Chapter 4

Overview of elements of the financial report audit process

Learning objectives
4.1 Explain the difference between accounting and auditing and the importance of professional
scepticism and professional judgment to auditing.
4.2 Outline the logical process of identifying financial report assertions, developing specific audit
objectives and selecting auditing procedures.
4.3 Explain the relationships between audit procedures and evidence, and describe common audit
procedures used in an audit of a financial report.
4.4 Define sufficient appropriate audit evidence and its relationship to auditing procedures.
4.5 Outline the audit risk model.
4.6 Explain the concept of materiality.
4.7 Define types of audit tests.
4.8 Explain how an auditor may use the work of an expert or component auditor.
4.9 Describe the general requirement to document audit work and the contents of audit working
papers.

Major chapter sections

Accounting and auditing contrasted
Financial report assertions and audit objectives and procedures
Audit procedures and evidence

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Sufficient appropriate audit evidence
Overview of the audit risk model
Materiality
Types of audit tests
Using the work of an expert or component auditor
Documentation of audit work: audit working papers

Lecture plan
In this lecture the aim is to provide students with a framework for the financial report audit process,
which can be built on in future weeks. Students are introduced to many new concepts in this lecture.
The chapter outlines in detail the concepts of audit evidence and the audit risk model.

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

[Use slides 4-1 to 4-3]

LO 4.1: Accounting and auditing contrasted

Students should have a good understanding of the financial reporting process, understand the
responsibility of management, and in the earlier lectures will have been introduced to the concept of
auditing. These slides provide an overview of these areas, including areas of audit interest and the
need for the auditor to exercise professional scepticism and professional judgment.

[Use slides 4-4 to 4-7]

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LO 4.2: Financial report assertions and audit objectives and procedures
It is unlikely that students would have thought of account balances and classes of transactions, and
related disclosures, as consisting of a number of assertions. It is worthwhile working through this list,
showing students that evidence must be found for each assertion before it can be said that the
representation in the financial report is true and fair, and thereby emphasising the importance of these
assertions to the audit process. It could also be stated that for different entities facing different
circumstances certain assertions will be more critical, and the auditor might need to concentrate their
attention on specific assertions.

It is useful to distinguish between the assertions that relate to classes of transactions and those that
relate to account balances.

For example, we explain that for transactions the auditor needs evidence of whether the transaction
occurs (occurrence), while for balances the auditor needs evidence that the asset/liability exists
(existence).

[Use slides 4-8 to 4-10]

LO 4.3: Audit procedures and audit evidence

This introduction to audit evidence is very important. It is important to show the breadth of audit
evidence and outline the audit procedures that help collect audit evidence and the factors affecting the
selection of audit procedures. Students are also introduced to the concept of an audit trail.

[Use slides 4-11 to 4-16]

LO 4.4: Sufficient appropriate audit evidence

The concept of sufficient appropriate audit evidence is an important concept to communicate to
students. This will entail a discussion of the relevance and reliability of audit evidence. At this stage,
we also introduce students to the impact of changing technology on the audit and the development and
use in the audit of advanced data analytics.

[Use slides 4-17 to 4-20]

LO 4.5: Overview of the audit risk model

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An overview is provided of the audit risk model. After defining the components, Figure 4.6 on slide
4-26 is a useful graphical depiction of how the risks relate to each other and overall audit risk. It is
important to give examples of the risks to illustrate them to best effect. Students are also introduced to
the concept of business risk and its relationship to audit risk. It is important that this is an overview, as
more detail will be gone into on each of the components of audit risk in future weeks.

[Use slides 4-21 to 4-32]

LO 4.6: Materiality
Materiality is a matter of judgment for auditors and a concept that many students struggle with. It is
important to go through the various bases for evaluating materiality, providing the setting for the
preliminary materiality judgment and the relationship between materiality and audit risk, and the
evaluation of misstatements based on accounting materiality.

