Chapter 5

Planning, understanding the entity and evaluating business risk

Learning objectives
5.1 Explain why the decision to accept a client is important and describe the primary features of client
acceptance and continuance, including the purpose and content of an audit engagement letter.
5.2 Explain the importance of planning to the audit process.
5.3 Identify the important aspects of the auditor’s understanding of an entity and its environment.
5.4 Assess entity business risk.
5.5 Explain how an auditor develops an overall audit strategy and prepares a detailed audit plan or
audit program.
5.6 Describe the process of assigning and scheduling audit staff.
5.7 Outline the types and uses of analytical procedures and distinguish those that are useful in
obtaining an understanding of an entity and assessing business risk.

Major chapter sections

Client acceptance and continuance
Audit planning
Understanding the entity and its environment
Business risk
Developing an overall audit strategy

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Assigning and scheduling audit staff
Analytical procedures

Lecture plan
The emphasis in this lecture is on outlining the procedures undertaken at the beginning of an audit.
These include the client acceptance and continuance decision, preparing the audit plan and the purpose
and content of the engagement letter. The chapter also covers the importance of understanding the
client's business and industry and making an assessment of the client's business risk. This approach
places emphasis on business strategy as distinct from financial risk.

With the emphasis on analytical procedure at this stage of the audit, the chapter also devotes
considerable attention to the types and uses of these procedures.

You should outline the learning objectives for this chapter and walk the students through how this
chapter fits into the flowchart of the planning and risk assessment stage of a financial report audit.

[Use slides 5-1 to 5-3]

LO 5.1: Client acceptance and continuance

The emphasis here is on the steps in accepting a client, discussing client evaluation procedures and
communications with the previous auditor.

The engagement letter is important because it is a letter from the auditor to the client to document the
arrangements made with the client and to clarify matters that may be misunderstood.

[Use slides 5-4 to 5-12]

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LO 5.2: Audit planning
These slides outline the importance of proper audit planning.
It is important to explain to students the difference between the two major planning documents.
• Audit strategy: sets the scope, direction and timing of audit and guides the more detailed audit
plan/program.
• Audit plan/program: sets out the nature, timing and extent of audit procedures.

The overall timing of the audit engagement is also explained, with an indication of what occurs at the
planning, interim and final stages of the audit.
.

[Use slides 5-13 to 5-16]

LO 5.3: Understanding the entity and its environment

The business risk approach emphasises the importance of obtaining an understanding of the client's
business and industry. These slides outline the purpose and the procedures involved in obtaining this
understanding.

[Use slides 5-17 to 5-23]

LO 5.4: Business risk

Business risk is the risk that an entity’s business objectives will not be attained and its assessment
requires obtaining knowledge of the client's business. It involves understanding the client's strategic
advantages in relation to its competitors, understanding key business processes and risks and
identifying and evaluating key performance indicators.

It is important that students understand that while most business risks have financial consequences and
therefore eventually affect the financial report, not all business risks result in risks of material
misstatement. Therefore, business risk is broader than the risk of material misstatement but includes it.

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It is also important that students understand that the auditor is required to determine whether any
identified risk is a ‘significant risk’, a risk of material misstatement that requires special audit
consideration.

At this stage it is also necessary to explain to students how the auditor needs to respond to assessed
risks.

[Use slides 5-24 to 5-34]

LO 5.5: Developing an overall audit strategy

At this stage consideration is given to introducing students to the different types of audit strategy, the
approach of relying on internal controls versus the predominantly substantive approach. This is done
before control risk is assessed.

[Use slides 5-35 to 5-38]

Preparing a detailed audit plan or program follows from the planned audit strategy and shows how the
audit strategy is documented.

[Use slides 5-39 to 5-43]

LO 5.6: Assigning and scheduling audit staff

As the audit strategy is developed, staff are assigned, including consultants, specialists and internal
audit.

[Use slides 5-44 to 5-45]

LO 5.7: Analytical procedures

Analytical procedures are also used extensively to gain an understanding of the client's business and
place even greater emphasis on the business risk approach. It is important for students to recognise that
analytical procedures can be used at all stages of the audit, although at this point we are concentrating
on their use at the planning stage.

It is important to go through how the key ratios are calculated and how the auditor may use the results
to identify risk areas. It is also important to point out to students that there are a number of acceptable
ways of calculating some of these ratios and we have included the most common formulae.

[Use slides 5-46 to 5-59]

Summary
We provide a summary slide of the main learning takeaways in this chapter.

