lOMoARcPSD|5391171

Exam 7 June 2017, answers

Auditing And Assurance Services (University of Melbourne)

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Auditing - Past Exam Question & Solutions

QUESTION 1

You are a manager in the audit firm of Ali & Co; and this is your first time you have worked on one
of the firm’s established clients, Stark Co. The main activity of Stark Co is providing investment
advice to individuals regarding saving for retirement, purchase of shares and securities and investing
in tax efficient savings schemes. Stark is regulated by the relevant financial services authority. You
have been asked to start the audit planning for Stark Co, by Mr Son, a partner in Ali & Co. Mr Son
has been the engagement partner for Stark Co, for the previous nine years and so has excellent
knowledge of the client. Mr Son has informed you that he would like his daughter Zoe to be part of
the audit team this year; Zoe is currently studying for her first set of fundamentals papers for her
ACCA qualification. Mr Son also informs you that Mr Far, the audit senior, received investment
advice from Stark Co during the year and intends to do the same next year. In an initial meeting with
the finance director of Stark Co, you learn that the audit team will not be entertained on Stark Co’s
yacht this year as this could appear to be an attempt to influence the opinion of the audit. Instead, he
has arranged a balloon flight costing less than one-tenth of the expense of using the yacht and hopes
this will be acceptable. The director also states that the fee for taxation services this year should be
based on a percentage of tax saved and trusts that your firm will accept a fixed fee for representing
Stark Co in a dispute regarding the amount of sales tax payable to the taxation authorities.

Required:

1) Explain the ethical threats which may affect the auditor of Stark Co.

2) For each ethical threat, discuss how the effect of the threat can be mitigated (in other words,
identify the possible safeguards for the threats identified.

Answer:

Ethical threat Mitigation of threat

Mr Son, the engagement partner has been
involved with the client for the last nine years.
This means he may be too familiar with the client
to be able to make objective decisions due to this
long association.
There is no ethical rule which stops Mr Son
recommending Zoe for the audit, or letting Zoe
take part in the audit.
However, there may be the impression of lack of
independence as Zoe is related to the engagement
partner.
Zoe could be tempted not to identify errors in case
this prejudiced her father’s relationship with the
client.
As long as Mr Far paid a full fee to Stark Co for
the investment advice, then there is no ethical
Mr Son should be rotated from being engagement
partner.
He can still contact the client but should not be in
the position of signing the audit report.
To show complete independence, Zoe should not be
part of the audit team. However, if Mr Son is no
longer the engagement partner then this removes the
ethical threat and Zoe could be included in the audit
team.
To show independence from the client, Mr Far
could be asked not to use the services of Stark Co

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threat. This would be a normal commercial again unless this is first agreed with the engagement
transaction and Mr Far would not gain any partner.
benefit.
However, continued use of client services could
imply a lack of independence especially if Mr Far
is not paying a full fee and therefore receiving a
benefit from the client.
The audit team have been offered a balloon flight The balloon flight should not be accepted.
at the end of the audit. Investigation would also be needed to find out why
Acceptance of gifts from a client, unless of an hospitality was accepted in previous years.
insignificant amount, is not allowed. The fact that
the flight costs less than the yacht expense is
irrelevant, independence could still be impaired.
Agreeing to accept taxation work on the The audit firm must confirm that assistance with
percentage of the tax saved is essentially taxation work is acceptable, although the fee must
accepting a contingent fee. be based on time and experience for the job, not the
There will be pressure to gain the highest tax contingent fee.
refund for the client and this could tempt the audit
firm to suggest illegal tax avoidance schemes.
Representing Stark Co in court could be seen as To remain independent, the audit firm should
an advocacy threat – that is the audit firm is decline to represent the client in court.
promoting the position of the client.
Objectivity could be compromised because the
audit firm is seen to take the position that the
client is correct, affecting judgment on the tax
issue.

