CHAPTER 3: Ethics, independence and corporate governance

REVIEW QUESTIONS: 3.1, 3.5, 3.9, 3.12 and 3.14,

DISCUSSION PROBLEMS AND CASE STUDIES: 3.18, 3.20, 3.22, 3.24 and 3.26

3.1 What is meant by the term ‘ethics’? LO 3.1

Ethics is concerned with the requirements for the general wellbeing, prosperity, health and
happiness of people, and with the things that promote or prevent these characteristics.
Professional ethics requires knowledge of moral principles and skill in applying those principles
to problems or decisions. Having professional ethics is an important part of auditing being
recognised as a profession.

3.5 Describe how ethical decision-making models can be used by auditors to assist them in
resolving ethical dilemmas. LO 3.3

Ethical decision-making models help to resolve ethical dilemmas by providing a framework for
decision making. Each of the models ensures that the auditor considers all the facts, the ethical
issues, the alternatives and the consequences, before making a decision.

3.9 List and briefly explain the five categories of threats to independence listed in APES 110.
LO 3.4

The five categories of threats to independence, according to APES 110.100.12 and APES
110.200.3, are:
1. Self-interest threats: may occur as a result of the financial or other interests of a member or
of an immediate or close family member
2. Self-review threats: may occur when a previous judgment needs to be re-evaluated by the
member responsible for that judgment
3. Advocacy threats: may occur when a member promotes a position or opinion to the point
that subsequent objectivity may be compromised
4. Familiarity threats: may occur when, because of a close relationship, a member becomes too
sympathetic to the interests of others
5. Intimidation threats: may occur when a member may be deterred from acting objectively by
threats, actual or perceived.

3.12 Explain how the fee for an audit engagement may be determined. LO 3.5
 The fee for an audit engagement should reflect fairly the value of the work performed, in
accordance with APES 110.240. It is determined by the time necessarily spent by members of
the audit team, billed at a standard rate corresponding to the experience, skills and
qualifications of the staff involved and the degree of responsibility applicable to the work.

3.14 Explain the characteristics of an audit committee and how it functions.

LO 3.6

Accounting bodies’ code of ethics 3.18 MEDIUM You have been asked by your audit client
Blue Water Ltd to prepare a report that analyses the potential acquisition of Ocean Pty Ltd.
As part of your analysis, you decide to verify the accuracy and completeness of Ocean’s most
recent cash flow statement. After reviewing a draft of your preliminary analysis, the chief
financial officer (CFO) of Blue Water, Jill Symes, has asked you to focus your attention on
Ocean’s sales and profitability and to avoid the distraction of cash flow reporting. She
suggests that the acquisition will provide substantial future financial benefits to Blue Water
and that confusing the board with cash flow issues would not be helpful to the acquisition or
to the likelihood of your being asked to undertake similar engagements in the future.
REQUIRED
List two threats that may exist in regard to compliance with the fundamental principles of
professional ethics, and identify the fundamental principles that are at risk of being breached.
LO 3.2

An audit committee is a subcommittee of the board of directors and usually consists solely or
mainly of non-executive directors. Audit committees have been established primarily to:

• assist the board of directors to fulfil its legal fiduciary responsibilities

• add to the credibility and objectivity of financial reports
• enhance the independence and effectiveness of auditors
• oversee the application of appropriate accounting policies and procedures and ensure
appropriate disclosure
• establish and monitor corporate policies to prohibit unethical or illegal activities
• establish and monitor effective internal and management controls
• provide a communication link between management, auditors and the board.
DISCUSSION PROBLEMS AND CASE STUDIES

Accounting bodies’ code of ethics

3.18 MEDIUM You have been asked by your audit client Blue Water Ltd to prepare a report
that analyses the potential acquisition of Ocean Pty Ltd. As part of your analysis, you decide
to verify the accuracy and completeness of Ocean’s most recent cash flow statement. After
reviewing a draft of your preliminary analysis, the chief financial officer (CFO) of Blue Water,
Jill Symes, has asked you to focus your attention on Ocean’s sales and profitability and to
avoid the distraction of cash flow reporting. She suggests that the acquisition will provide
substantial future financial benefits to Blue Water and that confusing the board with cash
flow issues would not be helpful to the acquisition or to the likelihood of your being asked to
undertake similar engagements in the future.
REQUIRED
List two threats that may exist in regard to compliance with the fundamental principles of
professional ethics, and identify the fundamental principles that are at risk of being breached.
LO 3.2

The threats in regard to compliance with the fundamental principles are:

• _intimidation threat, based on having to follow the directive of the CFO or risk harming the
working relationship and suffering a penalty of lost work (APES 110.100.12(e) or 200.3(e))

• _self-interest threat, where the potential for future benefits may be reduced (i.e. loss of
future work if the relationship breaks down (APES 110.100.12(a) or 200.3(a)).

The fundamental principles at risk of being breached are:

• _integrity—if you are not honest in your analysis. As part of demonstrating integrity you are
required to ensure that reports do not omit or obscure information, where such omissions or
obscurity would be misleading (APES 110.110.2)

• _objectivity—if you allow the intimidation or self-interest to influence your report (APES
110.120.2).

• _competence and due care—a proper competent analysis of the takeover requires
consideration of its impact on cash flows (APES 110.130.2).

Auditor independence
3.20 EASY ‘Auditors are responsible for the spate of major corporate collapses. They have
gotten too cosy with management, instead of protecting shareholders and investors.’
REQUIRED
Explain whether you agree or disagree with this statement. Your response should consider
the role that lack of auditor independence may have played in corporate failures. LO 3.4

Auditors do not cause companies to collapse. Usually collapses occur because of poor
management, fraud or external factors such as economic downturns and natural disasters.
However, the question is whether auditors should have warned users of the problems. Where
audit failure has occurred, the question is whether it has occurred because of lack of
competence or lack of independence. Clearly, in some corporate collapses, such as Waste
Management Inc., Enron and HIH Insurance, auditor independence was an issue. Although the
extent to which it contributed to the problems is unclear, there is a perception that lack of
auditor independence did play a role. As a result, there was a need for the profession and
regulators to toughen up independence requirements, which has occurred through the
tightening of independence requirements in APES 110 and the CLERP 9 amendments to the
Corporations
Act 2001 in Australia and similar requirements internationally, such as the Sarbanes-Oxley Act
2002 in the US.

3.22 MEDIUM Newport & Associates (Newport) is a large audit firm with clients located
around Australia. During April 2018, Newport was successful in obtaining a new client, Clear
Diagnostics Ltd (CDL), which is one of Australia’s leading providers of diagnostic imaging
services and owns 30 diagnostic clinics across Australia.
Prior to the appointment of Newport as the auditor of CDL for the financial year ended 30
June 2018, some preliminary analysis identified the following information:

Alex Silver, one of the assistants at Newport intended to be part of the 30 June 2018 audit
team, owns shares in CDL. Alex’s interest is not material to him.
Newport was previously engaged by CDL to value its intellectual property. The consolidated
statement of financial position as at 30 June 2018 includes intangible assets of $25 million,
which were valued by Newport on 1 March 2018, following CDL’s acquisition of another
diagnostic imaging company. The intangibles are considered material to CDL.
REQUIRED
(a) Identify and explain any potential threats to Newport’s independence
as CDL’s auditor.
(b) Explain what action Newport should take, if any, to eliminate any
potential threats identified in (a).
(c) Identify an appropriate safeguard that Newport could implement to
reduce the risk of a similar independence threat occurring in the
future. LO 3.4
Situation (a) Type of threat and (b) Action to (c) Safeguard to
explanation eliminate threat reduce risk of
threat in the
future
Self-interest—the audit The audit team Newport should
(i) team member holds member should put in place
shares in the audit client dispose of their policies and
such that their shares or should procedures that
independence and not be part of the prohibit
objectivity may be seen audit team employees from
to be impaired owning shares in
any audit client.
Audit team
members could
also be asked to
sign an
independence
declaration prior
 to joining the
team
Self-review—Newport An independent A policy should be
(ii) previously provided valuation should put in place
valuations that are be sought for the disallowing the
disclosed on the intangible assets provision of
statement of financial disclosed on the valuation services
position and that will statement of to audit clients,
now be audited by the financial position and prior to
same audit firm or Newport acceptance of any
should not be new audit
appointed as appointment all
auditor of CDL existing
relationships and
engagements
should be
disclosed

3.24 HARD You are an assurance services partner at Connor & Trainer (C&T), a
medium-sized audit firm in Brisbane. C&T was asked in March 2018 to accept nomination as
the auditor of Celestial Ltd, which operates in the mining and resources sector. Prior to
accepting the nomination, you wish to ensure that you and your firm meet all the relevant
independence requirements under the Corporations Act 2001.

Before accepting the nomination, you have identified the following situations:
1 Celestial currently has a vacancy on its board of directors and would like a partner of C&T
with expertise in business structures to fill the vacancy. Experience in assurance services is
preferred, but not required.
2 Francesca Bonnici, a former assurance services manager of C&T, is now the CFO of Celestial.
She left C&T to take up her new role in February 2017.
3 George O’Conner is a senior IT manager at C&T. Over the past two years he has carried out
several major projects for Celestial. George’s daughter, Crystal, is a university student who
lives at home and recently purchased shares in Celestial using a small inheritance she
received from her grandfather.
REQUIRED
(a) For each of the independent situations listed above, consider whether the requirements
of the Corporations Act 2001 have been met.
(b) Where the requirements have not been met, identify whether a remedy is available that
would allow C&T to accept the nomination. LO 3.4

(i) If a partner accepts the appointment, then the specific independence requirements of
section 324 CF (1) will be breached, as partners are included in the list of people given in
section 324 F (5) who are not allowed to be officers of the company and so section 324 CH will
apply. If the partner does not accept the directorship, then C&T can accept the nomination.
(ii) Francesca falls under section 324 CF (5) item 12 as a former employee of the audit firm now
employed with the client, creating a potential independence threat. However, she satisfies the
independence test under section 324 CF (7), as she now has no financial involvement, rights or
participation with the audit firm. Therefore, the independence requirements are met and no
action is required by the audit firm before they accept the nomination.

(iii) Crystal is included in the list of people in section 324 CF (5) under item 7, as she appears to
be dependent on her family for support, and George is a non-audit service provider who would
not satisfy the maximum hours test of less than 10 hours’ work on that client, as he has done
several major projects. Therefore, item 10 in section 324 CH (1) will apply and in order to
maintain independence Crystal will need to sell her shares in Celestial before C&T can accept
the nomination.

3.26 HARD You have recently joined the audit firm of Cameron, Casey & Associates (CCA) and
have been asked to review the firm’s audit clients to ensure that the independence
requirements of APES 110 are being met. Your review has revealed the following:
(a) Shannon O’Brien is an audit manager at CCA. Bell Pty Ltd is an audit client of CCA and has
requested that Shannon help implement a new control system, arrange interviews for Bell’s
hiring of new personnel and instruct and oversee the training of current personnel.
(b) Fortress Ltd requires an audit for the current year. However, Fortress has not paid CCA the
fees due for tax-related services performed two years ago. Fortress has now issued CCA a
promissory note for the unpaid fees, and CCA has proceeded to provide the audit services.
(c) CCA was recently appointed the auditor of Tasty Foods Ltd for the year ended 30 June
2018. The senior-in-charge, Marshall Thompson, and an assistant observed the inventory
stocktake on 30 June. On completion of the inventory observation, Carly Webster, Tasty
Foods’ accountant, informed Marshall that the shipping supervisor had a small gift for him
and the assistant. Marshall asked Carly what the gift was for, and Carly responded that they
had always given small gifts of food items to their previous auditors on completion of the
inventory observation. Marshall estimates that the value of the food is less than $100.
(d) CCA audits a retirement village in which the parents of a member of the firm, Judy Chung,
own a unit. The unit is material to the parents’ net worth, and the member participates in the
audit engagement.
REQUIRED
For each independent situation listed, state whether APES 110 has been breached and justify
your answer. LO 3.4

(a) No. APES 110.290.161–162 indicates that the auditor’s independence is not impaired under
these circumstances provided the client makes all significant management decisions related to
the hiring of new personnel and the implementation of the system. The auditor must also limit
their supervisory activities to initial instruction and training of personnel and should avoid
direct supervision of the actual operation of the system or related activities that would
constitute undue involvement in or identification with management functions.
(b) Yes. Independence under APES 110.290.120 is impaired because the promissory note is a
prohibited loan from the member to the client.
(c) No. APES 110.290.225 allows an auditor to accept a ‘token’ gift from a client, where the
value is trivial and inconsequential. In this instance, the gift of food items valued at less than
$100 would likely be trivial and inconsequential.
(d) Yes, APES 110.290.104 indicates that if a close relative (such as a parent) of a member of the
audit team has a direct financial interest or a material indirect financial interest in the audited
entity, it creates a self-interest threat that would be so significant that no safeguards could
reduce the threat to an acceptable level.

