Week 4: Planning, understanding the entity and assessing

business risk
Tutorial Solutions

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.
Week 4: Planning, understanding the entity and assessing
business risk
Tutorial Solutions
5.21
(a) Business risks
 Pressure from larger, aggressive
competitors.
 Reduction in gross margins/cost of  Going concern may be at risk due
‘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.
(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.
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).
Week 4: Planning, understanding the entity and assessing
business risk
Tutorial Solutions
5.23
(a) Business risk (b) Audit risk (b) Account balance
As there are purchase The risk that the translated  Purchases/cost of
contracts with overseas- values posted to the general sales
based suppliers, there is ledger accounts are misstated
a risk that the foreign (asset, liabilities, and income  Inventory
currency rates applied statement accounts could be over  Accounts payable
may be incorrect, or understated). This could be
 Foreign exchange
leading to loss of profits material given the main
and loss of cash purchasing expenditure relates to gain/loss
outflows. the overseas suppliers.
As the inventory comes The audit risk will be about the  Accounts
from overseas, there is impact of potential delays on receivable or
a risk that if there are year-end values, such as debtors allowance for
any delays in meeting and inventory if there are doubtful debts
shipment dates the concerns from customers about
delays will be delayed or unfilled orders.  Inventory
significant, which may Customers may not pay if they
impact MSL’s business cannot get maintenance, service
(e.g. unable to sell or or replacements parts, or they
perform services, as no may go elsewhere for equipment
parts are available). maintenance, which may affect
This has an impact on the resale of the equipment.
the financial report
results (cash, profits).
The quality of the The audit risk is associated with  Accounts
equipment and the the impact on the valuation of receivable or
spare parts ordered may various accounts that may be allowance for
not always be at the overstated, such as customers doubtful debts
same consistent level refusing to pay outstanding
across the suppliers. invoices or no longer being  Inventory
Any defect in the prepared to pay the set sale price
inventory may lead to for the equipment or spare parts,
customer complaints, due to quality issues impacting
loss of business, or the effective life, or other
refunds/returns on factors.
sales. This impacts the
financial results.
 Week 4: Planning, understanding the entity and assessing
business risk
Tutorial Solutions

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)
• 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.
Week 4: Planning, understanding the entity and assessing
business risk
Tutorial Solutions

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.
Week 4: Planning, understanding the entity and assessing
business risk
Special Question 1 – Analytical Procedures

What are analytical procedures and when can they be used during an audit?
Answer:
Analytical procedures is the investigation and analysis of fluctuations and relationships to
determine whether there are inconsistencies with other relevant information or deviations
from predicted amounts.

Analytical review procedures can be:

1. Used as part of the planning to identify any unusual trends which may
require closer examination or are at increased risk of misstatement
2. Used and the end of the audit to corroborate evidence obtained from other
procedures
3. Simples comparisons – comparing the amounts for the current year to the
previous year
4. Ratio analysis and comparing the results to expectations, industry data or
forecasts etc Examples include Dupont analysis
5. Common size statements / trend statements / regression analysis can be
used as more complex analytical procedures looking for relations amongst
certain bases or dependent variables.

Special Question 2 – Analytical Procedures – Their purpose.

What is the purpose of preliminary analytical review procedures. What types of comparisons are
useful when performing preliminary analytical review procedures.

Answer:
Analytical procedures are useful for indicating account balances that may be distorted by unusual or
significant transactions and that should be intensively investigated. They are also useful in reviewing
accounts or transactions for reasonableness to corroborate tentative conclusions reached on the
basis of other evidence.

The most important reasons for performing analytical procedures are the following:
1. Understanding the client’s industry and business.
2. Assessment of the entity’s ability to continue as a going concern.
3. Indication of the presence of possible misstatements in the financial statements.
4. Reduction of detailed audit tests.
Comparisons include:
 YoY comparisons
 Common size
 Trend analysis
 Liquidity ratios
 Profitability ratios
 Fraud indicator ratios
 Other…..