[Use slide 5-60]

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 SOLUTIONS

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REVIEW QUESTIONS
5.1 The auditor will be seeking information about the reasons for the change to determine
if there is a professional reason why the appointment should not be accepted.
Therefore, communication between the parties serves to protect:
 an auditor from accepting a nomination when they are not fully aware of all the
circumstances
 shareholders, who may not be fully informed of the circumstances surrounding the
proposed change
 the interests of the existing auditor, where the proposed change arises from, or is
an attempt to interfere with, the conscientious exercise by the existing auditor of
their duty as an independent professional.
5.2 Engagement letters are used to document the arrangements made with the client and to
clarify matters that might be misunderstood. They usually cover matters such as
(a) a description of the scope of services
(b) an explanation of the auditor’s responsibility for such matters as fraud detection
(c) procedural arrangements such as billing of fees. Refer to ASA 210 (IS 210).
5.3. Proper planning helps to ensure that important and potential risk areas of the audit are
given appropriate attention and problems are identified and dealt with. It also helps to
ensure that the audit is efficient and effective by allocating the appropriate quality and
quantity of audit staff to the engagement and coordinating resources and work done by
component auditors or experts.
5.4 Audit procedures that are used to obtain knowledge of the client’s business include the
following.
 Read manuals and other specifications of formal organisational structure.
 Inquire about organisational policies and procedures.
 Observe actions of employees and top management.
 Review last year’s correspondence files, permanent files and working papers.
 Tour the client’s physical facilities.
 Review legal documents, such as corporate charter and by-laws, minute book, tax
returns, and major contracts and correspondence.
 Review trade journals, industry publications and statistics, pertinent government
regulations, and the relevant industry audit guide, if available.
5.5. Understanding the entity and its environment helps the auditor to:
 assess risks and identify problems

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  determine materiality
 consider the appropriateness of accounting policies and disclosures
 identify areas requiring special audit consideration
 develop expectations for use when performing analytical procedures during the
audit
 design audit procedures in response to assessed risks of material misstatement
 evaluate audit evidence.
5.6 As outlined in ASA 315.11 (ISA 315.11), an auditor’s understanding of the entity and
its environment consists of an understanding of:
 industry, regulatory and other external factors, including the applicable financial
reporting framework
 the nature of the entity
 the entity’s selection and application of accounting policies
 the entity’s objectives and strategies, and those related business risks that may
result in risks of material misstatement
 the measurement and review of the entity’s financial performance.
5.7 Business risk is the risk that an entity’s business objectives will not be attained as a
result of the external and internal factors, pressures and forces brought to bear on the
entity and, ultimately, the risk associated with the entity’s profitability and survival.
In order to understand the business and assess whether the financial report is fairly
presented, the auditor must understand the entity’s business strategy and risks and its
ability to respond to changing environmental conditions. The auditor assesses the
specific business risks that the entity faces in achieving these strategies to determine if
they could result in a materially misstated financial report.
5.8 An audit strategy sets the scope, direction and timing of the audit and guides the more
detailed audit plan. An audit plan or program sets out the nature, timing and extent of
risk assessment procedures and evidence collection procedures at the assertion level
and any other audit procedures necessary to meet Australian auditing standards.
5.9. The auditor will need to adopt an audit strategy of a predominantly substantive
approach when the auditor believes that adequate internal controls do not exist or that
existing controls are likely to be ineffective.
The auditor might also adopt this strategy for cost/benefit reasons, when the auditor
believes that the cost of completing the audit procedures necessary to obtain an
extensive understanding of internal control and test controls to enable a lower level of
control risk will be more than the cost of performing extensive substantive procedures.
5.10 Three important aspects of establishing and coordinating the staffing requirements of
an audit are:
 selecting competent people

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  preparing a time budget and work schedule
 supervising audit staff.
5.11. Analytical procedures are used:
 to assist the auditor in planning the nature, timing, and extent of other audit
procedures
 as a substantive procedure
 as an overall review of the financial report in the final review stage of the audit.
The auditor must apply analytical procedures at the planning stage to aid
understanding the business and identifying areas of potential risk (ASA315.6 (ISA
315.6)). The auditor must apply analytical procedures at or near the end of the audit
when drawing a conclusion as to whether the financial report as a whole is consistent
with the auditor’s knowledge of the business (ASA 520.6 (ISA 520.6)). In addition, the
auditor may use analytical procedures as a substantive test of transactions or balances,
if they consider it appropriate as part of gathering sufficient appropriate audit evidence.
5.12. The auditor’s first step in investigating significant fluctuations should be to discuss
them with the entity’s management, as they may be able to provide an explanation for
the fluctuations.
The second step is for the auditor to consider whether the explanations received are
reasonable in light of the auditor’s knowledge of the entity and industry and the
information obtained through other audit procedures. This step should be applied with
an attitude of professional scepticism. These management explanations cannot be relied
upon without further checking, unless they are supported by conclusions already
arrived at as a result of other audit procedures.
The third step will be for the auditor to ensure that any risk areas that are identified are
appropriately addressed in the audit strategy and audit plan or program.