CHAPTER 5: Planning, understanding the entity and evaluating business risk

REVIEW QUESTIONS: 5.1, 5.3, 5.7, 5.10, and 5.12

DISCUSSION PROBLEMS AND CASE STUDIES: 5.15, 5.16, 5.21, 5.22, and 5.26

Client acceptance and continuance

5.1 List three conditions that APES 320 states an audit firm must adhere to
before it can undertake new engagements or continue existing
engagements. LO 5.1

Conditions that an audit firm must meet under APES 320.35 before undertaking a new engagement or
continuing an existing engagement include:
1 that it has considered the integrity of the client and does not have information that would lead it to
conclude that the client lacks integrity
2 that it is competent to perform the engagement and has the capabilities, time and resources to do so
3 that it can comply with ethical requirements.

Audit planning
5.3 List four planning activities outlined in ASA 300 (ISA 300) that the auditor
needs to consider prior to the performance of detailed audit
procedures. LO 5.2
Planning activities that need to be considered prior to the performance of further audit
procedures according to ASA 300.A2 (ISA 300.A2) are:
• application of analytical procedures as risk-assessment procedures
• obtaining a general understanding of the legal and regulatory framework applicable to
the entity and how the entity is complying with that framework
• determination of materiality
• involvement of experts
• performance of other risk assessment procedures.

Business risk
5.7 Identify five examples of matters that the auditor may consider in attempting
to obtain an understanding of the entity’s objectives, strategies and related
business risks that may result in a risk of material misstatement of the
financial report. LO 5.4
Examples of matters that the auditor may consider when obtaining an understanding of the
entity’s objectives, strategies and related business risks that may result in a risk of material
misstatement of the financial report include:

• industry developments (a potential related business risk might be, for example, that the
entity does not have the personnel or expertise to deal with the changes in the industry)
• new products and services (a potential related business risk might be, for example, that
there is increased product liability)
• expansion of the business (a potential related business risk might be, for example, that
the demand has not been accurately estimated)
• new accounting requirements (a potential related business risk might be, for example,
incomplete or improper implementation, or increased costs)
• regulatory requirements (a potential related business risk might be, for example, that
there is increased legal exposure)
• current and prospective financing requirements (a potential related business risk might
be, for example, the loss of financing due to the entity’s inability to meet requirements)
• use of IT (a potential related business risk might be, for example, that systems and
processes are incompatible)
• the effects of implementing a strategy, particularly any effects that will lead to new
accounting requirements (a potential related business risk might be, for example, incomplete or
improper implementation).

Developing an overall audit strategy

5.10 Explain the purpose of an audit program. LO 5.5
An appropriately prepared audit program serves the following purposes:
• It provides evidence of proper planning and allows a review of the proposed audit
scope.
• It gives the audit team and the senior audit staff an opportunity to review the proposed
scope of the audit before the work is performed, when there is still time to modify the
proposed audit procedures.
• It provides guidance to less experienced staff members by indicating the specific audit
procedures to be performed by each one.
• It provides evidence of the work performed, as each staff member signs or initials each
step in the program for which they have completed the required work.
• It provides a means of controlling the time spent on the engagement. The audit program
usually includes the estimated time required to complete each audit step and provisions for
recording the actual time taken.

Analytical procedures
5.12 Describe the purpose of performing analytical procedures at the planning
stage of an audit. LO 5.7
5.12 Analytical procedures at the planning stage of the audit assist in understanding the
business and
identifying areas of potential risk. Analytical procedures may reveal aspects of the business
about which the auditor was unaware, and assist in determining the nature, timing and extent
of other audit procedures.
They also give the auditor some knowledge of the business and a base against which to
compare subsequent evaluations of the reasonableness of the financial report.

Discussion problems and case studies

5.15 MEDIUM Quality Paper Ltd (QPL) operates a pulp and paper mill that
makes high-grade paper, using wood from surrounding forests. Highly toxic
chemicals are used to manufacture this paper and are discharged into the
nearby river. QPL is currently the subject of an investigation by the
Environmental Protection Agency (EPA) for a significant spill of toxic
chemicals into the river. There have also been media reports that senior
employees of QPL were allegedly responsible for this spill. In addition, the
Green Earth Society is threatening to sue QPL for excess logging of oldgrowth
forests in the vicinity of its mill.
Despite reappointing its current auditors only two months ago for the audit
of the current financial year ended 30 June 2018, QPL has now approached
you to do the audit, claiming that the current auditor cannot provide the
management advisory services that you can offer, and which are required
for implementing a necessary major restructure of the company’s internal
control system.
REQUIRED
(a) Outline briefly what information you should obtain from the previous
auditor.
(b) Before deciding whether to accept an engagement, what ethical
matters regarding the prospective client and its management should
you consider? LO 5.1
(a) APES 110 requires the successor auditor to communicate with the previous auditor. This
communication should be made with the client’s permission.
Also, you should attempt to confirm whether Quality Paper’s claim that the previous auditor could not
provide the management advisory services required in relation to the proposed major internal control
restructure is the real reason for the change.

In this case, the successor auditor may also specifically ask for any information the previous auditor has about the
EPA investigation into the chemical spill and the fact that senior management are under investigation. However, it
needs to be remembered that APES 110 section 210.12 states that the previous auditor has a duty of
confidentiality to the client and so may not be able to provide information on these matters.
The successor auditor may also ask to review the previous auditor’s working papers. While the previous
auditor is under no obligation to consent to such a review, many firms will consent to a supervised review,
given the client’s permission. If such a review is conducted and the successor auditor wishes to place
reliance on the previous auditor’s work, the successor auditor needs to consider the competence and
independence of the previous auditor.
APES 110 section 210.13 states that if the successor auditor is unable to communicate with the previous
auditor, the successor auditor should obtain information about potential threats by other means, such as
enquiries of third parties or investigations of senior management.
(b) ASA 220.A8 (ISA 220.A8) and ASQC 1.26 (ISQC 1.26) require the engagement partner to be satisfied
that appropriate procedures regarding acceptance have been followed, including evaluating the integrity
of management.
This potential client and industry would require special consideration because of its reputation regarding
environmental damage. The company is being investigated by the EPA, which might result in a significant
economic penalty, as well as harming Quality Paper’s reputation, particularly regarding its environmental
record.
Senior executives are allegedly involved with a toxic chemical spill, which is not a positive factor in
assessing management integrity.
The Green Earth Society is also suing the company for over-logging. If Quality Paper loses the court case,
there might be significant economic consequences. The courts may prevent Quality Paper from accessing
timber for their pulp and paper mill. The reputation of Quality Paper might also be harmed by the
negative media exposure in what could be a high-profile court case.
5.16 MEDIUM You are an audit partner with Ball & Rock. One of your firm’s
recently acquired clients, Fresh Air Ltd, an air-conditioning manufacturer,
has been placed into liquidation after the completion of your first audit, amid
a wave of adverse publicity concerning the directors and your audit firm. It
has since emerged that the directors had previous convictions for fraud and
trading while insolvent.
Ball & Rock has always maintained a policy that any potential clients should
have a low audit risk, so the failure to detect that Fresh Air had a high audit
risk was a major concern to the Ball & Rock partners.
As a result, you have been asked to develop a quality control procedures
manual that includes a checklist of questions that partners should ask when
considering whether to take on a new audit client or to continue with an
existing client. The checklist should take into account Ball & Rock’s desire to
have only clients who have a low audit risk profile.
REQUIRED
Provide five questions that you would include in the quality control manual
to assess whether the integrity of the client would raise its audit risk beyond
a low level. LO 5.1

In considering the integrity of the client, the checklist might include some of the following
questions (further questions are possible):
• What is the background and experience of management in the industry?
• Has a key member of management been convicted of a criminal offence?
• Does management take an unusually aggressive approach compared to others in the
industry?
• What is the attitude of management toward creating and maintaining an effective
system of internal control?

• Does a single member of management seem to be overly dominant?

• Has there been an unusual amount of press coverage of the entity or its managers?
• What were the circumstances of the previous auditors (if any) not continuing the audit?
Is there any evidence of disagreements regarding accounting principles or auditing procedures?
Are there any continuing issues with fees?
• Does the client associate with any entities (for example, lawyers, investment banks) that
may have a poor reputation or a high risk profile?
• What was the previous auditor’s opinion on the most recent financial report?
• Is there any litigation attached to the client? Are there any conflicts involved with
regulatory agencies?
• How has the client performed in relation to the rest of the industry?
• Is the client’s revenue overly dependent on a single source?
• How will the acceptance of this client affect the staffing of other engagements and the
work schedules of personnel involved?
• Has the client given any indication that the audit fee may be modified based on the
outcome of some future event?
• Is the audit fee commensurate with the estimated skills and hours estimated to
complete the audit?

Business risk
5.21 MEDIUM Breakfast Juice Ltd (BJL), a fruit juice company, has decided to
change its arrangements with its supermarket customers in relation to its
freshly squeezed orange juice. Under the previous arrangement,
supermarkets would purchase stock from BJL, with unsold stock being the
responsibility of the supermarket. As fresh fruit juice has only a very short
shelf life, supermarkets had a tendency to understock the product, as they
did not want to be left with outdated juice, and so were often out of stock.
BJL’s management believed that this resulted in significant loss of sales and
so has decided to implement a consignment stock arrangement with the
supermarkets to try to increase sales.
However, BJL’s sales manager has advised you that the new consignment
stock arrangement has not resulted in the increased sales they expected.
Despite increased deliveries of stock to the supermarkets, sales have not
increased, and profits on supermarket sales have decreased. Under the
new arrangement the supermarkets are responsible for disposing of any
unsold stock, and have been reporting large quantities of stock being
destroyed each week.

REQUIRED Page 225

Identify a business risk that arises as a result of the consignment
(a) stock arrangement with the supermarkets.
(b) Explain the risk of material misstatement of the financial report that
arises from the business risk identified in (a), including the three key
accounts affected.
(c) Identify and explain the key assertion at risk for each account
identified in (b). LO 5.4
(a) As the supermarkets are responsible for disposing of the unsold stock, there is a risk
that staff at the supermarkets could commit fraud against BJL Ltd by advising them that stock
was unsold and destroyed, when in fact that is not the case.
(b) If supermarkets are reporting stock as unsold and destroyed when in fact that is not the
case, there is also a risk that sales and accounts receivable or inventory are understated. Stock
may have been sold and the proceeds illegitimately kept by the supermarkets or their staff
instead of being remitted to BJL Ltd, or stock may still be on hand or have been fraudulently
taken by staff.
(c) The key assertion for sales is:
• completeness—as there may be sales that have occurred, but have not been recorded.

The key assertion for accounts receivable is:

 completeness—as there may be amounts owing by supermarkets that have not been
recorded.

The key assertions for inventory are:

• completeness—as some stock may still exist, but has been written off
• accuracy, valuation and allocation—as some stock may have been written down to nil
when it still has value.