[Use slides 4-33 to 4-43]

LO 4.7: Types of audit tests

This serves as an introduction to tests of control and substantive tests. The aim is to introduce the
concepts and how the different tests fit into the audit risk model.

[Use slides 4-44 to 4-48]

LO 4.8: Using the work of an expert or component auditor

Consideration is given to using the work of experts or other auditors and ensuring that the work of the
expert or other auditor is adequate.

[Use slides 4-49 to 4-52]

LO 4.9: Documentation of audit work: audit working papers

The aim here is to show that working papers are the means to record the evidence. The slides illustrate
the major divisions of working papers and provide an example of a working paper.

The legal aspects of working papers are also considered.

[Use slides 4-53 to 4-64]

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

[Use slide 4-65]

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 SOLUTIONS
REVIEW QUESTIONS

4.1 Accounting is the process used to prepare the financial report in accordance with accounting standards.
Auditing is the process of providing assurance on the financial report, by enhancing the degree of
confidence of intended users of the financial report through issuing an opinion on it. Therefore, there is a
close relationship between financial report auditing and accounting, as auditors work primarily with
accounting data. However, while the financial report audit function focuses on accounting, and an auditor
must first be a competent accountant, it also extends beyond accounting and looks behind the financial
report. The auditor must obtain sufficient appropriate audit evidence in accordance with the auditing
standards to support the financial report.

4.2 Professional scepticism is ‘an attitude that includes a questioning mind, being alert to conditions which
may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence’.

Further, ASA 200.A18–20 (ISA 200.A18–20) indicates that professional scepticism includes:

 questioning the reliability of documents and information and explanations provided by

management

 being alert to contradictory evidence

 questioning the sufficiency and appropriateness of audit evidence and not necessarily accepting the
most readily available audit evidence

 being alert to conditions that may indicate risks of fraud

 critically challenging management judgments, assumptions and estimates.

Professional scepticism is important, as it enhances the auditor’s ability to exercise professional

judgment in identifying and responding to conditions that may indicate possible misstatements in
the financial report. Therefore, professional scepticism is critical to enabling auditors to draw
appropriate conclusions in the conduct of their work. It is also essential to auditors fulfilling their
ethical requirements of objectivity and independence.

4.3 The categories of assertions contained in ASA 315.A128 (ISA 315.A128) are as follows.

Assertions about classes of transactions and events, and related disclosures, for the period under
audit

(a) Occurrence—transactions and events that have been recorded or disclosed have occurred and
pertain to the entity.

(b) Completeness—all transactions and events that should have been recorded have been recorded and
all related disclosures that should have been included in the financial report have been included.

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 (c) Accuracy—amounts and other data relating to recorded transactions and events have been recorded
appropriately and related disclosures have been appropriately measured and described.

(d) Cut-off—transactions and events have been recorded in the correct accounting period.

(e) Classification—transactions and events have been recorded in the proper accounts.

(f) Presentation—transactions and events are appropriately aggregated or disaggregated and clearly
described and related disclosures are relevant and understandable.

Assertions about account balances, and related disclosures, at the period end

(a) Existence—assets, liabilities and equity interests exist.

(b) Rights and obligations—the entity holds or controls the rights to assets and liabilities are the
obligations of the entity.

(c) Completeness—all assets, liabilities and equity interests that should have been recorded have been
recorded and all related disclosures that should have been included in the financial report have been
included.

(d) Accuracy, valuation and allocation—assets, liabilities and equity interests are included in the
financial report at appropriate amounts; any resulting valuation or allocation adjustments are
appropriately recorded, and related disclosures have been appropriately measured and described.

(e) Classification—assets, liabilities and equity interests have been recorded in the proper amounts

(f) Presentation—assets, liabilities and equity interests are appropriately aggregated or disaggregated
and clearly described, and related disclosures are relevant and understandable.

4.4 Inspection may be used in relation to:

 inspecting documents, such as invoices, receiving records, etc

 inspecting records, such as ledger accounts, minutes of board of directors’ meetings, etc

 inspecting physical assets, such as inventory, plant and equipment, etc.