DISCUSSION PROBLEMS AND CASE STUDIES

5.13 ASA 210.10 (ISA 210.10) states that the auditor and client must agree to the terms of
the engagement in writing and recommends the use of a written engagement letter. The
use of such a letter does have a number of advantages, including ensuring both parties
are aware of and acknowledge their responsibilities under the audit engagement.
As a first step, the audit partner could explain to the managing director the purpose of
the engagement letter and allow the managing director time to review the contents of
the letter and discuss the matter with her fellow directors. If she, or the board of
directors, refuses to acknowledge the terms of the engagement in writing, the audit
partner should consider the possible reasons for such a refusal and the implications for
the engagement. For example, the board might not provide the auditors with timely
access to company records. As a result, the auditor might wish to re-evaluate their
acceptance of the audit engagement.
5.14 (a) The risks to the audit firm of accepting this engagement include:
 it may not be possible to obtain sufficient appropriate audit evidence to form an
opinion, especially given doubts regarding management integrity

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  IPL may not have the resources to pay the audit fee, as it has limited customers and
assets
 the audit firm may become a party to legal action if the directors’ behaviour leads
to further prosecutions, or if IPL is wound up or made bankrupt
 the reputation of the audit firm may be adversely affected if the public becomes
aware of the legal action being taken against the directors.
(b) Guidance on information to be sought when evaluating a prospective client can be
found in ASA 220 (ISA 220).
Further information to be sought should include:
 obtain and review available financial information, such as results to date and
budgets
 obtain a copy of the business plan and check areas such as the marketing plan: how
IPL plans to compete against much larger companies
 obtain information about their new sunscreen product to determine if there is any
basis for their claim that it is a superior product
 make inquiries of third parties as to any information that might have a bearing on
evaluating the client (e.g. make inquiries of lenders and legal advisers)
 follow up the prosecutions and see if any outcome has been reached; if so,
determine its effect on the audit acceptance/rejection decision
 ensure the decision of whether to accept or reject the engagement is made in
accordance with the firm’s policies and procedures
 evaluate the firm’s independence and ability to serve the prospective client
 determine that acceptance of the client would not violate the ethical code of
professional conduct.
It is unlikely that the potential auditor would gain much from the evaluation of
available financial information, given this is the first year that the company has
operated and this has been highlighted as one of the reasons the prospective client is
assessed as being high risk. However, the information still should be reviewed.
5.15 Matters that would influence the scope of the audit may include the following:
 the financial reporting framework—it is a large proprietary company and therefore,
has to lodge its financial report with ASIC
 the expected audit coverage—Range has significant assets in a remote location and
therefore, it may be difficult to verify their existence. Also, there may be changes in
the composition of the group, if unsuccessful franchises have become owner-
operated during the year or if the new company-owned dog-grooming businesses
have been established
 the extent to which components are to be audited by other auditors (if applicable)