QUESTION 2
You are the auditor of Oak Pty Ltd, which is involved in the manufacture of quality wooden
furniture. One of the directors of Oak Pty Ltd has requested that you perform a review of the internal
controls within the purchases and payment cycle of the company’s operations. From your discussions
with management and staff you ascertain that the company is a small operation and only has the
following staff:
 Warehouse manager
 Assistant to the warehouse manager
 Four machinery operators who are involved in the manufacturing process
 Accounts payable clerk
 Banking clerk
 Secretary/receptionist
 Four directors (one of whom is responsible for the day to day operations of the company -
the ‘executive director’)

All operations are contained at one location

The warehouse manager is able to order from any supplier and will usually telephone a number of
suppliers to obtain quotes. The warehouse manager will then order from one of these suppliers by

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telephone and confirm the order by facsimile. The only documentation kept is the facsimile
confirmation of order, which is kept by the warehouse manager.
Once the order is confirmed, the warehouse manager will complete a purchase order (‘PO’). The
warehouse manager keeps one copy of the PO and signs the delivery note as evidence of this check.
The delivery note comprises two copies, one of which is retained by the persons delivering the goods
and the other by the warehouse manager.
The warehouse manager forwards a copy of the signed delivery note to the accounts payable clerk
who posts a journal entry to the creditors’ ledger for the amount shown on the delivery note. The
clerk then stamps the delivery note ‘entered and files the delivery notes by supplier.
Required
a) Identify the strengths and weaknesses in Oak Pty Ltd’s internal control for the purchasing
area
b) What impact will your assessment of internal controls affects the risk to the
accounts/assertions on the financial statements?

Answer:

Strengths Weaknesses Accounts/assertions affected

The warehouse manager The control helps ensure that

telephones a number of purchases are made at
suppliers to obtain quotes. appropriate prices, so inventory
is properly valued. (reduce the
risk of incorrect valuation and
allocation of inventory and
accounts payable)

Although the warehouse Valuation of inventory may be

manager calls many suppliers to
select supplier for purchase,
“he can order from any
supplier”. Furthermore, the
warehouse manager does not
leave any evidence of how he
selected the supplier (the only
documentation kept is the
facsimile confirmation of
order). Therefore, there is no
evidence of supplier selection
process to assess whether it is
properly done.
at risk. If the warehouse
manager purchase inventory at
higher than market price
(possibly for some personal
benefit), then purchased value
of inventory becomes lower
than market value. If this
happens, according to
accounting standards, inventory
needs to be written down to
market value.

There is no separation of duties There is a high risk that

between the purchasing
(operational) and warehousing
(custody of assets) function.
The warehouse manager
performs both tasks. This poses
inventory purchased has low
quality due to the fact that there
is no separate function to check
on the quality of inventory
purchased. This potentially

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the risk that goods are not affects the valuation of

purchased at good quality. inventory (inventory may be
overstated due to being
overvalued).

The warehouse manager also This increases the risk to both

performs the task of receiving quantity and quality of
the goods delivered to the inventory purchased. This leads
company after purchase. This to the risk of non-existing
reveals that there is no inventory and also over-
separation of duties between valuation of inventory.
good receipts function and
warehouse/purchase function.
This weakness leads to a high
risk for both quality and
quantity of inventory
purchased. There is no one
checking whether the goods
purchased are at good quality
and delivered at the quantity
stated in the supporting
documents.

Separation between warehouse/ This control helps prevents

purchase function and manipulation of accounting
accounting function (supporting records. This reduces the risk
documents for the purchases are that accounts payable are
forwarded to the accounting recorded for goods not
payable clerk for recording). purchased. (existence of
accounts payable and
occurrence of cash payments).

The delivery note is prepared
by the warehouse manager.
There is no evidence that the
supplier has signed the delivery
note. This delivery note is not a
reliable supporting document as
an evidence for a purchase.
This increases the risk that the
delivery note does not reflect
the true amount of good
delivered, thus the risk of non-
existing inventory.

QUESTION 3

Assume your risk assessment procedures in relation to CocoNott Ltd’s business processes indicate
there is a risk that payments to suppliers are made prior to goods being received.
As part of your examination of the information system and related control activities, you note the
following process is in place in relation to payments:
 A prenumbered cheque requisition is prepared by accounting staff for all payments
 Accounting staff then perform the following procedures:
o Match the details on the supplier’s invoice to the appropriate receiving report; and

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o Match the details on the supplier’s invoice and receiving report to an authorised
purchase order
 The cheque requisition, together with the above supporting documents, is then forwarded to
the appropriate senior staff member for review and authorisation.
Assume that you intend to rely on controls over the payments function.

Required
1) Identify the internal control that address the risk of payments being made to suppliers before
the goods are delivered.
2) What assertions does this internal control address?
3) How might you test this control?

