This Study Resource Was: 3102afe Auditing

3102AFE AUDITING
Suggested Solutions Workshop 5

___________________________________________________________________________
5.4 Explain why an auditor needs to understand the client’s business. LO 5.3
The auditor needs to have knowledge of the client’s business to enable them to obtain an
understanding of the events, transactions and practices that in their judgment might
have a significant effect on the financial report. Understanding the business and using
this knowledge appropriately assists the auditor in assessing risks and identifying
problems; planning and performing the audit effectively and efficiently; evaluating
audit evidence; and providing better service to the client.
The audit judgments facilitated by knowledge of the client’s business include:
m
 identifying accounting or auditing matters that need special attention
er as
co
 assessing the conditions under which accounting data are prepared
eH w
o.
 evaluating rs ethe reasonableness of management’s estimates and other
representations
ou urc
 making judgments about management’s selection and application of accounting
o
principles.
aC s
5.5 List five aspects of the entity and its environment that an auditor should
v i y re
understand, in accordance with ASA 315 (ISA 315). LO 5.3
As per ASA 315.11 (ISA 315.11), the auditor’s understanding of the entity and its
ed d
environment consists of an understanding of:

ar stu
 industry, regulatory and other external factors, including the applicable financial
reporting framework
sh is
Th
 the nature of the entity
 the entity’s selection and application of accounting policies
 the entity’s objectives and strategies, and those related business risks that may
result in risks of material misstatement
 the measurement and review of the entity’s financial performance.
5.7 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
1
This study source was downloaded by 100000828198589 from CourseHero.com on 07-23-2021 04:49:13 GMT -05:00
https://www.coursehero.com/file/57038734/3102W5Suggested-Solutionsdocx/
3102AFE AUDITING
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)
m
 expansion of the business (a potential related business risk might be, for example,
er as
that the demand has not been accurately estimated)
co
eH w
 new accounting requirements (a potential related business risk might be, for
o.
rs e
example, incomplete or improper implementation, or increased costs)
ou urc
 regulatory requirements (a potential related business risk might be, for example,
that there is increased legal exposure)
o
aC s
 current and prospective financing requirements (a potential related business risk

v i y re
might be, for example, the loss of financing due to the entity’s inability to meet
requirements)
ed d
 use of IT (a potential related business risk might be, for example, that systems
ar stu
and processes are incompatible)
 the effects of implementing a strategy, particularly any effects that will lead to
sh is
new accounting requirements (a potential related business risk might be, for
Th
example, incomplete or improper implementation).
5.12 Describe the purpose of performing analytical procedures at the planning stage of
an audit. LO 5.7
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
2
3102AFE AUDITING
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.
m
er as
co
eH w
o.
rs e
ou urc
o
aC s
v i y re
ed d
ar stu
sh is
Th
3
3102AFE AUDITING
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
m
experiencing difficulties with two of its major suppliers, McGregor’s Spirits Ltd
er as
and Old Vine Wines Ltd, who have reduced their payment terms from 60 to 30
co
eH w
days.
o.
rs e
REQUIRED Identify and explain three business risks that may lead to the risk of
ou urc
material misstatement in the financial report of Whisky & Wine for the year
ended 30 June 2018. LO 5.4
o
(a) Business risk (b)How it might lead to risk of

aC s
v i y re
material misstatement
Pressure from larger, aggressive competitors Inventory may be overstated, as
goods may be being sold below
ed d
cost, requiring a write-down to net

ar stu
realisable value
Significant reduction in gross margins has resulted Going concern may be affected due
sh is
in a movement away from its core business to new to reduced margins

Th
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 with two Going concern may be affected due
major suppliers reducing their credit limits. This to tighter terms of trade putting
may create liquidity problems and also may pressure on liquidity
indicate the supplier’s concern about Whisky &
4
3102AFE AUDITING
Wines
5.23 (Medium) Assume that you are responsible for preparing an audit plan in each of
the following three independent situations:
(a) Management of your client Precision Components Ltd informs you that during the
year the internal auditors discovered that a substantial amount of inventory had
disappeared from one of its small branches. A number of local managers have
subsequently resigned, although there were no prosecutions. The losses amounted
to 3 per cent of the company’s operating profit.
(b) A new competitor of your client Perspex Barriers Ltd entered the market two
months before balance date, and since that time, selling prices have fallen
m
er as
significantly. Your enquiries have revealed that the industry expects heavy
co
eH w
discounting to continue for the whole of next
o.
(c) Your client Formidable Ltd established an internal audit department in the second
rs e
ou urc
quarter of the year, consisting of four staff. The chief internal auditor is a former
Big Four audit manager with 15 years experience in the profession. He reports
o
directly to the managing director, and he has no internal audit experience. Since
aC s
joining the firm he has spent most of his time examining the internal control
v i y re
systems of the company. He is assisted by two new graduates and another staff
member who has two years internal audit experience and is presently in her third
ed d
year of a part-time commerce degree.