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  the nature of the business—as Range runs a sheep station, specialised knowledge
might be needed (e.g. valuing biological assets)
 the need for a stand-alone financial report, in addition to the consolidated financial
report—is any of the subsidiaries large enough to require a separate financial
report?
 the expected use of audit evidence obtained on prior audits—the computer system
has changed, so evidence relating to the control environment may no longer be
valid
 the effect of information technology on the audit—an incompletely implemented
computer system and the lack of staff continuity are likely to increase both inherent
risk and control risk
 matters that may affect the audit firm personnel—need to consider independence
implications, as the audit partner has been on the audit for many years and had a
close personal relationship with the previous bookkeeper, creating familiarity risks.
5.16 Matters that need to be considered by the auditor as part of audit planning include:
(a) Staff turnover: The high staff turnover rate and the increased pressure to process
payments promptly to reduce delays might result in additional errors being made. Tests
of control may need to be increased in the accounts payable area, to ensure that they
are operating effectively; otherwise a substantive approach would need to be adopted.
New staff might not be fully competent and aware of required procedures. This could
increase the auditor’s inherent risk assessment.
(b) Retrenchment of internal audit department: The impact on the audit plan will
depend on the auditor’s use of the work of the internal audit department. The removal
of internal audit means the removal of a control function and so is likely to increase
control risk. It might also reflect a poor attitude to controls by management and result
in an increase in both control risk and inherent risk.
(c) Conversion to the new software package: The auditor should consider the
possibility of errors being made in the conversion process. The auditor will need to
obtain an understanding of the internal controls in the new software package and make
a new assessment of control risk. The auditor will need to determine if the same or
similar information and reports will be available from the new ledger for use.
(d) Tax: The auditor needs to pay special attention to the provision for tax and related
accounts. The auditor should examine all documentation and might need to use an
expert to ensure the provision for tax is fairly stated.
(e) Accounts receivable confirmation letters: Additional work would need to be
performed regarding debtors' confirmations to determine whether the use of external
confirmations is necessary to obtain sufficient appropriate audit evidence in relation to
receivables or whether receivables can be verified by other procedures, such as
subsequent cash receipts. It would also be necessary to determine how, if at all, the
client's offer of assistance could be utilised.
5.17 Situation (i)
(a) Effect on audit planning

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  increase emphasis on construction WIP, particularly in relation to its
valuation and allocation
 increase emphasis on checking appropriateness of the going concern
assumption
 include the hotel project in discussions with management: do they intend to
continue with the project?
(b) Further information to be sought
 obtain the latest management plans with regard to the project: do they
intend to complete it? sell it? etc.
 obtain management’s policy for carry forward of construction WIP
 obtain copies of the latest estimates of patronage and profits.
Situation (ii)
(a) Effect on audit planning
 increase emphasis on checking compliance with the loan contract
 increase emphasis on checking appropriateness of the going concern
assumption
 increased emphasis should also be given to checking the account balances
on which the ratios are based
 include examination of alternate sources of finance in the audit scope.
(b) Further information to be sought
 obtain management action in relation to loan: determine the results of their
latest discussions with the bank
 review latest correspondence with the bank and discuss loan with the bank,
if necessary
 obtain forecasts/budgets etc. to determine likelihood of ratios
improving/deteriorating.
Situation (iii)
(a) Effect on audit planning
 increase emphasis on contingent liabilities
 solicitor’s representation letter will need to be obtained
 consider the appropriateness of the going concern basis.
(b) Further information to be sought
 obtain current situation in relation to case: determine whether it has been
settled or is still in progress. Obtain legal advice etc.

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  obtain the percentage of revenue lost and effects on going concern
assumption.
Situation (iv)
(a) Effect on audit planning
 increase emphasis on receivables, particularly the provision for doubtful
debts
 increase emphasis on checking appropriateness of the going concern
assumption.
(b) Further information to be sought
 obtain default rates and see if a general trend can be established
 obtain management plans for this ‘product’: determine whether it will be
discontinued or modified to suit another market
 obtain information as to whether the cancelled packages can be sold to
another party.
5.18 During the tour of a client’s premises, the auditor inspects inventory areas and makes a
note of the locations, types, security and general condition of the inventories. The
auditor visits the receiving and shipping departments and reviews the types of
documents maintained. Observations in these areas enable the auditor to form a
preliminary assessment of control risk for inventories and identify potential problems
with respect to obsolete or slow-moving inventories. The auditor can also begin
formulating plans for staffing and carrying out the physical inventory observation.
The auditor’s observation of the production processes helps to inform their
understanding of the client’s physical plant and layout, the nature of products and the
documentation for production orders, raw materials requisitioned to production, direct
and indirect labour, and inspection and testing of finished products.
The auditor meets the supervisors, engineers and other key personnel responsible for
production and, through inquiries and conversations, learns of any unique production
problems, including excessive spoilage and scrap. As a result, the auditor is able to
make a decision about whether a physical inventory of plant machinery and equipment
is necessary and is in a position to evaluate the client’s cost accounting system during
the course of the audit.
Any accounting records, such as perpetual inventories, job cost ledgers and
timekeeping records that are maintained in the plant area are inspected by the auditor.
In addition, the auditor ascertains whether budgets or standards are used in
production.
5.19 Industry specific factors include the following.
 Is the industry cyclical or seasonal? Cool Cate is in the summer-wear industry,
which is focused on the warmer months and is subject to seasonal sales.
 Is the industry competitive? The background facts suggest that the industry is
highly competitive, with low cost products available on the internet.