5.22 MEDIUM You are currently planning the audit for the year ended 30 June
2018 of Whisky & Wine Pty Ltd, a large proprietary company that operates a
small chain of liquor stores. Competition in the retail liquor sector is fierce,
with major supermarket chains discounting goods heavily, sometimes
below cost, in order to increase their market share.
In order to compete, Whisky & Wine has been forced to offer big discounts
including ‘buy two get one free’ offers. While this has helped to maintain its
customer base, Whisky & Wine’s gross margins have dropped by 20 per
cent.
In an effort to offset the impact of the discounting of liquor prices on profits,
Whisky & Wine has added additional, higher-margin products to its range,
such as gourmet snack foods to accompany the liquor. However, these
gourmet items have achieved only limited sales.
Whisky & Wine is also experiencing difficulties with two of its major
suppliers, McGregor’s Spirits Ltd and Old Vine Wines Ltd, who have
reduced their payment terms from 60 to 30 days.
REQUIRED
Identify and explain three business risks that may lead to the risk of
material misstatement in the financial report of Whisky & Wine for the year
ended 30 June 2018. LO 5.4

(a) Business risk (b) How it might lead to risk of material

 misstatement
Pressure from larger, aggressive Inventory may be overstated, as goods
competitors may be being sold below cost, requiring a
write-down to net realisable value
Significant reduction in gross margins has Going concern may be affected due to
resulted in a movement away from its core reduced margins
business to new products in an attempt to
claw back margins. Movement away from
its core business has had limited success
to date and may distract management
from the core business
Apparent deterioration in terms of trade Going concern may be affected due to
with two major suppliers reducing their tighter terms of trade putting pressure on
credit limits. This may create liquidity liquidity
problems and also may indicate the
supplier’s concern about Whisky & Wines

Analytical procedures
5.26 MEDIUM You are the audit senior on the audit for the year ended 30 June
2018 of Gleam Pty Ltd, a large manufacturer of lighting accessories. This is
the first year that your firm has performed Gleam’s audit. As part of the
planning work, you have annualised Gleam’s interim financial accounts and
performed analytical procedures on the annualised figures and compared
the results to industry averages and last year’s audited financial
information. The results are given below.

INDUSTRY
AVERAGE
GLEAM PTY
LTD
RATIO 2018 2017 2018 2017
REQUIRED
Providing a brief explanation of each of the above ratios, outline what
conclusions can be drawn about Gleam’s financial position and identify
potential audit risks to be investigated further. LO 5.7

What the ratio means Conclusions to draw and potential risks

to be investigated

1 Current ratio The current ratio is lower than the

This ratio indicates the net working capital position of
the entity. Therefore, it indicates the entity’s ability to
meet its current obligations (that is, its short-term
liquidity). A benchmark figure of 2 is generally accepted
as a minimum requirement.
CR= Current Assets/ Current Liabilities
2 Net profit ratio
This ratio shows the amount of net income
generated for each dollar of sales
3 Gross margin
This indicates the amount of gross profit each
dollar of sales earns.
industry’s and is following the same
downward trend. Given a benchmark of
2, the current level does not indicate
cause for immediate concern; however,
it needs to be monitored to ensure that
it doesn’t deteriorate further.
Enquire of management as to their
procedures for managing working
capital, and review current and
projected cash flows for future liquidity
problems.
Ratio is lower than that of the industry
and, like the industry ratio, has
increased slightly over last year’s.
Need to investigate the reason for the
ratio being below industry figures, and
whether this generates enough cash to
comfortably continue operations. It is
also inconsistent with ROTA, which
indicates that Gleam is performing
better than others in the industry.
Gross profit ratio is equal to that of the
industry, although the trends are in
opposite directions. Need to investigate
why Gleam is able to increase its
margins when others in the industry are
dropping their margins. May indicate a
problem with Gleam’s cost of sales
figure.
Need to investigate why the gross profit
ratio is the same as the industry’s but

4 Inventory turnover ratio
This ratio shows the number of times
inventory turns over in a year.
5 Receivables turnover ratio
This ratio shows the number of times
receivables turn over in a year.
6 Return on total assets
This ratio shows whether sufficient profits are
being generated for the assets employed.
Chapter 6 Assessing inherent risk and other specific business risks
REVIEW QUESTIONS: 6.1, 6.4, 6.5, 6.8 and 6.10
DISCUSSION PROBLEMS AND CASE STUDIES: 6.14, 6.17, 6.18, 6.22 and 6.25
the net profit ratio is
lower (this might, for example, indicate
higher operating expenses).
Inventory turnover is faster than that of
the industry and is following the
industry’s trend to slow slightly. The fast
turnover indicates good inventory
management practices. However, you
may need to check whether the faster
turnover is leading to any stock-outs, as
this could have a detrimental effect on
future sales and market share.
Also need to investigate the reason for
current deterioration, as a continuing
decline might indicate obsolete stock
problems.
Receivables turnover is faster than that
of the industry, indicating good working
capital management.
However, the slowing trend of the ratio
may need to be investigated and the
potential effect on the doubtful debts
provision examined. For example, the
reason could be a relaxation of credit
limits and debtors’ follow-up or inclusion
of potential bad debts.
Gleam is generating a much higher
return than the industry average and is
following the same upward trend. This
indicates that it is using its assets more
efficiently than the industry generally.
Need to investigate the reasons for
return being nearly double that of the
industry (for example, it may be due to
higher risk operations). Also need to
investigate reasons for the significant
increase in the current year.
6.1 Define inherent risk and explain why it is important to evaluate inherent risk as part of audit
planning LO 6.1
Inherent risk is the susceptibility of an account balance, class of transactions or disclosure to material
misstatement given inherent and environmental characteristics, but without regard to internal control.
Inherent risk at the financial report level is an important consideration in general planning because it
specifically affects other decisions made at this time, such as staffing requirements, and other aspects of
the audit plan. For example, some of the possible responses to high inherent risk are to assign more
experienced audit personnel, to increase the extent of supervision and to conduct the audit with a
heightened degree of professional scepticism. Consideration of the inherent risk of material
misstatement at the assertion level for classes of transactions, account balances and disclosures is
important, as it directly assists the auditor in determining the nature, timing and extent of specific
further audit procedures at the account and assertion level necessary to obtain sufficient appropriate
audit evidence.
6.4 What are the ways in which fraudulent financial reporting may be achieved?
LO 6.2
Fraudulent financial reporting may be achieved by:
• manipulation, falsification or alteration of records or documents
• suppression or omission of the effects of transactions from records or documents
• recording of transactions without substance
• intentional misapplication of accounting policies.
6.5 Describe three types of enquiry that an auditor will make of management with regard to fraud. LO
6.2
Types of enquiry that the auditor will make of management in regard to fraud include:
• management’s assessment of the risk that the financial report may be materially misstated due to
fraud
• management’s process for identifying and responding to the risks of fraud in the entity,
including any specific risks of fraud that management has identified or account balances, classes of
transactions or disclosures for which a risk of fraud is likely to exist
• management’s communication, if any, to those charged with governance regarding its processes for
identifying and responding to the risks of fraud in the entity
• management’s communication, if any, to employees regarding its views on business practices and
ethical behaviour
6.8 Provide four examples of transactions outside an entity’s normal course of business that may
indicate the existence of unidentified related parties. LO 6.3
Examples of transactions that may indicate the existence of unidentified related parties include
transactions that:
• are overly complex (for example, transactions involving multiple parties within a consolidated group) •
have abnormal terms of trade, such as unusual prices, interest rates, repayment terms or guarantees •
lack an apparent logical business reason to justify their occurrence
• have been processed in an unusual matter.
6.10 Explain why the auditor’s assessment of the appropriateness of the going concern assumption is
so important LO 6.4
The going concern assumption means that the entity is viewed as continuing in business for the
foreseeable future without any intention or necessity to liquidate or otherwise cease its operations.
When the going concern assumption is appropriate, assets and liabilities are recorded on the basis that
the assets will be realised and the liabilities discharged in the normal course of business. This means
either cost or fair value is used. However, an imminent business failure will have an effect on the
appropriateness of the presentation of the financial report. If the company is not a going concern, the
financial report should be prepared on a liquidation basis, which is likely to be vastly different to the
going concern basis. Further, going concern problems may motivate management misrepresentation.
Therefore, the appropriateness of the going concern assumption is very important in determining the
audit procedures and the degree of professional scepticism to be applied and whether the fina1ncial
report gives a true and fair view. As a result, ASA 570.10 (ISA 570.10) requires that when planning and
performing audit procedures and evaluating the results, the auditor must consider the appropriateness
of the going concern assumption that underlies the financial report.
6.14 MEDIUM You are currently involved in planning for the audit of Curtains &
Blinds Ltd (CBL), a national company producing curtains and blinds. The
curtain and blind market is highly competitive, and CBL has been
experiencing declining sales over the past three years. Cost cutting has
proven very difficult, as the cost of materials used in the company’s
production lines has increased each year. CBL’s bank has continued to
provide CBL with loan facilities; however, it has indicated that it expects to
see improved results in the next financial report and has placed a number of
quite restrictive covenants in CBL’s lending agreements. Recent articles
appearing in the financial press concerning CBL’s expected financial results
have been very pessimistic about its likely performance.
REQUIRED
Based on the information provided:
(a) Discuss the overall impact on audit risk.
(b) What specific component(s) of audit risk would be affected? LO 6.1
(a) The company might experience going concern problems in the future, given declining sales and
falling margins. This is especially so given the bank’s desire to see improved results in the next reporting
period and the related potential threat to loan funding. The pessimism displayed in the financial press is
also likely to deter future investors and lenders for CBL’s operations. The overall effect is an increase in
audit risk.
(b) The current circumstances are likely to place increasing pressure on the company’s management to
produce favourable financial results. This affects inherent risk at the financial report level. It is also likely
to increase inherent risk at the assertion level for accounts where judgment or estimates are involved,
such as provisions.
Risk of fraud
6.17 EASY Christopher Papadopoulos has been assigned to the audit of a new
client, Reality Loans Ltd, operating in the finance and banking sector. The
audit plan states that Reality Loans has an extensive information technology
(IT) system and therefore all auditors on the engagement should consider
the possibility of fraud. Christopher is confused by this comment, as he
believed that auditors did not concern themselves with fraud, and has asked
the audit manager to explain the comment.
REQUIRED
a. As the audit manager, explain to Christopher why the audit plan requires the audit team to consider
the possibility of fraud.
b. List six factors that may increase the susceptibility of IT systems to fraud. LO 6.2

(a) ASA 240.5 (ISA 240.5) indicates the auditor should plan and conduct the audit so as to have a
reasonable expectation of detecting misstatements that have a material impact on the financial report
as a result of fraud or error. Effectively this means the auditor should maintain an attitude of
professional scepticism and consider the possibility of fraud when planning the audit by taking into
account factors that increase the risk of fraud (and error). The existence of an extensive IT environment
is an example of such a factor.
(b) The following factors are considered to be some of the most common indicators of IT
vulnerability to fraud:
• poor controls over manual input/output handling
• weak or absent physical access controls
• weaknesses in computer and terminal operations
• poor control over computer programs
• lack of operating system access controls and integrity
• weak library controls.
6.18 MEDIUM Modern Electricals Ltd offers customers a range of payment
options. One increasingly popular method is interest-free finance. Generally,
such arrangements involve customers signing a consumer credit contract
with an interest-free term of up to two years from the date of purchase. The
growing demand for this financial arrangement has begun to stretch
Modern Electricals’ statement of financial position capacity, as it has had to
take on additional debt to fund the cash flow timing differential between its
receivables and payables. All interest-free finance contracts are held by
Interest Free Pty Ltd, a wholly owned subsidiary of Modern Electricals.
Modern Electricals must comply with various financial covenants for its debt
facilities with Australia Bank Ltd, and is close to breaching these covenants.
Modern Electricals obtained conditional approval for additional working
capital borrowings from Australia Bank in September 2017, subject to
meeting the debt to equity ratio at 30 June 2018 and meeting profit targets
for the year ended 30 June 2018. Australia Bank has requested a copy of
the 30 June 2018 audited financial report as soon as it is completed.
The significant growth in interest-free business is due in part to effective
incentive schemes that operate across all sections of the business. The
accountant at Interest Free, William Walters, obtains approximately 30 per
cent of his remuneration from monthly and year-end bonuses, based on
profit and the increase in finance receivable dollar value. Sales staff are paid
monthly bonuses made up of $50 per new finance contract signed and 1
per cent of the value of those contracts. At the end of each month, each
staff member emails the payroll department a log of contracts listing the
contract number and value. The payroll department processes the bonuses
based on this information.
Another reason for the growth in interest-free financing is a new initiative
that Modern Electricals has introduced whereby it does not run credit
checks on contracts of less than $1000, as the value of the contract is not
large and William has informed you that the hassle of the credit checks was
more than it was worth on that amount of money. Modern Electricals
promises customers easy finance and this has seen the number of contracts
for less than $1000 increase dramatically.
REQUIRED
Identify three possible fraud risk factors and explain why each is a fraud
factor. LO 6.2