4.5 The audit trail is the trail of documents linking the financial report with the underlying transactions. The
audit trail enables transactions to be traced from initial entry in the system to intermediate records, where
the transactions become components of subtotals, and ultimately to disposition in the final records, where
subtotals are summarised for presentation in the financial report. Therefore, the auditor can vouch the
entry in the final record back to the point of initiation to check existence or can trace from the originating
source to the financial report to check completeness.

4.6 Sufficiency relates to the quantity of audit evidence necessary to provide the auditor with a reasonable
basis for an opinion on the financial report. Appropriateness relates to the quality of the audit evidence,
which must be both relevant and reliable. Relevance is largely a matter of the relationship between the

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 evidence and the financial report assertion involved. The reliability of audit evidence is influenced by its
source and nature.

4.7 As per ASA 500.A31 (ISA 500.A31), factors that influence the reliability of audit evidence include:

 whether it is obtained from independent sources outside the entity

 whether, for internally generated audit evidence, the related controls imposed by the entity are
effective

 whether it is obtained directly by the auditor (for example, observation of the application of a
control) rather than obtained indirectly or by inference (for example, enquiry about the application
of a control)

 whether it exists in documentary form, be it paper, electronic or other medium (for example, a
contemporaneously written record of a meeting is more reliable than a subsequent oral
representation of the matters discussed)

 whether the audit evidence is provided by original documents (originals are more reliable than
audit evidence provided by photocopies or facsimiles).

4.8 The audit risk model is a combination of inherent risk, control risk and detection risk. It is designed to
focus audit attention on those classes of transactions or balances that are likely to contain material
misstatements. The audit risk model is described as follows.

AR = f (IR, CR, DR), where:

AR = audit risk

IR = inherent risk

CR = control risk

DR = detection risk

Assessment of each component is subjective and is based on the professional judgment of the auditor.
The levels high, medium or low are generally used, rather than specific percentages.

4.9 As per ASA 200.13(e) (ISA 200.13(e)), detection risk is the risk that the procedures performed by the
auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that
could be material, either individually or when aggregated with other misstatements.

As per ASA 200.A47 (ISA 200.A47), the auditor is not expected to, and cannot, reduce audit risk to zero
and cannot therefore obtain absolute assurance that the financial report is free from material misstatement
due to fraud or error. This is because there are inherent limitations to an audit which result in most of the
audit evidence on which the auditor draws conclusions and bases their opinion being persuasive rather
than conclusive. The inherent limitations to an audit arise from:
 the nature of financial reporting

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  the nature of audit procedures

 the need for the audit to be conducted within a reasonable period of time and at a reasonable cost.

4.10 As per ASA 320.6 (ISA 320.6), when planning the audit, judgments about the size of misstatements that
will be considered material provide a basis for:

 determining the nature, timing and extent of risk-assessment procedures

 identifying and assessing the risks of material misstatement

 determining the nature, timing and extent of further audit procedures.

4.11 As per ASA 320.A4 (ISA 320.A4), factors that affect the identification of an appropriate materiality
benchmark include:

 the elements of the financial report (for example, assets, liabilities, equity, revenue, expenses)

 whether there are items on which the attention of the users of the particular entity’s financial
report tends to be focused (for example, for the purpose of evaluating financial performance users
may tend to focus on profit, revenue or net assets)

 the nature of the entity, where the entity is in its life cycle, and the industry and economic
environment in which the entity operates

 the entity’s ownership structure and the way it is financed (for example, if an entity is financed
solely by debt rather than equity, users may put more emphasis on assets, and claims on them,
than on the entity’s earnings)

 the relative volatility of the benchmark.

4.12 The auditor performs tests of control to determine whether the policies and procedures of internal control
are effective. Substantive tests are performed on specific transactions and balances to determine whether
the dollar amount of the account balance is materially misstated.