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  Is the industry a high-risk industry? Cool Cate’s summer-wear is expensive, high-
end fashion. A bad season could materially impact Cool Cate’s financial results.
 Is there evidence that companies in the industry are experiencing adverse
conditions? The background shows that several of Cool Cate’s competitors have
closed and the industry as a whole is struggling.
5.20 Business risks for Repairs include:
 non-compliance with terms and conditions of the licence rights could lead to the
loss of rights to use ‘Self-Diagnosis’
 if competitors acquire similar technology, Repairs may not generate sufficient
returns on the use of ‘Self-Diagnosis’
 the risk that Repairs may lose exclusive rights of ‘Self-Diagnosis’.
Each of these business risks may lead to an audit risk that the intangible asset may
become impaired and may be recorded above its recoverable amount.
5.21

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(a) Business risks
 Pressure from larger, aggressive
competitors.
 Reduction in gross margins/cost of
‘value-added’ services.
 Movement away from core business
to new products in an attempt to claw
back margins—this has had limited
success to date. May distract
management from core business.
 Apparent deterioration in terms of
trade with one of its major suppliers.
 Three leases are up for renewal prior
to the end of the financial year, with
steep rises in costs foreshadowed.
 Legal action commenced against a
much larger rival that is likely to be
expensive and the case difficult to
prove.
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(b) How they might lead to risk of
material misstatement
 Inventory valuation and allocation
is at risk, as aggressive
competition is likely to lead to
price discounting and so may lead
to selling prices being below cost
for some lines, resulting in a need
to write inventory down to net
realisable value.
 Going concern may be at risk due
to reduced margins, tighter terms
of trade and likely rent increases.
This may lead to a risk of material
misstatement of the carrying value
of items in the financial report.
 This may result in an increased
risk of understatement of lease
commitments in the financial
report.
 This leads to the risk of an
understatement of legal costs
associated with this action.
 Also need to consider whether
any contingent asset needs to be
disclosed in accordance with
AASB 137 (IAS 37).
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5. 22