1) Controls 2) Assertion 3) Test of control

i. Match the details of Existence/accuracy accounts Test the evidence of matching
the supplier’s payable and inventory the invoice to receiving report
invoice to the (e.g initial/signature).
appropriate
receiving report.
This procedure helps make
sure that the purchase was
actually incurred (evidenced
by the fact that goods have
been received) before
payment is made. An
invoice from supplier alone
is not a complete evidence
that goods have been
received (thus is due for
payment).
ii. the cheque Same as above
requisition, together
with the supporting
documents, is
forwarded to the
senior staff member
for review and
authorization.
This is another step to
make sure there is proper
authorization on the
transactions. Although the
matching of supporting
documents has been done
(by a staff member), the
review and authorization
will make sure the matching
step is done properly by the
staff (being known that his/

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her work is being

reviewed).

QUESTION 4

Consider each of the following material independent situations:

You are auditing the sales and trade debtors of Eastern Block Limited (EB). All of EB’s customers
are in Eastern Europe. Due to language differences, and the current political situation in many
countries, direct confirmation of debtors’ balances is unlikely to give satisfactory results.

You are auditing the purchases and trade creditors at FE Pty Limited (FE). One of the FE’s major
creditors is very slow in sending invoices for the goods delivered. Also, owing to a quality control
problem a large number of goods supplied to FE have been deemed faulty and have had to be
returned with a request for credit.

Required:

a) Identify key assertion(s) at risk in relation to the balances described in each of the situations
above
b) Describe the audit procedures you would perform in order to gather sufficient, appropriate
audit evidence on each of these assertions.

Answer:

Audit assertions at risk

There is an increased risk of existence of accounts receivable, due to the fact that direct
confirmations cannot be obtained.

This increases the risk to completeness of accounts payable and inventory. Due to the problem in
quality of purchases, inventory quality may be in question as well, giving rise to the risk of valuation
of inventory and accounts payable.

Audit procedures:

To gain sufficient and appropriate audit procedures, the auditor need to design the procedures based
on the assessed level of risks and the assertions at risk.

The auditor should focus on testing existence (also accuracy and valuation) of accounts receivable.
As confirmation cannot be obtained, the auditor needs to find an alternative approach. The best
alternative approach is to examine the subsequent receipts related to Accounts receivable. Another
alternative approach is to examine the supporting documents of the accounts receivable items that
have not been paid by the customers (e.g sales invoices, receipts etc.) Verifying supporting
documents may help auditors verify the existence of A/R, but the auditor need to critically assess
whether the political conditions may affect some customers and their ability to pay (valuation of
accounts receivable). Therefore, to gain sufficient and appropriate audit evidence, the auditor may
need to go beyond checking supporting documents to gather evidence that helps assess the existence

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of customers and their ability to pay. Due to the increased risk, the auditor may also need to increase
the sample size for testing.

The auditor should place more focus (i.e more extensive work) on:

i) Verifying completeness of accounts payable, by:

o Send confirmations to the client’s suppliers confirming the amount of purchases
(including those suppliers with zero balances)
o Subsequent payment tests: examine supporting documents for the payments made
after year end to make sure all accounts payable belonging to the current
accounting periods have been recorded
o Examine supporting documents of invoices not yet paid after year end to verify
that they are recorded in the correct period (i.e any invoices related to purchases in
the current period have been recorded)

ii) Testing for the existence of accounts payable and inventory by inquiring client on the
items that are subject to being returned and examine supporting documents as well as
obtaining confirmation from suppliers on the probability of returns being granted. If not,
revaluation of inventory and accounts payable value need to be done.

(note: evidence is considered appropriate when they are appropriately designed to address the some
particular relevant assertions. The auditor is considered to have obtained sufficient audit evidence
when they have sufficient work (and no further evidence is necessary) to help them confidently
conclude on the accounts/assertions)

QUESTION 5

In the audit of Bright Chemicahs Ltd, a large public company, you have been assigned responsibility
for obtaining background information for the audit. Your firm is auditing the client for the first time
as a result of a dispute between Bright and the previous auditor over valuation of work-in-progress
inventory.

Bright Chemicals has been highly successful in the past two decades, primarily because of successful
mergers negotiated by Bert Randolph, the managing director and chairman of the board. Even though
the industry as a whole has suffered dramatic setbacks in recent years, Bright has been able to secure
strong earnings and growth until the last financial year when results began to show a downturn.
Randolph has hired an aggressive group of young executives by combining modest salaries with an
unusually generous profit-sharing plan.