4.13 As per ASA 600.A54 (ISA 600.A54), factors that may affect the group engagement team’s involvement
in the work of the component auditor include:

 the significance of the component

 the identified significant risks of material misstatement of the group financial report

 the group engagement team’s understanding of the component auditor.

4.14 As per ASA 620.A15 (ISA 620.A15), when evaluating the competence of an expert, the auditor would
usually consider:

 personal experience with previous work of the expert

 discussions with the expert

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  discussions with other auditors or others who are familiar with the expert’s work

 knowledge of the expert’s qualifications, membership of a professional body or industry

association, licence to practice, or other forms of external recognition

 published papers or books written by the expert

 the auditor’s firm’s quality-control policies and procedures.

4.15 As per ASA 230.2 (ISA 230.2) and ASA 230.3 (ISA 230.3), the purposes of audit documentation are:

 to provide evidence of the auditor’s basis for a conclusion about the achievement of the overall
objective of the auditor

 to provide evidence that the audit was planned and performed in accordance with Australian
auditing standards and applicable legal and regulatory requirements

 to assist the engagement team in planning and performing the audit

 to assist members of the engagement team responsible for supervision in directing and supervising
the audit work, and to discharge their review responsibilities in accordance with ASA 220 (ISA
220)

 to enable the engagement team to be accountable for its work

 to retain a record of matters of continuing significance to future audits

 to enable the conduct of quality control reviews and inspections in accordance with ASQC 1
(ISQC 1)

 to enable the conduct of external inspections in accordance with applicable legal, regulatory or
other requirements.

DISCUSSION PROBLEMS AND CASE STUDIES

4.16 As the loan is critical to SDL’s survival, there is an incentive for Albert to ensure that the restrictive loan
covenants seem to have been met. Therefore, the auditor needs to be sceptical about any statement Albert
may make about meeting the loan covenants and be alert for any information that contradicts Albert.

Specific ways that the audit team could exercise professional scepticism include:

 Obtaining a copy of the loan agreement and sufficient appropriate audit evidence to support
SDL’s adherence to the loan covenants

 Remaining alert for manipulation of SDL’s results, which may have occurred to ensure
compliance with the loan covenants

 Obtaining confirmation from the Regional Bank of adherence to the loan covenants and remaining
alert for any incorrect reporting of information to the bank.

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4.17 (Easy)

Misstatement Assertion
(a) Completeness
(b) Existence
(c) Completeness
(d) Accuracy, valuation and allocation
(e) Rights and obligations
4.18 (Medium)

Accounts at risk Assertion Explanation

1. Sales Cut-off At year-end, there is a risk that inventory shipped to

customers has not been invoiced, as it is not invoiced until
Accounts receivable Completeness
one week after delivery, potentially resulting in sales
being recorded in the wrong period and accounts
receivable being understated at year-end
2. Inventory Accuracy, valuation Spoiled inventory may not be valued at the lower of cost
and allocation and NRV, resulting in a risk of overstatement of inventory
at year-end
3. Sales Accuracy Special deals require manual processing, which results in
frequent errors in recording, which in turn results in a risk
Accounts receivables Accuracy, valuation
of either understatement or overstatement of sales for the
and allocation
period and receivables at year-end
4.19 (Medium)

Account Assertion Explanation

1. Sales Accuracy There were incidents where customers

Accounts receivable Accuracy, valuation and
allocation
2. Inventory Accuracy, valuation and
allocation
3. Property, plant and Accuracy, valuation and
equipment allocation / Classification
have not been correctly billed by the
new billing system. This indicates that
revenue and accounts receivable may not
be recorded accurately
As inventory turnover has decreased and
premium dog food has a shorter shelf-
life, there is a risk of obsolescence and
hence the assertion of accuracy,
valuation and allocation is at risk of
material misstatement
There is a risk that store maintenance
costs are incorrectly capitalised or that

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 Maintenance expense Accuracy / Classification PPE costs are incorrectly expensed
4.20 (Easy)

(a) Review of the repairs and maintenance account is designed to detect understatement of fixed
assets caused by expensing items that should have been capitalised.