Fraud risk factor Explanation

Modern Electricals Ltd is close to breaching
its debt covenants
William Walters receives a large proportion
of his remuneration from bonuses
Sales staff are paid bonuses based on
unverified emailed information provided by
staff
Risk of fraudulent financial reporting, as
getting close to breaching debt covenants
creates an incentive to manipulate assets
and liabilities to ensure that the required
ratio is met
Risk of fraudulent financial reporting, as
there is an incentive to overstate profits and
increases in receivables, as this has a direct
impact on his remuneration
Risk of misappropriation of assets, as there
is inadequate oversight by management as
to whether claims submitted by email for
payment of bonuses are legitimate

6.22 MEDIUM Golden Touch Ltd is a national fashion retail chain with stores
located throughout Australia. The major shareholders of Golden Touch are
the Campbell siblings Amos, Samantha and Terry. The remaining minority
shares are held by independent third parties. Both Samantha and Amos are
employees of Golden Touch, but only Amos, who is the CEO, is on the
board. All other board members are independent of the family.
Golden Touch specialises in expensive women’s swimwear and resort-wear
for summer use only, and designs its garments in Australia and
manufactures them in China from Italian-sourced fabrics. The only
exception is the material for Golden Touch’s resort-wear, which is
purchased at commercial rates from Kylie Campbell, the fourth Campbell
sibling, through her company Elite Fabrics Pty Ltd. The details of this
arrangement are contained in a note to the financial report.
Samantha Campbell is in charge of purchases for the year ended 30 June
2018 and renegotiated Golden Touch’s contract with Elite Fabrics, so that
Golden Touch pays cash on delivery for all materials purchased from Elite
Fabrics, instead of the industry standard of 30 days. No one outside of the
purchasing department is aware of the renegotiation.
Golden Touch owns 75 per cent of its manufacturing operations in China,
with the remaining 25 per cent being owned by a Chinese company, Fung
Ltd. Amos Campbell’s wife is a clothing designer and has her fashion line
manufactured in Golden Touch’s Chinese plant at no charge, provided
members of the Campbell family are supplied with garments free of charge.
Golden Touch simply writes off the manufacturing costs incurred by Amos’
wife as a bad debt. Fung is not aware of this arrangement.

REQUIRED
Outline the issues in relation to the related-party transactions above that
may increase the risk of material misstatement in the financial statements
or prevent fair presentation of the financial report. LO 6.3
Source: This question was adapted from the Chartered Accountants Program of the Institute of
Chartered Accountants in Australia, 2011 (2) audit and assurance module.

HARD You are the audit manager on Highland Ltd, a property investment
Related party transaction
Purchases between Golden Touch and
Elite Fabrics are now on cash terms
instead of the usual agreed-upon 30-day
terms
Use of Chinese factory by Amos
Campbell’s wife, including exchange for
free clothes to the Campbell family
How it increases risk or prevents fair
presentation
No one outside the purchasing
department is aware of the change in
terms, which increases the risk, including
the risk of non-commercial transactions
(given cash is involved).
The risk of material misstatement in the
financial report is increased because of
the practice of writing off manufacturing
costs as bad debts. The offer of free
goods may lead to unethical behaviour.

6.25 MEDIUM Mitchell Hazlewood is an audit senior with Lyon & Associates.
Mitchell is involved in planning the audit for the year ended 30 June 2018
of Blue Water Ltd, a manufacturer of engines for luxury leisure boats. Blue
Water’s operations are financed by a combination of long-term debt and
short-term loans from a financial institution, My Bank Ltd.

As part of the planning process Mitchell has noted the following matters:

Blue Water has been profitable for several years and has recently
successfully expanded its operations to manufacture a new type of
engine for export to New Zealand.
One of Blue Water’s major customers, Bob’s Boats, which represents 35
per cent of Blue Water’s annual sales, has indicated that it has started to
manufacture its own engines.
The strength of the Australian dollar against foreign currencies has had an
adverse effect on demand for locally produced engines. Competition in
the industry is becoming more intense, with some other customers of
Blue Water indicating they may now purchase their engines from Korean
suppliers at a much lower cost.
My Bank has requested cash flow forecasts for the coming year to
support the financing arrangements that are currently in place. Blue
Water’s level of debt has remained constant in recent years and it had a
positive working cash flow position to 30 June 2018.
REQUIRED
(a) Identify whether there are events or conditions that may indicate
material going concern uncertainties.
(b) Identify any mitigating factors. LO 6.4

(a) Events or conditions that may indicate material going concern uncertainties include:
• • _Bob’s Boats, a major customer of Blue Water, has indicated that it intends manufacturing its
own engines. This is likely to result in a significant loss of sales, as it is unlikely that Bob’s Boats will
continue to purchase Blue Water’s engines once they start producing their own engines.
• • _As a result of being able to import engines at a lower cost, some of Blue Water’s customers
have indicated that they may purchase their engines from overseas rather than from Blue Water,
potentially resulting in a significant loss of sales.

• • _The intense competition in the local market will make it harder for Blue Water to secure
contracts with alternative customers to sell its engines.

(b) Mitigating factors to support the going concern assumption include:

• • _Blue Water had a positive working capital position as at 30 June 2018

• • _Blue Water has been profitable for several years

• • _Blue Water has successfully expanded by developing a new type of engine for export to New
Zealand.

CHAPTER 7 Understanding and assessing internal control

REVIEW QUESTIONS: 7.1, 7.4, 7.5, 7.8, 7.9, and 7.11

DISCUSSION PROBLEMS AND CASE STUDIES: 7.14, 7.16, 7.19, 7.22, and 7.28

7.1 Why does the auditor assess control risk? LO 7.1

The auditor assesses control risk to determine whether the accounting data were developed under a
system of internal control that is likely to ensure their accuracy and reliability. If the auditor is able to
assess control risk as being less than high, then the detection risk can afford to be higher, resulting in
less substantive testing being required.
7.4 Explain what is meant by incompatible accounting functions and how an appropriate segregation
of functions can be achieved. LO 7.2
Incompatible accounting functions are functions that, when combined, allow an individual to perpetrate
an irregularity and not be detected. Appropriate segregation of functions is achieved by separating the
authorisation, execution and recording of transactions, and custody of the related assets
7.5 What is the internal control environment and why is it important? LO 7.3
According to ASA 315.A77 (ISA 315.A77) the internal control environment includes governance and
management’s overall attitude, awareness and actions regarding internal control and its importance in
the entity. The internal control environment is important because it sets the tone of an entity. It
influences the control consciousness of all personnel and is the foundation for the other components.
7.8 Identify the procedures an auditor uses to obtain an understanding of the flow of transactions and
the related controls. LO 7.4
The procedures the auditor uses to obtain an understanding of the flow of transactions and the related
controls are enquiry, observation, review of manuals and similar data, and tracing a few transactions of
each type through the system using a walk-through.
7.9 Distinguish between general controls and application controls in a computerised system and list
four areas over which general IT controls are commonly implemented. LO 7.5
General controls in a computerised system are those controls that relate to all or many computerised
accounting applications to provide a reasonable level of assurance that the overall objectives of internal
control are achieved. Examples include segregation of duties between operators and programmers,
approval of changes to programs and restricted access to the system.
According to ASA 315.A108 (ISA 315.A108), areas over which general IT controls are commonly
implemented include:
• data centre and network operations
• system software acquisition, change and maintenance
• program change
• access security
• application system acquisition, development, and maintenance. Application controls apply to the
processing of specific types of transactions, such as invoicing and payroll. Examples include user controls
such as control totals, input controls such as key verification, and programmed control activities such as
check digits, limit checks and validity checks.
7.11 Discuss the extent to which the external auditor is able to use the work of an internal auditor . LO
7.6
The work of internal audit may be used in an external audit where it is viewed as part of an audit client’s
internal control. ASA 610.15 (ISA 610.15) requires that when determining whether the work of the
internal audit is likely to be adequate for external audit purposes, the external auditor must evaluate the
internal audit’s:
• objectivity
• technical competence
• systematic and disciplined approach.
Further, in determining the effect of the internal audit’s work on the nature, timing and extent of the
external audit procedures, the external auditor also needs to consider:
• the amount of judgment involved
• the assessed risks of material misstatement.
In addition, if the external auditor intends to use the work of the internal audit, the external auditor
needs to review the internal audit working papers and re-perform some of the internal audit work.
Further, the external auditor must discuss the planned use of its work with the internal auditor, so they
can coordinate their activities, and read the relevant reports of internal audit. In addition, external audit
must communicate the proposed use of internal audit to those charged with governance, as part of their
understanding of the proposed audit approach.
Direct assistance by internal audit to perform audit procedures under the direction, supervision and
review of external audit is prohibited by ASA 610.AUS 1.2 and ASA 610.AUS 25.1.

7.14 EASY Easy Beat Ltd sells CDs to music shops all over Australia. Although
each sale is of relatively low value, the company has a very high sales
volume and is very profitable. You are conducting the audit of Easy Beat for
the year ended 30 June 2018. You have just completed a review of Easy
Beat’s controls and have concluded that its internal control is satisfactory
REQUIRED
Indicate the audit strategy that you are likely to adopt. Give
reasons. LO 7.1
Since Easy Beat’s internal control is satisfactory, its control risk will be assessed as less than high. This
provides evidence that Easy Beat’s controls could potentially be relied on; its accounting records are
probably credible, reducing the need for routine checking of large volumes of sales transactions.
Therefore, in choosing an audit strategy with the most efficient and effective combination of tests of
controls and substantive tests of transactions and balances, more emphasis will be placed on tests of
controls. Tests of control will be performed to gain evidence that the specific control activities have
been effectively and consistently applied throughout the period under audit. If these controls are found
to be effective, then substantive testing will be reduced.
7.16 MEDIUM Supremo Ltd is a major manufacturer of industrial
machinery. When the stores department requires items to be purchased,
they issue a three-part pre-numbered purchase requisition that needs to be
approved by the stores manager. Copy 1 is sent to the purchasing
department, copy 2 is sent to the accounts payable department and copy 3
is filed in the stores department. On receipt of an approved purchase
requisition, the purchasing department issues a five-part pre-numbered
purchase order. Copy 1 is sent to the supplier, copies 2 and 3 are forwarded
to the receiving department, copy 4 is forwarded to the accounts payable
department and copy 5 is filed in the purchasing department.
When goods are received, the receiving department just stamps ‘order
received’ on its two copies of the purchase order, which then forms its
receiving record. One copy of the receiving record is filed in the receiving
department and the other is forwarded to the accounts payable department.
The accounts payable department checks that there is a purchase
requisition, purchase order and receiving record for each supplier invoice
and then approves it for payment. The accounts payable department
prepares a pre-numbered payment voucher and forwards it, along with the
supplier’s invoice, purchase requisition, purchase order and receiving
record, to the financial accountant, who signs the payment voucher,
completes the payment by bank transfer to the supplier and returns the
supporting documents to the accounts payable department.
At the end of the month, the assistant accountant undertakes a sequence
check of all pre-numbered documents. The financial accountant receives the
monthly bank statement, prepares a bank reconciliation and investigates
any reconciling items.
REQUIRED
(a) Identify the weaknesses in Supremo’s internal control concerning the
purchases and payments functions.
(b) Explain why each is a weakness and provide a recommendation as to
how to overcome the weakness. LO 7.2
Internal control weaknesses include the following.
• Simply making a notation that the order was received is not an adequate check on the quantity
and condition of goods received and may result in short deliveries or damaged goods being received.
The receiving department should count and inspect the goods received.
• The matching process requires more than making sure that a purchase requisition, purchase
order and receiving report exist for each purchase. If the details are not checked, then incorrect
payments may be made. The clerk should check that there is a match between dates, descriptions,
amounts, prices, terms and reference numbers on the supporting documents.
• The clerical accuracy of suppliers’ invoices is not checked, which may result in inaccurate
payments being made. Checking the mathematical accuracy of suppliers’ invoices assures that the billing
is correct.
• Supporting documentation for payments is not cancelled, which may enable items to be
resubmitted and the same item paid twice. Supporting documentation should be cancelled at the same
time as the bank transfer is made.
• There is a lack of segregation of duties in that the financial accountant has cash payments duties
and performs the bank reconciliation. Therefore, the financial accountant may be able to
misappropriate funds without being discovered. The bank reconciliation should be performed by
someone independent of payments and receipts functions to provide a cross-check on these functions.