A major difficulty you face in the new audit is that the computer software system installed five years
ago now has serious problems in handling and processing the increased volume of data. Randolph
believes that profits come primarily from intelligent and aggressive action based on forecasts, not
relying on historical data. Most of the forecast data are generated by the sales and production
department seem competent but are somewhat overworked and underpaid relative to other
employees. A recent change that will potentially improve record keeping is the progressive
installation of sophisticated new computer equipment. Not all the accounting records have been
changed to the new system as yet, but perpetual inventory and sales/accounts receivable modules
have been converted. Because of the serious problems with the old computer system software, the

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old and new inventory/sales systems were not run in parallel before implementing the new system
and discarding the old one. Most the computer time is being reserved for production and marketing,
as Randolph considers that these areas are more essential to operations than ‘bookkeeping’.

The first six months’ financial statements for the current year include a profit that is only about 10%
less than the first six months of the preceding year, which is somewhat surprising considering the
reduced sales volume and the disposal of a segment of the business. Mercury Supplies Pty Ltd. The
disposal of this segment was considered necessary because it had become increasingly unprofitable
over the previous four years. At the time of its acquisition from Roger Randolph, who is a brother to
Bert Randolph, the company was highly profitable and was considered a highly desirable purchase.
The main customer of Mercury Supplies was Saturn Holding Ltd, a company owned by Roger
Randolph. Gradually, the market for Mercury products declined as Saturn Holdings Ltd began
diversifying and phasing out its primary products in favour of more profitable business. Saturn
Holdings is no longer buying from Mercury, so Bright had no option but to sell Mercury.

According to financial analysts, the main difficulties facing Bright are severe under-financing and a
pending legal case arising from employee health problems at one of the chemical production plants.
Cash flow is also tight because of an excessive amount of current and long-term debt because of the
depressed capital markets. Management is reluctant to obtain equity capital at this point because the
increased number of shares would decrease the earnings per share by more than 10%. At present,
Randolph is negotiating with several cash-rich companies in the hope of being able to merge with
them as a means of overcoming the capital problems and restoring liquidity.

REQUIRED

1) List the main concerns (representing inherent risks) you should have in the audit of Bright
Chemicals and explain why they are potential problems.
2) Identify the accounts that may have been affected by the above risks and explain how such
accounts may be affected.

MAJOR CONCERNS REASONS FOR CONCERN ACCOUNTS AFFECTED

1. First-year audit.
2.Relationship with previous
auditors was severed over
accounting disputes.
3.The company has prospered even
though its industry as a whole has
suffered dramatic setbacks in
recent years.
Unfamiliarity with the All accounts
company, its operations, and
its previous history.
Attempt by management to The inventory account may
improperly value inventory be over-valued (valuation
(i.e., as they had done in the and allocation assertion)
previous year).
Normally companies follow Sales (potential
the trends of their industry. overstatement) and expense
The company's prosperity accounts (potential
could indicate misrepresented understatement)
financial statements or a
downturn several years after
the industry's experience.

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4.Executives receive relatively low Aggressive executives reliant Sales/expenses

salaries with a high proportion of
income resulting from an unusually
generous profit-sharing plan.
5.The personnel in the accounting
department are being overworked
and underpaid relative to other
employees.
6.The company recently installed a
sophisticated computer system.
7. The new computer system was not
run in parallel before implementing
the new system and discarding the
old one.
8.The first six months' profit
decreased by only 10% from the
previous year even though the
volume was reduced significantly
and a segment of the business was
disposed of.
on profit sharing for higher
incomes have an unusually
high motivation to create large
profits for the company; in
fact, their existence depends on
it.
These employees may not be All accounts are subjected
motivated to achieve accurate to high risks processing
recording of transactions or to errors.
assure that the proper internal
controls are enforced.
Part of the audit trail may have All accounts: Errors in
disappeared with the use of the recording/processing the
computer, and control over the accounts
entry of transactions may no
longer rest with the accounting
department.
Systems that are not properly All accounts
tested may result in system
errors or unforeseen
programming problems.
Unreliable accounting systems
is an inherent risk.
The reduction in volume and Sales/expenses accounts
disposal of the segment
Sales being overstated and
normally would have produced
or expenses being
a more dramatic drop in
understated.
profits.