(b) Reconciliation of interest expense is designed to detect unrecorded interest-bearing liabilities,

unrecorded accrued interest expense payable or unrecorded interest expense.

(c) Confirmation of receivables is testing existence and is designed to detect overstatement of the
receivables balance. The cause of such an error could be any of a number of errors or
irregularities.

4.21 (Easy)

(a) 4 Analytical procedures

(b) 1 Inspection

(c) 5 Enquiries

(d) 1 Inspection Re-performance????

(e) 1 Inspection

(f) 6 Observation

(g) 3 Confirmation

(h) 1 Inspection

(i) 1 Inspection

(j) 3 Confirmation

4.22 (Easy)

(a) The bank confirmation would be considered more reliable than the observation of segregation of
duties because an independent external party provided the information. Observation is not as
reliable because the individuals performing the functions might not act properly when no one is
observing them.

(b) The auditor’s recalculation of depreciation is more reliable than the examination of the raw
material requisitions because the auditor has direct personal knowledge of the outcome of the
recalculation, whereas the raw material requisition is only internal evidence.

(c) The bank statement would be considered more reliable than the client’s shipping documents
because the bank statement is prepared by an entity external to the client, whereas the client’s
shipping documents are internal documents.

4.23 (Medium)

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 The junior audit team member’s conclusion is not correct. Sufficient appropriate audit evidence has not
been obtained in relation to the accuracy, valuation and allocation assertion. Further procedures will be
needed to specifically cover the value of existing assets; for example, testing for indicators of
impairment.

4.24 (Medium)

(a) Sufficient appropriate audit evidence has not been obtained to support the conclusion. To
conclude that the balance is fairly stated, all material assertions must be verified. Test counts
should also have been selected from the factory floor and checked to the client’s inventory sheets
to test for completeness. In addition, no work has been carried out on the valuation and allocation
assertion.

(b) Sufficient appropriate audit evidence has not been obtained to support the conclusion. The test of
control is checking for existence and effectiveness of the control. Failing to complete the ‘prices
checked’ box means that there were three deviations out of 20 for the test of existence. The fact
that the prices were correct is not relevant when checking the existence assertion.

(c) Sufficient appropriate audit evidence has not been obtained to support the conclusion. Gillian has
not considered the possible effect of the sales returns on other accounts, such as valuation and
allocation of the inventory of Product XLP, collectability of accounts receivable in relation to
sales of Product XLP and the need for a provision for warranty if the goods are faulty.

(d) Sufficient appropriate audit evidence has not been obtained to support the conclusion. The
primary risk with the advertising expenses is understatement, considering the 50% reduction from
the previous year. However, the testing done has been only for overstatement.

(e) Sufficient appropriate audit evidence has not been obtained to support the conclusion. Gillian has
only selected 20 items, of which three, or 15%, were found to be in error, as they had not been
properly accrued. This might affect our assessment of controls to ensure that expenses are
correctly accrued. All items were for services rather than goods, which might mean that other
amounts owing for services were not accrued.

4.25 (Easy)

Situation Component of audit risk

(a) Segregation of duties is inadequate Control risk
(b) Confirmation of receivables by an auditor fails to detect a Detection risk
material misstatement
(c) Cash payments have occurred without proper approval Control risk
(d) A client, Expo Ltd, has a large cash balance Inherent risk
(e) A necessary substantive audit procedure is omitted Detection risk

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 (f) Technological innovations within the industry have caused a Inherent risk
major product to become obsolete
(g) A client, Rocket Ltd, has insufficient working capital to continue Inherent risk
its operations
4.26 (Medium)

(a) Why the situation constitutes an audit risk (b) Component of the audit risk model
affected
1 Internal control in the credit department may be Control risk
affected. Reduced staff would mean reduced
segregation of duties.