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Business risks
Gemstones are small and of high
value and are subject to high risk of there is a high risk regarding the existence of
theft.
EJL has inventory in multiple
locations.
Sales are declining and EJL is
having difficulty meeting its debt
covenants.
Precious gems are imported from
overseas, exposing the company to
foreign exchange risks.
Valuation of gems is dependent on
their classification and subject to
market fluctuation in price.
(Valuation of gems was qualified in
last year’s auditor’s report.)
Previous year’s auditor’s report
was also qualified due to
disagreements with management
over the valuation of intangible
assets, indicating that there was a
business risk associated with
intangibles last year.
Increased risk profile of EJL’s
customer base and the downturn in
sales for the industry.
Publicly listed entity—need to
ensure EJL adheres to ASX Listing
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How business risk increases risk of material
misstatement
Gemstones have a high risk of theft and so
inventory.
As inventory is held in many locations there is a
risk that inventory may be either counted twice
or not counted at all.
Also, due to the multiple locations there is an
increased risk that various experts have been
used to value the inventory who may not have
used a consistent valuation methodology.
Management will have increased motivation to
ensure the financial (debt) covenants are met by
manipulating the financial report. (There is
evidence that some directors are pressuring
other directors to do this.)
Errors may be made on the exchange rates
used at the time of purchase. Hedging
strategies may be put in place that are complex
and need constant monitoring. There is a risk
that not all cost elements of the inventory are
included, such as freight, duties and brokerage.
If the appropriate valuation at reporting date
has not been applied, there is an increased risk
of misstatement of inventory due to valuation
errors. Given the subjectivity of the
classification of the gems, there is a risk that
the gems may be misclassified and therefore,
valued incorrectly.
A disagreement last year about the valuation of
intangibles increases the risk of misstatements
in intangibles this year, as the issue was not
resolved.
Risk of debtor write-offs (and bad debts
increasing), considering the downturn in sales
and relaxing of payment terms with stores.
Increased reporting and disclosure complexity
increases risk of errors in the financial report.
16
Rules and Accounting Standards.
5.23
(a) Business risk
As there are purchase
contracts with overseas-
based suppliers, there is
a risk that the foreign
currency rates applied
may be incorrect,
leading to loss of profits
and loss of cash
outflows.
As the inventory comes
from overseas, there is a
risk that if there are any
delays in meeting
shipment dates the
delays will be
significant, which may
impact MSL’s business
(e.g. unable to sell or
perform services, as no
parts are available). This
has an impact on the
financial report results
(cash, profits).
The quality of the
equipment and the spare
parts ordered may not
always be at the same
consistent level across
the suppliers. Any
defect in the inventory
may lead to customer
complaints, loss of
business, or
refunds/returns on sales.
This impacts the
financial results.
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(b) Audit risk (b) Account balance
The risk that the translated  Purchases/cost of
values posted to the general sales
ledger accounts are misstated
(asset, liabilities, and income  Inventory
statement accounts could be over  Accounts payable
or understated). This could be
material given the main  Foreign exchange
purchasing expenditure relates to gain/loss
the overseas suppliers.
The audit risk will be about the  Accounts
impact of potential delays on receivable or
year-end values, such as debtors allowance for
and inventory if there are doubtful debts
concerns from customers about
delayed or unfilled orders.  Inventory
Customers may not pay if they
cannot get maintenance, service
or replacements parts, or they
may go elsewhere for equipment
maintenance, which may affect
the resale of the equipment.
The audit risk is associated with  Accounts
the impact on the valuation of receivable or
various accounts that may be allowance for
overstated, such as customers doubtful debts
refusing to pay outstanding
invoices or no longer being  Inventory
prepared to pay the set sale price
for the equipment or spare parts,
due to quality issues impacting
the effective life, or other
factors.
17
5.24 Payroll controls
Payroll controls are not operating effectively. This increases control risk, as MAT will
be unable to rely on the payroll controls. Therefore, MAT will not perform any tests of
controls and will need to adopt a totally substantive approach to payroll.
Revenue recognition
Revenue recognition for CTL is complex and includes reliance on management’s
judgements for multi-element sales contracts to split sales contracts between revenue
and deferred revenue liability. Controls over revenue recognition are not automated
and would not provide sufficient assurance to reduce substantive testing significantly.
Controls will not be tested because the benefit from such testing would be minimal and
it would not be cost-effective to do so. As a result, a totally substantive approach will
be adopted.
5.25 (a) The impact on the audit strategy would include:
 the new computer system provides additional information that increases the
opportunity to use analytical procedures as part of substantive testing, given that
gross margins and inventory items by product type and geographical area are now
available.
(b) The impact on the audit strategy would include:
 less reliance can be placed on the internal control system, therefore greater
substantive testing is required
 because of the weaker internal control system, less reliance can be placed on
analytical procedures, as the data being used in the analytical procedures may be
unreliable
 follow up the explanation for the changes (difficulty in maintaining past sales
levels) and evaluate the implications for other audit areas (for example, future
viability, inventory valuation)
 greater attention should be paid to the provision for doubtful debts due to credit
ratings not being checked
 because of the discounts, gross margins will vary more and less use can be made of
analytical procedures as part of the substantive testing of sales.
(c) The impact on the audit strategy would be to perform work on the fixed assets
register so that it can be relied upon. Additional work to be performed regarding new
fixed assets register would include:
 check the assets were correctly transferred to the new system; that is that assets are
complete and only the assets in existence have been recorded in the new register
 update systems notes on fixed assets to reflect the introduction of the new register
 consider whether depreciation calculation complies with AASB 116 (IAS 16)

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  obtain a list of reports produced by the new system and determine their use for
audit purposes — the more detailed reports might give greater scope for use of
analytical procedures during the audit.
5.26 (a) The auditor should not follow the client’s suggestions of how to conduct an audit,
unless the suggestions clearly do not conflict with the auditor’s own professional
judgment and independence. The auditor must decide on the scope and conduct of
their work, including the staff required to carry out the work.
(b) The reasons against dividing the assignment of audit work solely according to
assets, liabilities, and income and expenses include the following.
 Work should be assigned to staff members by considering the degree of difficulty in
relation to the technical competence and experience of individual staff members.
 The sequence of work performed should be in accordance with the audit plan.
 It is impossible to segregate audit work areas completely by financial report
captions, because often a close relationship exists among a number of accounts in
more than one category, such as when revenues are based on assets or expenses are
based on liabilities.
 Often the scope of work for a single account requires simultaneous participation by
several staff, such as for the observation of inventories.
5.27 In the planning of the audit, there will be a greater focus on accounts receivable and
inventory due to the following.
 Accounts receivable—the higher than expected days outstanding indicates possible
bad or doubtful debts that may not be adequately provided for, resulting in the risk
of overstatement of accounts receivable.
 Inventory turnover—the discrepancy between the actual inventory turnover figure
and all the comparatives indicates that the auditor should investigate inventory
further. The increase in the inventory turnover may indicate to the auditor that the
inventory is being run down, with a risk of stock outs or that, due to heavy
discounting to sell the stock, inventory is valued above the lower of cost and net
realisable value.
There is also a risk that accounts receivable are overstated because of an increase in
sales. The risk is that sales are fictitious or revenue is inappropriately recognised,
contributing to the increase in days in receivables discussed above. The auditor would
look at the income statement, compare sales to budget and investigate large
fluctuations.
The current ratio is in line with budget, past experience, industry average and the
general rule of thumb benchmark of 2. The increase in accounts receivable and the
decrease in inventories seem to cancel each other out. Therefore, based only on the
preliminary analytical procedures, the auditors would not focus greater attention on
current assets or liabilities.