QUESTION 6

Shiny Happy Windows Co (SHW) is a window cleaning company. Customers’ windows are cleaned
monthly, the window cleaner then posts a stamped addressed envelope for payment through the
customer’s front door.
SHW has a large number of receivable balances and these customers pay by cheque or cash, which is
received in the stamped addressed envelopes in the post. The following procedures are applied to the
cash received cycle:
1. A junior clerk from the accounts department opens the post and if any cheques or cash have been
sent, she records the receipts in the cash received log and then places all the monies into the locked
small cash box.
2. The contents of the cash box are counted each day and every few days these sums are banked by
which ever member of the finance team is available.
3. The cashier records the details of the cash received log into the cash receipts day book and also
updates the sales ledger.

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4. Usually on a monthly basis the cashier performs a bank reconciliation, which he then files, if he
misses a month then he catches this up in the following month’s reconciliation.

REQUIRED:

For the cash cycle of SHW:

(i) Identify and explain THREE deficiencies in the system;

(ii) Suggest controls to address each of these deficiencies; and list tests of controls the auditor of
SHW would perform to assess if the controls are operating effectively.

deficiency control test of control

a junior clerk opens the post
unsupervised. this could result
in cash being misappropriated.
cash and cheques are secured
in a small locked box and only
banked every few days. a small
locked box is not adequate for
security of considerable cash
receipts, as it can easily be
stolen.
cash and cheques are only
banked every few days and any
member of the finance team
performs this.
a second member of the accounts
team or staff independent of the
accounts team should assist with
the mail, one should open the post
and the second should record cash
received in the cash log.
cash and cheques should be
ideally banked daily, if not then it
should be stored in a fire proof
safe, and access to this safe
should be restricted to
supervised individuals.
cash and cheques should be
banked every day.
observe the mail opening
process, to assess if the
control is operating
effectively.
Enquire of management
where the cash receipts not
banked are stored.
Inspect the location to
ensure cash is suitably
secure.
inspect the paying-in-books
to see if cash and cheques
have been banked daily or
less frequently.

review bank statements

cash should ideally not be held
over-night as it is not secure.
also if any member of the team
banks cash, then this could
result in very junior clerks
having access to significant
amounts of money.
the cashier should prepare the
paying-in-book from the cash
received log. then a separate
responsible individual should
have responsibility for banking
this cash.
against the cash received
log to confirm all amounts
were banked promptly.
enquire of staff as to who
performs the banking
process and confirm this
person is suitably
responsible.

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the cashier updates both the the cashier should update the cash observe the process for
cash book and the sales ledger. book from the cash received log. recording cash received into
this is weak segregation of a member of the sales ledger the relevant ledgers
duties, as the cashier could team should update the sales and note if the segregation
incorrectly enter a receipt and ledger. of duties is occurring.
this would impact both the
cash book and the sales ledger.
in addition weak segregation
of duties could increase the
risk of a ‘teeming and lading’
fraud.
Bank reconciliations are not bank reconciliations should be review the file of
performed every month and performed monthly. a responsible reconciliations for evidence
they do not appear to be individual should then review of regular performance and
reviewed by a senior member them. review by senior finance
of the finance department. team members.
errors in the cash cycle may
not be promptly identified if
reconciliations are performed
infrequently.

QUESTION 7

The following are common audit procedures for tests of sales and cash receipts.

i. Compare the quantity and description of items on duplicate sales invoices with related
shipping documents.
ii. Trace recorded cash receipts in the accounts receivable master file to the cash receipts
journal and compare the customer name, date and amount of each one.
iii. Examine duplicate sales invoices for an indication that unit selling prices were compared
with the approved price list.
iv. Examine duplicate sales invoices to determine whether the account classification for sales
has been included on the document.
v. Examine the sales journal for related-party transactions, notes receivable and other unusual
items.

REQUIRED:

For each audit procedure:

(a) Identify whether each audit procedure is a test of control or substantive test of transactions.

(b) State which transaction-related audit objective(s) each of the audit procedures fulfils.

(c) For each test of control in (a), state a substantive test that could be used to determine whether
there was a monetary misstatement.