ar stu
REQUIRED How would the information provided in each case affect your audit
strategy? Provide a brief explanation for each situation. LO 5.5
sh is
(a) You will need to check on the internal auditor’s assessment of the total loss and
Th
check whether it is isolated to this branch. The materiality of the losses will need
to be considered (However, if the internal auditor’s assessment is reasonable and
it is isolated to this branch, it appears likely that the amount is not material.)
You will also need to consider whether the stock disappearance was the result of a
weakness in internal control. If so, you will need to reconsider your prior
evaluations of internal control and whether you need to change to a substantive
approach to the audit.
5
3102AFE AUDITING
(b) As the competition caused selling prices to fall prior to balance date, this may
cause the net realisable value of the stock on hand at year-end to be less than cost.
As a result, testing will need to concentrate on selling prices at and after balance
date to verify the accuracy, valuation and allocation of inventory.
The impact of reduced selling prices on cash flow and going concern will also
need to be considered.
(c) There is a need to determine the reliance that can be placed on the work of the
internal auditor. As the internal auditor was only appointed in the second half of
the year, this reliance is likely to be limited. Further, the auditor would need to
evaluate the internal audit function considering its objectivity, competence and
application of due professional care. The fact that internal audit reports to the
m
er as
CEO casts doubt on its objectivity and therefore the extent of reliance that can be
co
placed on it.
eH w
o.
5.26 (Medium) You are the audit senior on the audit for the year ended 30 June 2018 of
rs e
Gleam Pty Ltd, a large manufacturer of lighting accessories. This is the first year
ou urc
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
o
aC s
procedures on the annualised figures and compared the results to industry

v i y re
averages and last year’s audited financial information. The results are given
below.
ed d
ar stu
sh is
Th
6
3102AFE AUDITING
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
Current
1 ratio The current ratio is lower than the
industry’s and is following the same
This ratio indicates the net working capital
downward trend. Given a benchmark
position of the entity. Therefore, it
of 2, the current level does not
indicates the entity’s ability to meet its
indicate cause for immediate
current obligations (that is, its short-term
concern; however, it needs to be
liquidity). A benchmark figure of 2 is
monitored to ensure that it doesn’t
generally accepted as a minimum
m
er as
requirement. deteriorate further.
co
Enquire of management as to their
eH w
Current assets
procedures for managing working
o.
Current ratio rs e
Current capital, and review current and
=
ou urc
liabilities projected cash flows for future
liquidity problems.
o
Net
2 profit ratio Ratio is lower than that of the industry and,
aC s
like the industry ratio, has increased

v i y re
This ratio shows the amount of net income slightly over last year’s.
generated for each dollar of sales.
Need to investigate the reason for the ratio
Net profit
Net profit ratio = being below industry figures, and
ed d
Net sales whether this generates enough cash

ar stu
to comfortably continue operations.

It is also inconsistent with ROTA,
sh is
which indicates that Gleam is

performing better than others in the
Th
industry.
Gross
3 margin Gross profit ratio is equal to that of the
industry, although the trends are in
This indicates the amount of gross profit each
opposite directions. Need to
dollar of sales earns.
investigate why Gleam is able to
Gross profit
Gross profit ratio = increase its margins when others in the
Net sales industry are dropping their margins.
May indicate a problem with Gleam’s
cost of sales figure.
7
3102AFE AUDITING
Need to investigate why the gross profit

ratio is the same as the industry’s but
the net profit ratio is lower (this
might, for example, indicate higher
operating expenses).
Inventory
4 turnover ratio Inventory turnover is faster than that of the
This ratio shows the number of times inventory industry and is following the
turns over in a year. industry’s trend to slow slightly. The
fast turnover indicates good
COGS
Inventory turnover = inventory management practices.
Average inventory However, you may need to check
whether the faster turnover is
leading to any stock-outs, as this
m
er as
could have a detrimental effect on
co
future sales and market share.
eH w
Also need to investigate the reason for
o.
current deterioration, as a continuing
rs e
ou urc
decline might indicate obsolete stock
problems.
o
Receivables
5 turnover ratio Receivables turnover is faster than that of
aC s
the industry, indicating good working

This ratio shows the number of times
v i y re
capital management.
receivables turn over in a year.
However, the slowing trend of the ratio
Net credit sales
Debtors turnover = may need to be investigated and the
ed d
Average accounts receivable potential effect on the doubtful debts

ar stu
provision examined. For example, the

reason could be a relaxation of credit
limits and debtors’ follow-up or
sh is
inclusion of potential bad debts.

Th
Return
6 on total assets Gleam is generating a much higher return
than the industry average and is
This ratio shows whether sufficient profits are
following the same upward trend. This
being generated for the assets employed.
indicates that it is using its assets more
Net profit before interest & taxes efficiently than the industry generally.
ROTA =
Total assets
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
8
3102AFE AUDITING
investigate reasons for the significant

increase in the current year.
m
er as
co
eH w
o.
rs e
ou urc
o
aC s
v i y re
ed d
ar stu
sh is
Th
9
Powered by TCPDF (www.tcpdf.org)

This Study Resource Was: 3102afe Auditing

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

This Study Resource Was: 3102afe Auditing

Uploaded by

Copyright:

Available Formats

3102AFE AUDITING

Suggested Solutions Workshop 5

The audit judgments facilitated by knowledge of the client’s business include:

understand, in accordance with ASA 315 (ISA 315). LO 5.3

environment consists of an understanding of:

 the nature of the entity

 the entity’s selection and application of accounting policies

 the measurement and review of the entity’s financial performance.

 current and prospective financing requirements (a potential related business risk

and processes are incompatible)

example, incomplete or improper implementation).

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

cost, requiring a write-down to net

in a movement away from its core business to new to reduced margins

products in an attempt to claw back margins.

year of a part-time commerce degree.

procedures on the annualised figures and compared the results to industry

What the ratio means Conclusions to draw and potential risks to

like the industry ratio, has increased

Net sales whether this generates enough cash

to comfortably continue operations.

which indicates that Gleam is

Need to investigate why the gross profit

the industry, indicating good working

Average accounts receivable potential effect on the doubtful debts

provision examined. For example, the

inclusion of potential bad debts.

investigate reasons for the significant

You might also like