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 Similarly, the drop in the debt to equity ratio is probably not significant enough to
warrant special attention and its actual level of 0.36 does not indicate a high
dependence on debt.
5.28 Quick asset ratio
This ratio has decreased significantly and is well below the usual benchmark of 1. This
is an indicator of short-term liquidity concerns for the company. This is of particular
concern given it appears that accounts receivable have gone up over this period
(inferred from the ‘days in receivables’ ratio). It would be useful to review the
company’s cash flows to gain more information about its short-term liquidity.
Days in receivables
This ratio has increased significantly over the three years. It may indicate greater
leniency in credit terms to try and generate sales. This may have a subsequent effect on
the collectability of accounts receivable.
Debt/equity ratio
This ratio has increased over the three years, indicating the company’s higher reliance
on debt compared to equity. Given that much of the investment in productive assets
occurred in the company’s earlier years, it would be worth evaluating what the recent
borrowings have been used to finance.
Gross profit ratio
This has decreased substantially over the last three years. This indicates that the
company may be using greater discounting to generate sales.
Net profit ratio
This is very poor and getting worse. Losses three years in a row indicates that the
company may have difficulty surviving and so going concern is an audit issue, even
although CEO has told you that he has raised sufficient finance to enable the
finalisation and launch of the new computer game within four months.
5.29 The results of the ratio analysis undertaken as part of your analytical procedures may
include the following ratios:
Ratios 2013 2014 2015
Current ratio 2.7 2.2 1.8
Quick asset ratio 1.3 1.2 0.9
Receivables turnover ratio * 8.4 5.75
Days in receivables * 43.2 days 63.5 days
Inventory turnover ratio * 4 3.1
Return on total assets 0.44 0.43 0.31
Return on shareholders’ equity 1.6 2 2.5
Debt/Equity 2 2.4 4
Gross profit ratio 0.47 0.47 0.43
Net profit ratio 0.27 0.26 0.22

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 * Turnover ratios have not been calculated for 2013, as opening balances are not
available to calculate average receivables or average inventory.
An analysis of these ratios indicates the following:
 The current ratio and quick asset ratio have decreased significantly and are below
the usual benchmarks of 2 for current ratio and 1 for quick asset ratio. This
indicates liquidity problems that may lead to going concern problems as Meteor
currently has insufficient liquid assets to meet its current liabilities. In addition,
these ratios may actually be worse based on the possible overstatement of
receivables and inventory discussed below.
 The inventory turnover ratio is at a relatively low level and has deteriorated, while
sales have increased over the three years. The auditor needs to investigate the
reasons for this situation, which may indicate the possibility of obsolete or slow-
moving inventory. Given that sales and inventory levels have increased and gross
profit ratio has decreased, there is also a possibility that some of the obsolete or
slow-moving inventory was cleared at discounted prices.
 The receivables turnover ratio has decreased significantly indicating possible
collection problems, resulting in bad or doubtful debts. Correspondingly, the days
in receivable, which has increased over the two-year-period from 43.2 days to 63.5
days, needs to be compared to the company’s terms of trade and the cause of the
deterioration in the receivables turnover investigated.
 The debt/equity ratio has increased significantly and is now at a dangerously high
level, indicating the company’s very high reliance on debt compared to equity. The
cause for increased dependence on debt and the company’s ability to repay the debt
needs to be investigated, as it may give rise to going concern problems.
 All profitability ratios, except the return on equity, have deteriorated over the three
years. The increase in return on equity is due to the company’s higher reliance on
debt compared to equity, as is evident from increased debt/equity ratio.

CONTINUOUS CASE STUDY

5.30
Matters to include in
engagement letter
Arrangements concerning the
involvement of internal auditors
(ASA 210.A24/ISA 210.A24).
Arrangements to be made with
predecessor auditor (ASA
210.A24/ISA 210.A24).
Background reference
RPL has established an internal audit department
whose organisational status, scope of function,
technical competence and due professional care
will require assessment to determine the extent to
which its work can be relied upon.
You will need to communicate with Jones &
Associates to ascertain whether there is any
professional reason why you should not accept the
appointment as auditors of RPL.