7.19 HARD Festival Ltd, a diversified manufacturer, has three divisions that
operate throughout Australia. Festival has always allowed its divisions to
operate autonomously, with head office intervention occurring only when
planned results were not obtained. Head office management has high
integrity, but the board of directors and audit committee are not very active.
Festival has a policy of hiring very competent people and has an ethical
code of conduct, but there is little monitoring of compliance by employees.
Management is relatively conservative in terms of accounting principles and
practices, but employee compensation packages depend largely on
performance. Usman Singh is the general manager of the electronics
division, which produces a variety of standardised parts for small appliances.
Usman has been the general manager for the past four years, and each year
he has been able to improve the profitability of the division. His
compensation is based largely on the division’s profitability. Much of the
improvement in profitability has come through aggressive cost cutting,
including a substantial reduction in control activities over inventory.
During the past year, a new competitor has entered the electronics division’s
markets and has offered substantial price reductions in an effort to obtain
market share. Usman has responded to the competitor’s actions by
matching the price cuts to try and maintain Festival’s market share. However,
Usman is very concerned, as he cannot see any other areas where costs
can be reduced so that the division’s growth and profitability can be
maintained. If profitability is not maintained, his salary and bonus will be
reduced.
Usman has decided that one way to make the division more profitable is to
manipulate inventory, because it represents a large amount of the division’s
statement of financial position. He also knows that controls over inventory
are weak. He views this inventory manipulation as a short-run solution to the
profit decline due to the competitor’s price cutting. Usman is certain that
once the competitor stops cutting prices, the misstatements in inventory can
be easily corrected.
REQUIRED
(a) Evaluate the strengths and weaknesses of Festival’s control
environment.
(a) Festival’s control environment has the following strengths:
• corporate management has high integrity
• Festival has an ethical code of conduct
• Festival hires very competent people
• management is conservative in its use of accounting principles and practices.
Festival’s control environment has the following weaknesses:
• divisions operate autonomously with limited monitoring (management intervenes only when
planned results are not obtained)
• the board of directors and audit committee are not very active
• there is limited monitoring of employee compliance with the corporate code of conduct.
(b) What factors have led to and facilitated Usman’s manipulation of
inventory? LO 7.3
(b) The following factors led to and facilitated Usman’s manipulation of inventory:
• As general manager, Usman has a strong incentive to ‘look good’. His division has had four years
of increasing profits, and his salary and bonus depend on the division’s performance
• competition in the industry is fierce, and sales prices are declining
• inventory represents a large portion of the statement of financial position, and controls over
inventory are weak
• there is limited monitoring by corporate management.

CHAPTER 8

8.1  Briefly explain the matters that an auditor may consider in determining the
extent of their tests of controls. LO 8.1
Matters that an auditor may consider in determining the extent of their tests of controls include:

 the frequency of the performance of the control by the entity during the period
 the length of time during the audit period that the auditor is relying on the operating effectiveness of the control
 the expected rate of deviation from a control
 the relevance and reliability of the audit evidence to be obtained regarding the operating effectiveness of the
control at the assertion level
 the extent to which audit evidence is obtained from tests of other controls related to the assertion.

8.5 Explain the factors that determine whether the auditor has obtained sufficient
appropriate audit evidence to support a control risk assessment. LO 8.3
There are a number of factors that will determine whether the auditor has obtained sufficient appropriate evidence to
support a particular control risk assessment. The auditor requires stronger evidence if the assessed level of control
risk is low rather than medium. If control risk is high, the auditor does not need to gather evidence to support this
assessment, as they do not intend to rely on controls. Rather, they will gather their evidence via substantive testing.
Other factors that the auditor considers in determining whether the tests of controls have yielded sufficient
appropriate evidence include the type and source of evidence, as some types of audit tests provide stronger evidence;
and the interrelationship with other evidence, which may point to the same or a different conclusion.

8.7  Explain three controls related to the accuracy assertion for sales and indicate
the tests of controls that the auditor would undertake to test the effectiveness of
these controls. LO 8.4
The following is a list of several possible controls related to the accuracy assertion for sales, together with
appropriate tests of those controls. Any three of the following are required to answer the question.

Test of control
Control
Client undertakes recalculation and comparison Select a sample of transactions from the sales journal (daily activity
of details (quantity, price and terms) to report) and review evidence that comparison with supporting
supporting documents (such as sales invoice documentation is undertaken and that prices are traced to approved
and shipping documents) price list, and extensions and additions are recalculated

Monthly statements are mailed to customers

Authorisation and independent follow-up are
undertaken of correspondence with customers
concerning disputed amounts
Supervisory review and approval of
summarisation and posting are undertaken
Observe mailing of monthly statements
Review evidence of follow-up of correspondence with customers
concerning disputed amounts
Inspect indication of supervisory review and approval of
summarisation and posting

Write-offs of uncollectible accounts and Inspect approval of write-offs of uncollectible and disputed
disputed amounts must be approved amounts

Test the techniques used to test specific programmed controls (e.g.

Programmed controls are in place for
undertake a test transaction of a sale = $10 001 and ensure that this
processing sales to identify unusual sales
is identified by the control in the program as an unusual sales
amounts (e.g. sales greater than $10 000)
amount)

8.9  List control procedures that typically relate to the occurrence assertion for a
purchase transaction. Identify the tests of controls that are usually performed for
this assertion. LO 8.5
Examples of controls related to the occurrence assertion for purchases, together with appropriate tests of controls
include the following:

Assertion Controls Tests of controls

Occurrenc  Purchase orders are
e approved
 Goods received are
counted, inspected and
compared to purchase
order before acceptance
 Purchase order,
receiving report and
supplier’s invoice are
compared before
recording liability
  Examine evidence of approved purchase orders
 Observe receiving procedures
 Select a sample of order entries in purchases journal, trace
back to vouchers and inspect supporting documentation
including receiving report, ensuring agreement of details
and indication of approval

8.11  What distinguishes contractual transactions from other major classes of

transactions? Explain the sort of controls that would be important for such
transactions and the way that the auditor would test these controls.
LO 8.6
Contractual transactions, such as for rent, lease and insurance payments, are characterised by the existence of a
formal contract specifying the details of the transaction. Therefore, the controls are not so much built around a flow
of transactions through the system, as they would be for other major classes of transactions, but are focused on
ensuring that the details of the individual contracts are appropriately captured and recorded. Often this makes the
audit easier, as inspecting an original copy of the contract provides audit evidence for many assertions, including
occurrence, accuracy, and rights and obligations.

8.16  MEDIUM New Release Ltd provides pay TV services across Australia. To
subscribe to New Release, customers call a hotline number, select the package they
require and provide a credit card number, to allow automatic payment of the
monthly fee. Approximately 600 new subscribers sign up each month.

There are no contracts and no payments accepted other than via credit card. There
is no hard-copy documentation generated in relation to the sale —hotline staff
enter the customer’s details directly into the computer, which then generates the
relevant journal entries and postings to the ledger.

From discussions with management you believe this system has not Page 355
changed since you tested it during last year’s audit, when you
placed a high level of reliance on the controls and found only one minor deviation.

REQUIRED

Assuming that you have decided it is appropriate to test internal controls over the
relevant transactions, provide a brief explanation of how the information provided
above would affect the nature, timing and extent of your tests of controls. LO 8.1
Nature
The lack of hard-copy documentation of sales makes it more likely CAATs will need to be used to check any
computerised controls (for example, automatic verification of credit card details, posting of sales to appropriate
accounts).

Timing

As the controls appear to be the same as those used in the previous year, the auditor has the option of relying on last
year’s evidence from tests of controls. In order to do this, however, the auditor must:

 confirm that no changes in controls have taken place (it may be necessary to select a small sample in order to do
this)
 test the operating effectiveness of the controls at least once every three years, with some controls being tested
each year. The controls tested this year should cover the current period (that is, 12 months).

Extent

The extent of tests has the potential to be significant, given that the related controls are likely to be performed
approximately 7200 times per year (600 new subscribers per month) and that a high level of reliance is likely to be
planned (the same as last year’s audit). However, the extent of the tests is likely to be reduced given the discussion
above regarding no changes in controls. If this is confirmed, then the extent of tests will be relatively low.

8.17 EASY EasyCut Ltd operates a sawmill located in Tasmania. EasyCut sources
its timber from a number of local growers and from its own plantations. Logs are
transported on large trucks that are weighed-in on the company’s weighbridge and
weighed-out after dropping their loads in the storage area. Logs are then debarked
and sawn to size in the cutting area of the mill. The logs are then sent to other areas
of the sawmill depending on what they will be used for.

Two documents are generated when the logs are received:

• a pre-numbered weighbridge ticket

• a pre-numbered goods received docket (one copy is provided to the truck driver
as the truck driver exits the mill). The goods received docket can only be signed
by the foreperson in charge.

The company’s chief financial officer (CFO), Ricky Myer, advises you that one
cubic metre of timber weighs approximately one tonne and that the cost price per
cubic metre to the mill varies according to the contract with each supplier. You
compare this to the information from an expert’s report obtained from the
permanent audit file and find that it is consistent.

REQUIRED
Outline three tests of controls that you would undertake on the effectiveness of
controls relating to the receipt of logs. LO 8.2
Possible tests of control include selecting periods at random and then:

 checking the integrity of the pre-numbering sequence of both the weighbridge tickets and the goods received
dockets (GRD) to ensure that they have all been accounted for
 comparing the net weight per the GRD with the weighbridge tickets (in and out)
 checking that the personnel signing the GRD are authorised to do so in accordance with the internal control
system and procedures.

8.22 MEDIUM You are the audit senior on the Gemstone Ltd audit for the year
ended 30 June 2018. Gemstone manufactures a wide range of jewellery. Orders are
received by the sales order department by mail, fax, email or via a sales
representative and are passed on to the credit manager for his review of the credit
limit and approval of the order. Once approved, orders are returned to the sales
order department where data-entry clerks key in the order via the terminals located
in that department.

Orders are subject to various computer edit checks when they are input at the
terminal. If orders satisfy all the computer edit criteria, a picking slip is

produced that lists the goods ordered. Orders that fail any of the computer edit
criteria are not accepted by the system. Rejected
orders are noted by the data-entry clerk and passed to the department’s supervisor
for investigation.

Picking slips are printed in the dispatch office and then forwarded to the warehouse
by the dispatch supervisor. A storeperson picks and assembles the orders. If goods
are not in stock the storeperson alters the picking slip quantity to reflect actual
goods picked. The storeperson then initials the picking slip prior to forwarding it
together with the goods to dispatch. The dispatch clerk agrees the picking slip to
physical goods picked, making adjustments for any stock-outs, before printing the
invoice, which is forwarded to the accounts department.

REQUIRED

Identify the key controls and determine an appropriate test of controls you would
employ for each control. LO 8.4
Key controls Tests of controls
Credit limits on orders are reviewed by the credit Select a sample of sales and ensure all sales are made to
manager for their approval authorised customers. Look for evidence of the credit
 manager’s approval
 Re-perform edit checks on a sample of sales orders to
Orders are subject to various computer edit checks see if automated control is working
when they are inputted on the terminal in the sales
 Using test data, submit a dummy invoice with errors
order department. Only those orders satisfying all
and see if it is rejected
edit criteria are accepted

Select a sample of rejected orders and check the investigation

or any follow-up edit checks made. Check that rejected orders
Rejected orders are noted by the data entry clerk and are marked ‘rejected’ and not included in sales without further
passed to the department’s supervisor for edit checks
investigation
Segregation of duties in receiving, entering,
checking and picking orders. Observe functions for receiving, entering, checking and
picking orders being performed.