SOLUTION

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QUESTION 8

The following situations are independent and material:

Situation 1
An auditor hires an actuary to assist in corroborating a client’s complex superannuation calculations
concerning accrued superannuation liabilities that account for 35% of the client’s total liabilities. The
actuary’s findings are reasonably close to the client’s calculations and support the financial report.

Situation 2
A client holds a note receivable consisting of principal and accrued interest receivable. The note’s
issuer recently filed for voluntary bankruptcy, but the client failed to reduce the recorded value of the
note to its net realisable value, which is approximately 20% of the recorded amount.

Situation 3
A client (wine producer) has capitalised significant costs incurred in developing an improved new
wine cap that allows the wine to continue to develop in the bottle. On 20 July, the client applied for
a patent for the cap, only to discover that a competitor had lodged a similar application on 15 June.
The granting of the client’s patent application is now in serious doubt. Management do not believe
any change to the financial report is required.

Situation 4
A note to the financial report of your client (footwear manufacturer) refers to an agreement to sell its
major subsidiary, Cleanskins Pty Ltd, to a rival wine company. This agreement was finalised the day
before the financial report was to be signed and the sale is to take place a month after the audit
report is to be signed. You have verified this transaction. However, when reviewing the ‘Chairman's
Review’, which is to be included in the annual report that contains the audited financial report, you
see that:
(a) plans for expanding Cleanskins Pty Ltd's facilities are outlined;
(b) the additional revenue to be generated over the next ten years as a result of this expansion
is tabulated; and
(c) there is no reference to the sale of Cleanskins Pty Ltd.
Management believe that it is too late to make any changes to the annual report, as it is ready to
send to the printers, as soon as the audit report is signed.

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REQUIRED:

For each of the above situations, state the type of audit opinion you would issue, as well as the
reasons for issuing the particular audit opinion.

SOLUTION

Situation 1
An unqualified opinion would be issued as the auditor has the right to rely on the work of an
expert in such a situation and therefore, has gathered sufficient and appropriate audit evidence
to support the financial report.

Situation 2
An qualified opinion would be issued because of a disagreement with management about the
valuation of the note receivable. The amount involved is material but not extreme, therefore a
“qualified” rather than an adverse opinion would be issued.

Situation 3
This is a Type 1 or adjusting event as the problems associated with the carrying value of the
capitalised development costs relating to development of the patent arose prior to balance date,
when the competitor lodged their patent application. The development costs should be
expensed (adjusted to reflect their reduced value). If no adjustment is made, there is a
disagreement with those charged with governance that is material, but not extreme. Therefore,
a qualified audit opinion would be required.

Situation 4
The agreement to sell the major subsidiary is a Type 2 subsequent event, as it is a new event
arising after reporting date that is likely to have a material effect on the decision-making of
users of the financial report, and therefore should be disclosed in the financial report.
Therefore, the financial report information is correct. However, there is an inconsistency
between financial report information and other information accompanying the financial report.
The other information accompanying the financial report is incorrect. Therefore, an
unqualified opinion with an emphasis of matter paragraph would be required.

QUESTION 9

The following information has been gathered during the course of the audit of RW Ltd for the year
ended 30 June 2016.

 For the year 2016, RW Ltd recorded a 7% decline in sales revenues compared to the
previous year and a decline of gross profit from 20% to 15%. The 2016 draft financial
statements record an operating loss of $30 million and the board expects a similar loss in the
2017 financial year.

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 Gross profit margins continue to be under pressure due to the intense competition from two
new competitors. This is compounded by a reduction in consumer spending due to a slow-
down in the economy. It is anticipated that gross profit margin will continue to decline over
the next 2 years.
 RW Ltd has difficulty paying its short term debts. In addition, suppliers that account for over
40% of the annual purchases have reduced RW’s credit terms from 60 days to 30 days.
 The shareholders of RW Ltd have indicated that they are willing to take up $30 million in
additional ordinary shares.
 RW is negotiating with the suppliers of over 40% of the supplies, to bulk purchase goods in
return for extending the credit term from 30 days to 90 days. The initial responses from the
suppliers are positive.
 RW Ltd is hoping to negotiate a huge $30 million contract with a vendor in 6 months.
 RW Ltd’s rent is due for a 15% increase. RW Ltd is negotiating with the landlord to freeze
the rent at its present rate for the next 3 years. Initial indications are that the landlord will not
agree to the request.