Instituting a new bonus scheme for management Inherent risk

creates an incentive to overstate profit to earn a
higher bonus.
2 It is reasonable to assume that if two invoices from Control risk
last year were included in this year’s sales, there
may be more.

It is likely that control procedures that ensure correct Inherent risk

recording of sales transactions are not effective.

If this was intentional earnings management, there

will be greater risk of other misstatements in the
financial report.
4.27 (Medium)

(a) An appropriate benchmark for determining preliminary materiality would be profit before income
tax expense, as this is likely to be of major interest to shareholders and analysts given that
Structural is a publicly listed company. If profit before tax expense is considered unreliable due to
changing economic circumstances, either net or total assets could be considered as a more
relevant and stable base.

(b)

Factor Effect on materiality

1 Listed public company
2 Major shareholder
controls the board
Likely to decrease preliminary materiality, given that the financial report
will be distributed to and used by a large number of people. The financial
report will also be relatively complex, given the large number of
requirements it must comply with.
Likely to decrease preliminary materiality, given that the major
shareholder may use their influence to manipulate the financial report;

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 for example, by selecting accounting policies that favour certain results.
3 Structural sells mainly to The construction industry undertakes large long-term projects that can be
the infrastructure relatively easily affected by changes in economic and/or political
construction industry circumstances. Therefore, the Structural audit may be considered to be of
relatively higher risk and so result in a decrease in the preliminary
materiality level.
4 Economy is static and Combined with factor 3 above, likely to reduce preliminary materiality,
consumer confidence has as there may be pressure on future contracts and profitability.
fallen
5 Internal audit and Likely to increase preliminary materiality (provided you plan to test the
effective internal control effectiveness of controls), as this goes some way towards negating the
negative impacts of the factors discussed above.
(c) The debt covenant is likely to reduce the materiality level as, prima facie, any error affecting
compliance with the covenant is material. Based on current forecasts, Structural’s debt to equity
ratio is 0.99:1.00, as equity (net assets) is $302 million and total assets are $600 million; that is, it
is already dangerously close to breaching the covenant of 1:1.

4.28 (Hard)

(a)

Qualitative factor Explanation of relevance

1 Acquisition of High Ace  Revenue accounting policy inconsistencies may continue to
cause difficulties

 Impact of 2017 fraud on 2018 results

 Determining fair values of High Ace service stations and

goodwill, as a result of the government announcement on
roadworks, which is likely to result in impairment.
2 New exclusive US  Foreign-exchange volatility resulting in significant losses and
contract/significant foreign complexity of accounting
exchange losses/no hedging
3 Significant number of 120-  No follow-up of overdue debtors indicates potential weakness in
day debtors the system of internal controls
(b) Due to the increased overall risk, the preliminary materiality for 2018 would be lower than the
previous year’s preliminary materiality.

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4.29

Test Type of test

1 Examine the financial report to determine whether all related Substantive test of disclosure
party loans are properly presented
2 Recalculate depreciation figure Substantive test of transactions
3 Trace sales recorded in the sales journal to shipping Substantive test of transactions
documents
4 Examine sales invoices for initials to indicate that prices and Test of control
extensions have been checked
5 Check cost of closing inventory to subsequent sales prices Substantive test of balances
6 Confirm loan balances with financial institutions Substantive test of balances
7 Compare wages expense to previous year and budget Substantive analytical
procedure

4.30 (Easy)

As per ASA 600.19 (ISA 600.19), if the group engagement team plans to request a component auditor to
perform work on the financial information of a component, the group engagement team shall obtain an
understanding of:

 whether the component auditor understands and will comply with the ethical requirements that are
relevant to the group audit and, in particular, is independent

 the component auditor’s professional competence

 whether the group engagement team will be able to be involved in the work of the component
auditor to the extent necessary to obtain sufficient appropriate audit evidence

 whether the component auditor operates in a regulatory environment that actively oversees
auditors.