8.24 MEDIUM While working on the audit of Cosmopolitan Ltd, you are
involved in a review of control activities in the cash disbursement area. As part of
your review, you have noted the following procedures:

1. All payments prepared by the clerk include a pre-numbered bank transfer

requisition.
2. The bank transfer requisition requires the clerk to confirm that they have
performed the following procedures for each payment:

• checked the additions and prices on the invoice

• confirmed the details on the invoice have been matched to a delivery note by
the warehousing department
• verified a valid purchase order exists for the goods.

3. The clerk forwards the bank transfer requisition together with any supporting
documentation (invoice and any other relevantcorrespondence) to the CFO for
approval.

REQUIRED

For each of the three controls identified above:

(a) Describe the purpose of the control—what is the control designed to prevent or
detect?

(b) Identify the account(s) and assertion(s) that this control will have an effect on
in the financial report.
(c) Give one example of a procedure that could be used to test the control. LO 8.5
1.  All payments prepared by the clerk include a pre-numbered bank transfer requisition:

(a)  to prevent and detect non-recording of payments

(b)  accounts payable (and related expense/asset) completeness—(ensure all payments are recorded)

(c)  sequence check to ensure that all pre-numbered bank transfer requisitions are accounted for.

2.  The bank transfer requisition requires the clerk to confirm that they have performed the following procedures for
each payment:

• checked the additions and prices on the invoice

• confirmed the details on the invoice have been matched to a delivery note by the warehousing department
• verified a valid purchase order exists for the goods

(a)  To prevent unauthorised access to company funds (fraud/theft) by ensuring payments are only made for goods
received and ordered by the company and are recorded for the proper amount.

(b)  Expense/asset—occurrence and accuracy in relation to the expense (is it a real transaction and is the amount
correct?) or existence and accuracy, valuation and allocation (do the assets purchased exist and have they been
recorded at the proper amount?)

(c)  Review a sample of bank transfer requisitions and ensure all procedures have been completed. Re-perform
checks for a sample of requisitions.

3  The clerk forwards the bank transfer requisition together with any supporting documentation (invoice and any
other relevant correspondence) to the CFO for approval:

(a)  to prevent unauthorised access to company funds (fraud/theft) by ensuring all payments are approved by a
suitable company official to prevent error in accounting entries and information posted as approver checks the
details also.

(b)  expense/asset—occurrence and accuracy in relation to the expense (is it a real transaction and is the amount
correct?), or existence and accuracy, valuation and allocation (do the assets purchased exist and have they been
recorded at the proper amount?)

(c) review a sample of bank transfer requisitions and ensure all contain evidence of authorisation.

8.25 MEDIUM Snowfields Pty Ltd operates a hotel in the New South Wales ski
fields, providing accommodation, bar and restaurant facilities for tourists. Casual
and part-time wages are a major expense item, particularly during winter, when up
to an additional 50 staff are employed.

In order to keep track of casual and part-time wages, Snowfields’ operations

manager, Betty Zhang, prepares a weekly roster (using Excel), showing:
• employee name

• position of employment (e.g. kitchen hand)

• days and hours rostered for the week

• hourly rate

• any additional amounts to be paid (e.g. meal allowances).

The immediate supervisor of each employee is required to sign a hard copy of the
Excel spreadsheet on a daily basis, as evidence that the hours were worked as
rostered. Any discrepancies (such as additional hours) are recorded on a separate
payroll adjustment form (PAF) and co-signed by the employee. The spreadsheet
plus any PAFs are forwarded to the payroll officer each Friday and used as the
basis for that week’s casual and part- time employee payroll. Last year, you tested
and placed reliance on controls over casual and part-time wages.

REQUIRED

Assume that you have decided it is appropriate to test internal controls over the
relevant transactions.

(a)  How would the information provided above affect the nature, timing and
extent of tests of controls in relation to casual and part-time wages?

(b)  Provide one test of control for accuracy and one test of control for occurrence
in relation to casual and part-time wages. LO 8.6
(a)  The information provided would affect the nature, timing and extent of tests of controls as follows:

Nature—Casual and part-time wages appear to be supported by a solid evidentiary trail, so it is likely the auditor
will select samples of employees and trace the related wages through the system, checking appropriate authorisation
of hours worked and so on.

Timing—Regarding the timing of tests, there is nothing to indicate that anything other than 12 months’ worth of
tests would be performed in the current period.

Extent—The extent of tests is affected by both the planned level of reliance and the expected rate of deviation. If
these are assessed as similar to last year then tests of control similar in extent to the previous year will be carried out.

(b)  Possible tests of control include selecting a sample of casual and part-time wages from throughout the year from
the payroll records and:
• agreeing hours worked per payroll to the manager’s weekly Excel roster and to payroll adjustment forms
(PAFs) where applicable (accuracy and occurrence)
• checking that the employee’s immediate supervisor has signed the Excel roster (occurrence)
• checking that any PAFs are signed by the employee’s immediate supervisor (accuracy)
• agreeing position of employment and hourly rate to personnel file (accuracy)
• checking calculations (accuracy).

CHAPTER 9

9.2  Explain the differences between substantive tests of transactions and

substantive tests of balances. LO 9.1
The difference between substantive tests of transactions and substantive tests of balances is explained in Global
Example 9.1 of the text. For example, the accounts receivable balance at the end of the year comprises a number of
transactions, sales and cash receipts from the perspective of the audit client. If the auditor undertakes testing of the
balance, which is the aggregate of a number of transactions (such as by a debtor’s confirmation), then they are
undertaking substantive testing of balances. If they test the dollar value of the individual transactions that make up
the balance, such as by vouching each individual transaction to supporting documentation, or vouching a sample of
those transactions, then they are undertaking substantive testing of transactions.

9.3 Explain the objective of cut-off testing, and indicate the classes of transactions
for which cut-off is typically tested. LO 9.2
The objective of cut-off tests is to obtain reasonable assurance that transactions around balance date have been
recorded in the proper accounting period. Cut-off is usually tested for sales, purchases, cash receipts and cash
disbursements, transactions which have a continuous flow and which need to be ascribed to an accounting period.
For example, for sales, the auditor would determine when the final sale was made for the accounting period of audit
interest. They would then determine that the sales before this date were recorded in the current accounting period,
and the sales after this date were recorded in the next accounting period.

9.4 Explain why the auditor sends a confirmation request to the bank when they
already have access to the client’s copy of the bank statement. LO 9.3
Evidence obtained directly from the bank is more reliable than a copy of the bank statement obtained from the
client, as the client has had the opportunity to manipulate the bank statement. Also, the bank confirmation will
provide other information besides the balance, such as other accounts held at the bank, securities held by the bank
and financial instruments.

9.7  Explain which assertion is the auditor’s primary concern in tests of balances
for liabilities. LO 9.6
The auditor’s primary concern in tests of balances for liabilities is normally the completeness assertion. The auditor
is most concerned about the possibility of unrecorded liabilities, because there is usually a greater risk of
understatement of liabilities than of overstatement. Understatement of liabilities is associated with an
understatement of related expenses, and therefore an overstatement of profit and owner’s equity. The most common
way of understating liabilities is not including them, leading to completeness being the major assertion at risk.
9.11 Identify three matters that the auditor usually considers in designing
substantive analytical procedures to test account balances in the income statement.
LO 9.9
When designing substantive analytical procedures to test income statement items the auditor will consider whether:

 the volume of transactions is sufficiently large for the procedure to be valid

 the transactions are sufficiently predictable over time for the procedure to be valid
 substantive analytical procedures on their own will be sufficient to reduce audit risk to an acceptably low
level.

9.16 MEDIUM Leeanne Harris is the director of Quick Clean Pty Ltd, a family
business that provides cleaning services. As Leeanne is interested in purchasing
some new cleaning equipment for her business, she has approached a bank for
finance. The bank has requested that Leeanne provide an audited financial report to
assist them in considering her loan request. Leeanne has approached your firm for
this service and you have been allocated the task of auditing Quick Clean for the
year ended 30 June 2018. You have undertaken a preliminary review of the
business and determined that a substantive testing approach would be appropriate.
You are now preparing an audit program for the revenue cycle.

The following information has been obtained from your review: Leeanne usually
works 60 hours a week. Part of this time is spent

travelling between clients and is not charged to the clients. The remaining time is
charged at $50 per hour, regardless of the task undertaken.

Customers typically pay Leeanne in cash for the work undertaken, except

for a small number of regular small-business customers. Leeanne allows these

customers to pay on account by bank transfer on a monthly basis.

Leeanne supplies each cash customer with a written receipt, prepared

manually from a receipt book purchased at the local newsagency. The book
contains pre-numbered blank receipts, which are completed in duplicate.

REQUIRED

For each of the assertions of accuracy, completeness and occurrence, identify a

procedure you could use to audit Quick Clean’s revenue. LO 9.2
The following is a list of possible substantive audit procedures for each assertion.
Accuracy

• Trace a sample of sales to the receipt book to ensure that details, in particular dollar amount, are recorded
correctly.

Completeness

 Undertake analytical procedures based on the average number of billable hours (this might detect non-recording
of revenue).
 Test a sample of receipts from the receipt book and ensure that all have been recorded (this will not detect
monies that Leeanne does not provide a receipt for).
 Check that all pre-numbered sales receipts are accounted for.

Occurrence

 Obtain written confirmation of services performed (as recorded in the receipt book and customer accounts).
 Undertake analytical procedures based on average number of billable hours (this might detect over-recording).
 Trace sales recorded in the accounts to the receipt book (however, this will not detect instances where Leeanne
has also completed a false receipt).

9.17 MEDIUM Digital Solutions Ltd is a large company involved in a number of

technology projects, including mobile networks and digital equipment.

Digital Solutions has created a number of subsidiaries to

concentrate on specific aspects of Digital Solutions’ activities. While
Digital Solutions and its subsidiaries each have an individual bank account, all of
the main banking activities of the group are undertaken through the bank account
of Digital Solutions. Jacinda Barker, the senior banking clerk of Digital Solutions,
maintains and monitors all of the accounts. Your preliminary discussions with
Jacinda indicate the following:

• The proceeds of the technology operations are deposited in the subsidiaries’

bank accounts.
• Digital Solutions pays all expenses of the group, including the costs of the
technology operations.
• Each subsidiary reimburses Digital Solutions on a quarterly basis for costs
associated with its activities and also pays it a management fee. Payments are
completed via a direct transfer between the bank accounts. The transfer is
authorised by the chief financial officer (CFO) of Digital Solutions and the
chief executive officer (CEO) of the relevant subsidiary.
• Jacinda’s responsibilities include preparing a schedule of transfers each quarter
and reconciling each of the bank accounts.

REQUIRED
(a)  Explain which assertions are most likely to be assessed as high risk for
material misstatement for the cash balances of Digital Solutions and its
subsidiaries.

(b)  Outline three substantive audit procedures that may be used to test whether
these risks will result in a material misstatement and indicate the assertion
addressed. LO 9.3
(a) High-risk assertions

 Rights and obligations: Owing to the transfer arrangement there might be some concern as to who has
ownership of the funds within the bank accounts of Digital Solutions and its subsidiaries.
 Existence: It is not uncommon in complex transfer arrangements for cash to be accounted for twice (i.e.
once in the transferee account as an outstanding deposit, and once in the transferor account, not shown as
withdrawn until the next day, as money that they have custody of). This can lead to an overstatement of the
bank balance through this practice, which is known as kiting.
 Cut-off: Owing to movement of funds around year-end, cut-off is likely to be of concern.

(b) Procedures to test whether these risks will result in a material misstatement

 Rights and obligations: Review the terms of the transfer arrangement to determine at which point the
funds are considered to be ‘owned’ by the transferee/transferor.
 Existence: Review the bank reconciliation and ensure all outstanding deposits are received within a
reasonable period after year-end.

• Cut-off: Review the transfer schedule, together with bank statements and bank reconciliations, to ensure that all
transfers between bank accounts are accounted for in the same period for the transferor and the transferee.

9.18 EASY You are auditing the financial report of Top Dog Pty Ltd for the year
ended 30 June 2018. You have concluded that your team cannot rely on the
internal controls of Top Dog and that the existence of accounts receivable is at risk.

REQUIRED

(a)  Identify the procedure you could use to test the existence assertion for
accounts receivable.