REQUIRED:

a) Describe four (4) factors that indicate RW Ltd is having a going concern problem.
b) Describe four (4) factors that mitigate RW Ltd’s going concern problem

SOLUTIONS

Factors indicating RW has a going concern problem

1. Sales revenue has been declining since last year. The 2016 draft financial report disclosed
an operating loss of $30 million and the board expects the company to record a similar
operating loss of $30 million in the 2017 financial year. Accordingly, RW Ltd is currently not
profitable.
2. Gross profit margins continue to be under pressure given the intense competition in the
market and the reduction in consumer spending. It is anticipated that the gross profit margin
will continue to decline in the next two years. The reduction in margins will put further
pressure on the overall financial performance of the RW Ltd.
3. Suppliers representing over 40% of RW Ltd’s annual purchases have reduced RW Ltd’s
credit terms from 60 days to 30 days. This will add further pressure to the company’s ability
to meet its short-term obligations as and when they become due and payable, given that the
company expects to record a loss in the 2017 financial year which, in itself, will require
funding.
4. RW Ltd is facing a massive 15% increase in its rental which will worsen its financial
ability to meet debts in the short term.

QUESTION 10

Consider each of the following independent and material situations. In each case:
 the balance date is 31 October 20X7.
 the fieldwork was completed on 5 December 20X7.
 the financial report and audit report were signed on 12 December 20X7.
 the financial report and audit report were mailed to the members on 20 December 20X7.

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(i) Your client, Outback Mining, owns a mineral exploration licence in central
Australia. At 31 October, this licence was valued by an independent expert at $50,000,000.
This valuation is reflected in the financial report. On 8 December, Outback Mining received
notice that a claim was being lodged under the Native Titles Act for land that is subject to the
exploration licence. If the claim is successful, the exploration licence will be worthless.

(ii) Your client, Bird Pty Limited, derives approximately 10% of revenues from selling
aviary supplies to city-based bird breeders. A draft copy of a government report, leaked to the
press and reported in the media on 11 November, recommends that strict limits be placed on
the number of birds that are allowed to be kept in suburban areas. Bird Pty Limited estimates
that if the recommendations are enacted, about 70% of its customers will have to cut their
flocks by 50% or more. This would affect not only future sales but also their ability to pay
existing debts. No further information, other than the draft report, is available as at 12
December.
(iii) On 14 December 20X7, you discover that a debtor of your client, Galaxy Ltd, was
placed in provisional liquidation on 8 December. The debtor owed $600,000 as at 31 October;
a specific provision of $300,000 of this amount was made at this date. On very preliminary
information, the likely payout to unsecured creditors is zero.

(iv) A flood occurred in the warehouse of your client SuperSpring Ltd on 2 November
20X7. Inventory valued at $2,000,000 was destroyed. The directors believe only half of this
value will be recovered from the insurers.

REQUIRED:

For each of the above situations (i) to (iv):

i. state the appropriate action (either adjust the financial report, disclose the information in the
notes to the accounts, request the client to recall the accounts, or no action is required) that
the auditor would require in order to issue an unqualified opinion for the situation
ii. provide reasons for your choice of the appropriate action to be taken

SOLUTIONS

The alternative actions in this question are as follows:

(A) Adjust the 31 October 20X7 financial report.

(B) Disclose the information in the notes to the 31 October 20X7 financial report.
(C) Request the client to recall the 31 October 20X7 financial report for revision.
(D) No action is required.

P Action
Reasons
a
r
t

(i) B  As it occurred prior to signing, it is the auditor’s responsibility to

investigate.
 However, as the claim is only contingent at this stage, it should
be disclosed by way of a relevant note to the financial report
only.

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 The report is only leaked and not final, and the impact is
(ii) D impossible to predict as it is only a recommendation.
 The event is more likely to be addressed in the Director’s
Report.

(iii) A  Type 1 subsequent event as further information is now

available on an existing condition. The relevant subsequent
event occurred on 8 December and an additional provision of
$300,000 should be made.
 The provisional liquidation occurred before the date of the audit
report and prior to the issue of the financial report and is
therefore the auditor has a responsibility to ensure that it is
correctly treated or qualify the audit report.

(iv) B  Type 2 subsequent event that creates a new condition affecting

year-end balances. Thus, disclose in notes to financial report.
 Auditor’s responsibility to identify, as it occurred before financial
report was signed.

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