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5.31
Ratios 2013 2014 2015
Current ratio 1.42 1.47 1.50
Quick asset ratio 0.83 0.94 0.85
Receivables turnover ratio * 10.79** 9.12**
Days in receivables * 33.83 days** 40.02 days**
Inventory turnover ratio * 12.26 10.56
Return on total assets 0.267 0.211 0.148
Return on shareholders’ equity 0.258 0.212 0.179
Times interest earned 40.94 times 40.13 times 4.79 times
Debt/Equity 0.10 0.08 0.68
Gross profit ratio 0.176 0.161 0.152
Net profit ratio 0.069 0.061 0.050

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 .* Turnover ratios have not been calculated for 2013, as opening balances are not
available to calculate average receivables or average inventory. Gross figures have
been used for receivables and inventory, i.e. figures before deduction of allowance for
doubtful debts and allowance for obsolescence respectively.

** Credit sales used in the calculations include revenue from operations and storage
fees. Commission revenue is collected on a cash basis and therefore is not included.

An analysis of these ratios and the financial report indicates that:

 The inventory turnover ratio has deteriorated from 12.26 to 10.56. This indicates
the possibility of obsolete or slow-moving inventory. Further, while inventory has
increased significantly in 2015 by $1 383 262 or 49%, the allowance for
obsolescence of $125 876 has been written back as no longer being required.
Therefore, extra audit attention will need to be given to the valuation and
allocation of inventory, particularly as the accounting method has also changed
during the year from average cost to FIFO.

 The receivables turnover ratio has decreased significantly with days in receivables
going out from 33.83 days to 40.02 days, indicating possible collection problems,
resulting in possible bad or doubtful debts. Further, while accounts receivable has
increased significantly in 2015 by $783 309 or 17%, the allowance for doubtful
debts has increased by only $30 000. Therefore, extra audit attention will need to
be given to the valuation and allocation of accounts receivable.

 The gross profit ratio has decreased indicating a possibility that some inventory is
obsolete or slow-moving and can only be sold at discounted prices, supporting the
conclusion drawn from the inventory turnover ratio.

 The reduction in the net profit ratio is in line with the drop in the gross profit ratio
and so does not indicate any unexpected movements in operating expenses. The
significant drop in the return on total assets and the return on equity is due to the
significant increase in property, plant and equipment of $7 177 312 or 85.5% partly
financed by an increase in equity of $1 466 841 or 13.6%, but a slight decrease in
net profit after tax of $103 171. Audit attention will need to be given to verifying
the significant amount of fixed asset additions and also investigating why this
investment in property plant and equipment has not generated additional profit.
 The debt/equity ratio has increased significantly to finance the investment in
property plant and equipment, but is still at a relatively low level, being less than 1
and meets the loan covenant requirements. The times interest earned has dropped
due to the significant increase in interest expense of $724 375 related to the
increase in long-term debt of $7 500 000. Audit attention will need to be directed
at confirming the long-term debt and interest charge. However, there is no
indication of any problems relating to debt dependence.

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  The current ratio has improved slightly, but this is due to the build-up in inventory
discussed above. It is slightly below the usual benchmark of 2, but also only just
meets the loan covenant requirement of 1.5. Therefore, additional audit attention
will need to be given to potential manipulation of the current ratio to meet the loan
covenant, particularly based on the possible overstatement of receivables and
inventory discussed above and the change in accounting method for inventory from
average cost to FIFO, which is likely to have contributed to part of the increase in
the value of inventory.
 The quick asset ratio has decreased slightly and is slightly below the usual
benchmark of 1 for the quick asset ratio. Therefore, it needs to be monitored as
any further decline could indicate problems with paying creditors and hence
potential going-concern problems. In addition, the ratio may actually be worse
given the possible overstatement of receivables discussed above. Therefore, audit
attention should be given to cash flows.
 Deferred revenue of $697 500 has been recognised for the first time. This is due to
a change in accounting method and so will require additional audit attention.
 Intangible assets of $975 000 have been recognised for the first time and will
require audit attention to ensure that they meet the recognition requirements of the
accounting standards. An article published in a medical journal could cause the
medical textbooks that RPL acquired the rights to during the year to become
obsolete. As a result, the valuation of the copyright attached to the medical
textbooks is at risk of being impaired.

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