(b)  How would your answer change, if at all, if it was established that the internal
controls of Top Dog were operating effectively? LO 9.4
(a) In order to test that accounts receivables are genuine obligations owed by customers at the balance date (i.e. that
accounts receivable exist), the auditor could:

 confirm accounts receivable from customers in writing

 verify whether the amount in outstanding receivables is subsequently received, and/or
 test from subsidiary ledger to supporting documentation of sale (i.e. invoice or signed delivery note).
(b) The answer to (a) above would be unlikely to change if the existence of accounts receivable is still at risk. What
may change is that the auditor may identify controls that would help to reduce the risk of material misstatement for
these assertions. The auditor may then test those controls and reduce the extent of the substantive testing procedures
outlined, if this is then determined to be a more effective and efficient way of gathering audit evidence to reduce the
risk of material misstatement to an acceptable level.

9.21

MEDIUM You are a senior on the audit for the year ended 30 June 2018 of Office
Supplies Ltd, a Perth-based manufacturer of customised office furniture. You are
carrying out audit checks on cut-off at year end. Office Supplies maintains details
of stock quantities on its computer and these stock quantities are updated from
goods received notes and sales invoices. Office Supplies conducts a ‘wall-to-wall’
count of inventory when all operations cease at 30 June, and all inventory is
counted in a single stocktake. The bulk of inventory is held in two adjoining
warehouses owned by Office Supplies. However, a material amount of special desk
fittings is held in a separate warehouse in a different suburb by a third party.

During the planning stage of the audit, you have discovered that the following
potential misstatements may occur or exist:

• Obsolete and damaged furniture fittings may be overlooked in the warehouse.

• Some empty containers may have been included in the inventory count due to
poor labelling procedures.

• The lower of cost or net realisable value method may have been incorrectly
applied.

Based on your audit procedures completed during the planning stage, you have
concluded that there are no relevant control activities that could prevent these
potential misstatements from occurring.

REQUIRED

(a)  Outline one substantive test of detail that will substantiate each of the potential
misstatements.

(b)  For each substantive test of detail that you outlined in (a), indicate the
assertion at risk. LO 9.5
Potential misstatement (a) Substantive test of detail (b) Assertion at risk
Obsolete and damaged furniture Select a sample from inventory records and Accuracy, valuation and
fittings may be overlooked in the
warehouse
Some empty containers may have
been included in the inventory
count, due to poor labelling
procedures
The lower of cost or net realisable
value may have been incorrectly
applied
match to physical inventory, looking for
allocation
obsolete or damaged furniture components
Select a sample from the inventory records
and match to physical inventory, looking for Existence
empty containers in the sample count
Check subsequent sales prices and compare
Accuracy, valuation and
with cost to ascertain whether the correct
allocation
valuation method has been applied

9.24 MEDIUM Asian Foods Ltd has been operating for a number of years as a
producer of canned vegetables. Asian Foods imports most of its vegetables from
Thailand and Vietnam. All overseas shipments to
Asian Foods are invoiced and require settlement in US dollars. Furthermore, Asian
Foods is required to pay for freight and insurance costs. The insurance covers the
period from the day the goods are loaded onto the ship (i.e. Asian Foods assumes
ownership of the goods on the day the goods are loaded onto ships in the various
Asian ports from where the produce is shipped) until the day they arrive in Asian
Foods’ warehouses in Australia. All shipments arrive in Australia within a 21-day
period after loading onto a ship. All overseas suppliers are settled 30 days after the
date of shipment.

Overseas suppliers now represent 70 per cent of accounts payable. Local and
overseas suppliers are maintained in separate subsidiary ledgers within the
accounting system.

The audit partner has identified that accounts payable is at risk of material
misstatement.

REQUIRED

(a) Outline two key reasons why accounts payable is at risk of material
misstatement.

(b) For each key reason outlined in (a), identify and explain the assertion most at
risk.

(c) For each assertion at risk outlined in (b), describe one substantive

test of detail that is specifically responsive to the risk of material

misstatement. LO 9.6
(a) Reason
(b) Assertion
accounts payable Explanation (c) Substantive test of detail
most at risk
is at risk
A large portion of Select a sample of overseas accounts
Foreign accounts payable are
accounts payable is payable from the overseas accounts
Accuracy, required to be translated at the
represented by payable ledger and check that the
valuation and closing exchange rate at balance
overseas accounts liability in foreign currency has been
allocation date, leading to the risk of error in
payable paid in translated using the closing exchange rate
using an incorrect rate
foreign currency at balance date
Select a sample of supplier
invoices/shipping documents in respect
of shipments received after balance date
and determine when the goods were
Asian Foods takes ownership of loaded. If they were loaded prior to
overseas shipments upon their balance date, ensure that they have been
Asian Foods accepts being loaded onto the ship. recorded in accounts payable at balance
liability for goods Accordingly, there is a risk that date.
Completeness
upon the goods being shipments loaded prior to balance
loaded onto the ship date and received thereafter may Select a sample of supplier payments
not have been recorded as a made after balance date and check
liability at balance date. against relevant supplier
invoicing/shipping documents. If the
goods were loaded before balance date,
ensure that they have been recorded in
accounts payable at balance date.

CHAPTER 11

11.1  Explain why the auditor’s report cannot be dated before the directors’
declaration. LO 11.1
According to ASA 560.A3 (ISA 560.A3), the auditor’s report cannot be dated earlier than the date on which the
auditor has obtained sufficient appropriate audit evidence on which to base the opinion on the financial report,
including that those with the recognised authority have asserted that they have taken responsibility for that financial
report. As a result, the date of the auditor’s report cannot be earlier than the date of approval of the financial report
by those charged with governance.

11.3  How does an auditor distinguish between an adjusting event and a non-
adjusting event? LO 11.2
Adjusting events provide evidence of, or further elucidate, conditions that existed at balance date. Therefore, if
material, they require adjustment to the figures contained in the financial report.

Non-adjusting events are events that create new conditions, as distinct from any that may have existed at balance
date. Therefore, if material, they need to be disclosed in the financial report.
11.4  List three audit procedures an auditor might use to obtain sufficient
appropriate audit evidence that all events up to the date of the auditor’s report that
may require adjustment of (or disclosure in) the financial report have been
identified. LO 11.2
According to ASA 560.7 (ISA 560.7), the following procedure shall be carried out to identify relevant subsequent
events.

(a) Obtain an understanding of any procedures management has established to ensure that subsequent events are
identified.

(b) Enquire of management and, where appropriate, those charged with governance, as to whether any subsequent
events have occurred that might affect the financial report.

(c) Read minutes, if any, of the meetings, of the entity’s owners, management and those charged with governance,
that have been held after the date of the financial report, and enquire about matters discussed at any such meetings
for which minutes are not yet available.

(d) Read the entity’s latest subsequent interim financial report, if any.

11.6  Identify audit procedures that are performed with respect to an entity’s risk of
litigation and related matters. LO 11.3
The audit procedures that are performed with respect to an entity’s risk of litigation and related matters include:

 reviewing and discussing with management the entity’s internal control for bringing claims to the attention of
management and the arrangement for instructing solicitors, as well as the system for recording legal expenses
for control and identification
 obtaining from management a list of legal matters referred to solicitors, including a description of the matter
and an estimate of possible liabilities
 reading the minutes of meetings of shareholders or directors and reading contracts and correspondence
 reading the minutes of management meetings where they refer to legal matters
 reviewing documents in management’s possession concerning legal matters, correspondence with solicitors and
accounts rendered by third-party solicitors
 obtaining a solicitor’s representation letter.

11.13  Give three audit procedures that an auditor will typically undertake once an
event has been identified that places the going concern assumption at risk. LO 11.5
According to ASA 570.16 (ISA 570.16), procedures that shall be carried out if events or conditions have been
identified that cast significant doubt on an entity’s ability to continue as a going concern include:

 where management has not yet performed an assessment of the entity’s ability to continue as a going concern,
requesting that management make its assessment
 evaluating management’s plans for future actions in relation to its going concern assessment, whether the
outcome of these plans is likely to improve the situation and whether management’s plans are feasible in the
circumstances
 where the entity has prepared a cash flow forecast, and analysis of the forecast is a significant factor in
considering the future outcome of events or conditions in the evaluation of management’s plans for future
action:
(i) evaluating the reliability of the underlying data generated to prepare the forecast, and

(ii) determining whether there is adequate support for the assumptions underlying the forecast

• considering whether any additional facts or information have become available since the date on which
management made its assessment

• requesting written representations from management and, where appropriate, those charged with governance,
regarding their plans for future action and the feasibility of these plans.

11.18

HARD You are the audit partner on the audit of Australian Water Purification Limited
(AWP) for the year ended 30 June 2018. AWP designs and constructs water purification
plants and equipment to convert sewage into drinking water.

In December 2017, AWP acquired a 100 per cent shareholding in Crystal Lake Water Ltd
(CLW), one of the largest producers and distributors of bottled mineral water in
Australia, with contracts with all the major supermarket chains and liquor stores in
Australia.

It is now late August 2018 and, while finalising the audit for AWP and its newly
purchased subsidiary, CLW, you come across the following information before signing
the auditor’s report:

1. The standard customer contract contains a clause allowing cancellation if CLW’s

ownership changes within a specified period (expiring August 2018). A few of
CLW’s major customer contracts (representing approximately 30 per cent of the
company’s revenue for the last year) have been cancelled since year end.
2. Heavy rain and subsequent floods during late July 2018 have seeped into the
underground water table in western Victoria and contaminated one of the major
sources of CLW’s mineral water supply. This will cut CLW’s production by
almost 50 per cent for the next three to four months unless an alternative supply
is established.

For each situation above, you have no concerns other than those described, and going
concern is not an issue.

REQUIRED

Considering each situation independently, explain the impact, if any, of the item on the
consolidated financial report for the year ended 30 June 2018. LO 11.2

Ite (b) Justification

 (a) Impact
m

This is an event that provides evidence The financial report will need to be adjusted, as this is a potential
of conditions that existed at the significant impairment of goodwill relative to the purchase of CLW
reporting date. Given that it represents regarding the terms of the contract and the conditions existing at the
(i) 30% of customer contracts, it is time of purchase.
material.
As the purchase happened during the financial year, the conditions
were in existence at the reporting date and so it is an adjusting event.
This is an event that is indicative of
conditions that arose after the The event may have a significant impact on future revenue and the
reporting date. As such, the value of CLW and its goodwill. As the conditions arose after the
reporting date (i.e. the flood happened in late July and the reporting
(ii) contamination will have to be
disclosed in the financial report. date is 30 June) and the event is material (the flood cut CLW’s mineral
water supply by 50%), disclosure in the financial report is needed, as it
is a non-adjusting event.

11.29 HARD You are currently auditing Purple Pty Ltd, a subsidiary of Fawn Ltd. Purple
is an internet service provider that provides free internet access to its subscribers. In
return, subscribers agree to provide their name, address and other details to Purple for the
purpose of on-selling this information to various marketing firms. When Purple was
established two years ago, its business plan stated that it would need 30 000 subscribers
in order to break even. Purple has experienced demand far in excess of this break- even
point, but unfortunately, due to technological problems, it can only provide services to 21
000 subscribers at the present time. This has reduced the price that third parties are
prepared to pay for subscriber information, as they need a certain volume of each type of
consumer (for example, males aged 25–35 earning more than $70 000 p.a.) to make their
marketing efforts worthwhile. Purple is the third-largest of seven ‘free- access’ providers
in the industry. The two biggest providers are each approximately 30 per cent larger than
Purple, and both are seeking to rapidly expand their customer base. Over the past few
months, Purple has been negotiating to buy the business of one of its smaller rivals,
FastNet Pty Ltd. This would give Purple access to more subscribers and, more critically,
access to FastNet’s software, which has the capacity to support another 45 000 users.

In response to the concerns of Purple’s directors regarding its financial situation, Fawn
has agreed to become a ‘lender of last resort’ should Purple need urgent financial
assistance. However, Fawn’s management has made it clear that this assistance will only
be provided if Purple is in serious danger of becoming insolvent.

Purple’s directors are all young ‘whiz kids’ with backgrounds in the computer and
technology industries. Each has an equity share in the business. Recently the board split
into two distinct factions, and relations among the board members are now less than
harmonious. The CFO has expressed concern that key business decisions are being
delayed because the board is not focused on the business. Unresolved issues include a
proposed additional capital injection from each of Purple’s directors to see the company
through its present difficulties.

