet repayments on the long-term debt as well as convince the bank to
extend the short-term debt.


3) Identify the factors that may affect the Hiltins going concern ability.
4) Identify the mitigating factors that may help reduce the risk that the
company is not going concern.
5) If you are an auditor, what is your assessment of this clients ability
to continue as a going-concern?

1) Going concern issue factors:

Hotel occupancy fees are lower due to reduced business, shopping, and sport related travel.
Rent from coffee shop has stopped due to the shops closure, uncertainty about recovery of
penalty fees or new lease.
Short term finance for renovations will not be renewed.

2) Mitigating factors:

Hotel occupancy could increase if sport related travel is realised as predicted.

If penalty fees are recoverable, this could repay the short term debt.
Long term debt is not due, although repayments must be made.

Other, not discussed in question:

Refinance short term debt through seeking a new bank for both the long term and short
term debt
Coffee shop could be leased to a new tenant.
Global financial crisis could be less severe due to government stimulus package,
increasing business related travel.
Renovations are complete and could help boost occupancy.
Consider likely success of sale of property.

Auditor should consider evidence for each risk and mitigating factor. For example, review
correspondence with the existing and any new bank with respect to both loans, discuss the
case against the coffee shop tenant with the clients solicitor (with the clients permission),
review advance bookings for travel associated with the football games, review
correspondence (if any) with potential new coffee shop tenants, read minutes of board of
directors where the issues have been discussed, obtain independent evidence on travel to the
city and retain spending, obtain valuations of property (should be higher following the

The auditors conclusion should be based on the strength of the evidence supporting the
mitigating factors and the going concern issues, and professional judgement about the
likelihood of the events occurring.