4.31 (Easy)

Acceptable changes to documentation would include:

 deleting or discarding superseded documentation

 sorting, collating and cross-referencing working papers

 signing off on completion checklists relating to the file assembly process

 documenting audit evidence that the auditor has obtained, discussed and agreed with the relevant
members of the engagement team before the date of the auditor’s report.

CONTINUOUS CASE STUDY

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4.32 (Easy)

The audit team is likely to need to engage an expert in two areas:

1 The change in the depreciation of the printing presses from 20 years to 30 years on a straight line basis
suggests that it will be necessary for the audit team to engage an expert to determine the useful life of the
printing presses. Rogers and Brown are not experts in assessing the expected life of printing presses and
there appears to be some diversity in the expected useful life of such assets. Accordingly, for the purpose
of forming a view on the board’s resolution to change the depreciation of the printing presses from 20
years to 30 years on a straight line basis, it will be necessary to use the work of an expert.

2 The valuation and allocation of intangibles is at risk. An article published in a medical journal could
cause the medical textbooks that RPL acquired the rights to during the year to become obsolete. As a
result, the valuation of the copyright attached to the medical textbooks is at risk of being impaired and
would require an expert to value it.

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4.33 (Medium)
(a) Factors (b) Explanation
Existence of The internal audit function is headed
internal audit by an experienced auditor, working
function together with two other qualified
chartered accountants, and reporting
directly to the board. This should
reinforce the internal control
environment, reducing the possibility
of material misstatements in the
financial report.
Experienced The presence of experienced
management management is likely to contribute to
the presence of sound systems of
internal control and appropriate and
prudent accounting policies.
Management The remuneration of the CEO includes
remuneration a performance bonus which is based on
structure RPL achieving specific growth in sales
and net profit after tax. Accordingly,
management is in the position to
override controls and manipulate the
financial report.
Requirement to The loan agreement contains a debt
maintain specific covenant that requires RPL to maintain
financial ratios specified current and debt to equity
ratios. Failure to maintain them will
result in Trim Finance having the right
to recall the loan This provides an
incentive to management to manipulate
the financial report to ensure
compliance with the debt covenants
and retention of the loan funds.
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(c) Influence upon preliminary
overall materiality
The internal audit function should
reduce the level of risk of material
misstatement, which will result in the
setting of a higher materiality level.
The likelihood of sound internal
controls should contribute to overall
lower risk, which will result in the
setting of a higher materiality level.
The incentive to produce strong
results to achieve the performance
bonus will increase the risk of
manipulation of the financial report,
which will result in the setting of a
lower materiality level.
The pressure to maintain the
specified financial ratios, and thus
compliance with the debt covenant,
will contribute to a higher risk of
manipulation of the financial
statements, which will result in the
setting of a lower materiality level.
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 Changes in In the current year, RPL changed its
accounting accounting policies in relation to
policies inventory, depreciation and revenue
recognition.
Change in Acquisition of a new business
business structure generally increases inherent risk.
through the Specifically, RPL recognised an
acquisition of the intangible asset for the copyright
business attaching to the medical textbooks that
operations of MBL produces. However, an article
MBL published in a medical journal could
cause the medical textbooks that RPL
acquired the rights for to become
obsolete.
Installation of a With a new system, there is a risk that
new accounting more errors will be made, as staff are
system not necessarily familiar with the system
and there may be errors in the transfer
of data from the old system to the new
system. In addition, there is a high risk
that the system has not been adequately
tested.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 7e by Gay & Simnett
© McGraw-Hill Education (Australia) 2018
Chapter 4
The changes in accounting policies
increase the risk that the financial
report will be materially misstated,
which will result in the setting of a
lower materiality level.
Acquisition of the new business and
possible impairment issues with the
medical textbook copyright increases
the risk of material misstatement and
will result in the setting of a lower
materiality level.
The new accounting system is likely
to significantly increase risk and
therefore result in a lower materiality
level.
18