REQUIRED

(a)  List the factors that indicate that Purple may have a going concern problem. For each
factor, identify and discuss any related mitigating factors.

(b)  Outline the key additional information you would need to obtain before reaching a
conclusion on Purple’s going concern status. LO 11.5

(a)

Going concern indicators Mitigating factors

 The possible purchase of FastNet may provide the

services needed to expand the customer base.
 Purple can only provide service to 21 000
 Purple has plenty of potential subscribers wanting
subscribers, but it needs 30 000 to break even.
the service, so once the software problems are
 Third parties are paying less for subscriber
resolved the business should reach break-even
information, due to the lower-than-expected
point and profitability fairly quickly.
volume of subscribers.
 Fawn has agreed to become a ‘lender of last
resort’ if Purple is in danger of insolvency

 Being the third-largest producer in the industry

may make Purple’s position vulnerable if the
two larger competitors reduce their prices to try
and obtain Purple’s client base. • Purple may become more competitive and be able to
 In addition, Purple may be vulnerable to a reduce prices if it takes over FastNet.
takeover, given that the two larger competitors
both wish to expand rapidly.

 The board of directors is made up of people with

strong backgrounds in the industry.
 Board members all hold equity in the business
• Board members are in dispute with each other at a
and so have a vested interest in seeing it succeed.
crucial time in the company’s operations.
 The board is considering an additional capital
contribution, which would see Purple out of its
current difficulties.

(b) Key additional information includes:

 written confirmation from Fawn as to the amount, terms and conditions of the ‘emergency’ funding it has
agreed to provide
  Fawn’s financial strength and ability to actually provide the funding
 signed agreement with FastNet regarding purchase, including terms, price, timeline and how it will be
funded (if the deal goes ahead)
 details of how Purple plans to increase the volume of subscribers if the FastNet purchase falls through,
given the software problems it is experiencing
 current contracts with third parties regarding sale of information, to ensure that prices paid are sustainable
and also to ascertain whether Purple has lost any major contracts to other providers
 details of the proposed injection of capital funding (if it goes ahead), including amounts, terms and timing
 general market information about the internet service provider industry (for example, whether demand is
likely to rise or whether consumers are looking for other ways to satisfy their internet needs).

CHAPTER 12

12.1  Provide details of the matters that the auditor of a company is required to
report to the Australian Securities and Investments Commission
(ASIC). LO 12.1
Section 311 of the Corporations Act 2001 requires the auditor to report immediately in writing to ASIC where the
auditor has reasonable grounds to suspect that there has been a significant contravention of the provisions of the
Corporations Act 2001. Further, for all other contraventions, the auditor must report to ASIC if the auditor believes
that the matter will not be adequately dealt with by comment in the auditor’s report or notifying the directors.

12.2  Listten mandatory elements of the auditor’s report required when an audit for
a listed entity has been conducted in accordance with Australian auditing
standards. LO 12.2
According to ASA 700.21–42 (ISA 700.21–42), an auditor’s report shall include:

 title
 addressee
 auditor’s opinion
 basis for opinion
 going concern, where applicable
 key audit matters
 other information
 responsibilities for the financial report
 auditor’s responsibilities for the audit of the financial report
 other reporting responsibilities
 name of the engagement partner
 signature of the auditor
 date of the auditor’s report
 auditor’s address.

12.4 Outline four items that you would consider when evaluating whether a
financial report gives a true and fair view (or presents fairly in all material
respects) in accordance with the specific requirements of the applicable financial
reporting framework. LO 12.3
According to ASA 700.13 (ISA 700.13), the auditor must evaluate, based on the applicable financial reporting
framework, whether:

 the financial report adequately discloses the significant accounting policies selected and applied
 the accounting policies selected and applied are consistent with the applicable financial reporting
framework and are appropriate
 the accounting estimates made by management are reasonable
 the information presented in the financial report is relevant, reliable, comparable and understandable
 the financial report provides adequate disclosures to enable the intended users to understand the effect of
material transactions and events on the information conveyed in the financial report
 the terminology used in the financial report, including the title of each financial statement, is appropriate.

12.6 Discussthe three basic types of modifications that can be made to the auditor’s
opinion, and outline the circumstances under which each might be issued. LO 12.4
The three basic types of modifications that can be made to the auditor’s opinion are:

1. (a)  A disclaimer of opinion, which is issued when the auditor has been unable to obtain sufficient
appropriate audit evidence (scope limitation) to form an opinion on the financial report taken as a whole
(that is, the uncertainties are both material and pervasive to the financial report as a whole).
2. (b)  An adverse opinion, which is issued when the effect of disagreement with management is both material
and pervasive to the financial report as a whole.
3. (c)  A qualified opinion, which is issued when the auditor concludes that an unmodified opinion is
inappropriate because of a disagreement with those charged with governance or an inability to obtain
sufficient appropriate audit evidence (scope limitation) that is material, but not pervasive, to the financial
report as a whole.

12.12 What are the auditor’s responsibilities with respect to comparative

information contained in the financial report? LO 12.6
According to ASA 710.7 (ISA 710.7), the auditor shall determine whether the financial report includes the
comparative information required by the applicable financial reporting framework and whether such information is
appropriately classified. For this purpose, the auditor shall evaluate whether:

 the comparative information agrees with the amounts and other disclosures presented in the prior period or,
when appropriate, have been restated
 the accounting policies reflected in the comparative information are consistent with those applied in the
current period or, if there have been changes in accounting policies, whether those changes have been
properly accounted for and adequately presented and disclosed.

12.19 EASY You are the auditor of Bricks & Mortar Ltd (BML) for the year ended
30 June 2018. You have identified a material misstatement of the property, plant
and equipment account. BML has not changed its depreciation rates for the past
four years. However, recent technological changes in the industry have convinced
you that the useful lives of BML’s assets need to be adjusted downwards, resulting
in an increased depreciation charge. BML’s directors have refused to make any
change to the depreciation rates, despite you explaining that this will put them in
breach of the requirements regarding impairment tests contained in Australian
accounting standards.

REQUIRED

Explain the auditor’s opinion you would issue for BML for the year ended 30 June
2018. LO 12.4
The impact of the situation on the auditor’s opinion is as follows:

 There is a disagreement with management regarding the application of an accounting standard.

 A qualified opinion should be issued as the disagreement is material, but not pervasive, as it affects only
property, plant and equipment. The auditor’s opinion should cite the accounting standard and quantify the
financial effects of the disagreement.

12.22 MEDIUM You are auditing Indian Imports Ltd for the year ended 30 June
2018. The company is incorporated in Australia and imports a variety of products
from India. A significant proportion (15 per cent) of Indian Imports’ assets,
including warehouses and inventory, are located in New Delhi. In previous years,
an accountant in New Delhi has inspected these warehouses and inventory on your
behalf. Unfortunately this year, due to recent economic and social turmoil, you
have been unable to obtain assistance from the New Delhi accountant. The chief
executive officer (CEO) of Indian Imports has assured you that the company will
be able to continue as a going concern, as it is currently obtaining new suppliers
and its existing customers and suppliers have expressed a desire to continue trading
with the company. However, your audit procedures have not revealed any firm
commitments from suppliers, customers or financiers, and you have doubts about
the ability of the entity to continue as a going concern. The directors of Indian
Imports have agreed to make disclosures indicating the extent of the problems they
are facing. After reviewing the information, you are satisfied that the disclosures
are adequate.

REQUIRED

Explain the most appropriate auditor’s opinion for Indian Imports for the year
ended 30 June 2018. LO 12.4
There are two issues here. The first issue is an inability to obtain sufficient appropriate audit evidence (scope
limitation) as the auditor is unable to verify the existence of 15% of the company’s assets. This will result in a
qualified opinion as the amount is material, but does not seem to be pervasive.

The second issue is the existence of an inherent uncertainty concerning the ability of the entity to continue as a
going concern. On the basis of the information contained in the question, especially the conclusion of the auditor
that the disclosures made with regards going concern are adequate (implying that the auditor has been satisfied that
it is not improbable that Indian Imports would continue as a going concern, even though there is significant
uncertainty), the auditor’s report should also include a paragraph under the heading ‘Material Uncertainty Related to
Going

Concern’, drawing attention to the disclosures related to the ability of the entity to continue as a going concern.

12.23 You are the audit partner at Preston & Associates, a mid-tier audit firm. You
are responsible for the audits of the following three independent entities for the
year ended 30 June 2018:

(a)  Helping Hand Ltd is a non-profit entity. You have discovered that it has not
kept substantiating vouchers or receipts for more than 65 per cent of its expenses,
excluding salaries and allowances.

(b)  Skyscraper Ltd is a building contractor with a varying workload. In order to

compensate for the irregularity of its contracted building projects, Skyscraper also
purchases large vacant blocks of land that it later subdivides for the construction of
houses and units. Skyscraper then sells these on its own account. Your analysis
strongly suggests that the apportionment of costs to houses and units sold has been
kept low in order to boost profits. In your opinion, this has resulted in the
overvaluation of the unsold properties. The directors of the company do not agree,
and hold to their view that the stock of properties is correctly valued.

(c)  Big Event Ltd arranges for popular overseas entertainment artists to perform in
Australia. The band Eclipse was booked by Big Event to play in major cities across
the country. Big Event’s written contract required the company to pay the band in
US dollars but, in order to reduce costs, it did not hedge the amounts. Subsequent
to year end, the Australian dollar fell against the US dollar and a substantial loss
relating to the band’s tour was predicted. The management of Big Event tried
unsuccessfully to renegotiate the band’s contract and has been unable to obtain
finance to cover the expected shortfall. Big Event has now cancelled the tour and
expects a substantial claim from Eclipse. It is clear to you, as the auditor, that Big
Event does not have the income, cash or other assets to sustain such a loss.

REQUIRED

Assuming that all amounts involved are material, identify and discuss the most
likely auditor’s opinion that you would issue on each financial report for the year
ending 30 June 2018. LO 12.4
Situatio Auditor’s
Justification
n opinion
 Helping Hand has placed a scope limitation on the audit by not having a majority of non-
salary/allowance vouchers available as evidence of expenses. Therefore, there is an
inability to obtain sufficient appropriate audit evidence. The most likely auditor’s opinion
(a) Disclaimer
is a disclaimer, as the impact of not being able to verify 65% of non-salary/allowance
expenses is likely to affect the usefulness of the financial report as a whole and so be
considered pervasive.
Qualified The situation has led to a disagreement with management, resulting in the financial report
being materially misstated. The most likely auditor’s opinion is a qualified auditor’s
(b)
opinion, as the extent of the disagreement is not so pervasive as to render the financial
report as a whole misleading, as it relates only to the valuation of the properties.
Big Event does not have the income, cash or other assets to sustain such a loss. Therefore,
it is unable to continue as a going concern.
(c) Adverse
As Big Event has prepared its financial report on a going concern basis when, in fact, it
should be prepared on a liquidation basis, the auditor is likely to render an adverse opinion,
as the financial report as a whole is likely to be misleading.

12.25  MEDIUM You have completed the audit of Cruiser Ltd for the year ended
30 June 2018. You experienced a number of difficulties during the audit, including
significant disagreements over the valuation of Cruiser’s investment property
holdings. The audit partner had suggested that the property value was overstated by
$8 million, a figure which was twice the level of materiality of $4 million set for
the audit. As a result of discussions with the audit committee, the CEO of Cruiser
agreed to revise the valuations downward by $5 million. All other issues were
resolved to the satisfaction of the audit partner, resulting in an overall misstatement
in the financial report of $3 million. The audit partner is now considering the effect
of this misstatement on the auditor’s report.

REQUIRED

Explain the effect of the misstatement on the auditor’s report for Cruiser for the
year ended 30 June 2018. LO 12.5
The difference noted ($3 million) is now below the quantitative materiality level set for the audit ($4 million) and,
provided there are no qualitative reasons for adjustment (for example, related party transactions), the financial report
is no longer materially misstated, and as such a modified auditor’s opinion is not necessary. It should be noted
however, that the auditor should be concerned about negotiated adjustments that take the effect of misstatement just
below the materiality level set for the audit.