Solutions manual

to accompany

AUDIT AND ASSURANCE

Leung, P., Coram, P., Cooper, B.J., Richardson, P. (2019). Audit and Assurance
(1st Ed), John Wiley & Sons Australia (ISBN:9780730363477)

The following questions and answers are from John Wiley & Sons
and reproduced with permission of the publisher

© John Wiley & Sons Australia, Ltd 2019

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Chapter 8: Audit risk assessment

Review questions
8.12 Describe the auditor’s responsibility with regard to business risk and financial
statement assertions.
At the planning stage of the audit the auditor must obtain an understanding of the
entity (ASA 315). This understanding is required to assess the risk that the financial
statements contain material misstatements. In identifying business risks the auditor
can establish the extent to which the financial statements are at risk.
When management prepare the financial statements, they can be considered to be
making a number of assertions about each transaction class, account balance or
disclosures (see ASA 500). In order to understand the extent of the risk in the financial
statements the auditor must understand the extent to which these assertions are at
risk.

8.19 Audit risk is said to be a function of inherent risk, control risk and detection risk.
Explain audit risk. Define and differentiate between each of its components.
ASA 200 describes audit risk and its components. Audit risk (AR) is the risk that the
auditor gives an inappropriate opinion on financial statements that are materially
misstated.
The three components of audit risk are:
Inherent risk (IR) is the possibility that a material misstatement could occur in the
absence of related internal controls. This risk exists independently of the audit of a
financial report. The auditor cannot change the actual level of inherent risk.
Control risk (CR) is the risk that a material misstatement could occur and not be
prevented or detected on a timely basis by the entity’s internal control structure.
Control risk is a function of the effectiveness of the client’s internal control structure
policies and procedures.
Detection risk (DR) is the risk that any remaining misstatements will not be detected
by the auditor’s substantive procedures. Detection risk is a function of the
effectiveness of audit procedures and their application by the auditor.

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Professional application questions

8.21 Assertions 
In planning the audit of a client’s liabilities, an auditor derived the following specific
objectives from management’s financial statement assertions:
1. Liabilities are not valued below the amount expected to be paid in accordance
with an applicable accounting standard.
2. The total of the schedule of purchase ledger balances agrees to the balance on
the purchase ledger control account.
3. All liabilities represent obligating events occurring before the year end.
4. Current liabilities include all amounts owed by the company that fall due within
12 months of the year end.
5. All liabilities that were settled before the year end have been excluded from the
balance sheet.
6. Liabilities have been properly classified in the balance sheet.
7. All finance lease obligations have been included in liabilities.
8. Details of any mortgages in relation to bank loans have been disclosed in the
notes of the financial report.
9. Provisions for staff annual leave have been correctly calculated.
10. Long-term liabilities have been discounted to present value where the
discounting amount is material.
Required
For each specific audit objective (items 1-10), identify the management assertion
from which it was derived.
Assertions from ASA 500.
1. Accuracy, valuation and allocation
2. Accuracy, valuation and allocation
3. Rights and obligations
4. Completeness
5. Existence
6. Classification
7. Completeness
8. Presentation
9. Accuracy, valuation and allocation
10. Accuracy, valuation and allocation.

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8.25 Business risk and assertions

You are a senior auditor working on the audit of HealthyGlow for the year ended 30
June 2021. You are in the planning stage of the audit. It is April 2021 and you discover
that HealthyGlow has recently acquired two new, full-body scanning machines,
representing the very latest in technology, at a cost of more than $10 million each.
The machine enables a full 360-degree scan of the body with the ability to identify
tumours, cysts and other abnormal internal growths which currently have a 50%
probability of being detected with other scanning devices on the market.
Recent studies have shown there may be potential long-term side effects to patients
who are scanned by the new technologically advanced machine. However, given the
machine has only just arrived on the market, the long-term side effects will not be
known for many more years. This uncertainty and the potential high risk associated
with the machine have caused bad press for both the scanning machine and
HealthyGlow.
HealthyGlow charges patients a premium price for scanning due to the machine’s
advanced technological abilities. As a result of high demand, the hospital has
decided to reserve the use of the machine for pre-paid patients only. All scans must
be paid for in full by patients at the time of booking. Payments are immediately
recognised as revenue by the hospital.
Demand for the scanners has been extremely high and HealthyGlow now has
bookings for four months in advance. You note that, even though it is only April
2021, the hospital has bookings for July and August 2021.
The Medical Association of NSW is currently reviewing the use of the scanning
machines and may ban their use within Australia until the issue is resolved. The
decision is expected to be communicated on 1 August 2021. Management have
indicated there is an 80% chance the scanners will be given the go ahead.
Required
1. Assess the main business risks for HealthyGlow.
2. Identify two key account balances likely to be affected by the above information.
3. For each account balance identified in (2), identify and explain the key assertion
most at risk.

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a. Business risks are threats that the organization faces in attempting to achieve its
goals. In this case, there are a couple of main business risks to HealthyGlow, both
are in relation to the purchase of the new full-body scanning machines.
• Studies that have shown the potential side-effects of the new machines is a
concern, which is a risk in the longer term. In the short term, the bad publicity
is a risk although it appears to have had little effect on the level of bookings.
• The potential ban of the use of the machines by the Medical Association of
NSW is a much more significant short-term business risk – even though
management only assesses this likelihood at 20% (the auditor would want
more evidence on this). HealthyGlow have significant capital investment in
these machines and also significant revenue that is contingent on the
continued operation of the machines.
b.
1. The scanners (property, plant and equipment)
2. Revenue and unearned revenue
c.
1. Valuation. The scanners may become worthless if they cannot be used due to
the possible decision by the Medical Association of NSW. There may be an
overseas market for them but this presumably would result in a significant
discounting of value.
2. Accuracy and cut-off for revenue. There is a risk that HealthyGlow has been
incorrectly recording revenue before the service is provided. The auditor will
need to ensure that only those services provided before the end of June have
been included in revenue and payments received for bookings after the end of
June should be included as ‘Unearned revenue’.
Completeness for unearned revenue. There is a risk that revenue that has not been
earned has not been accounted for properly.

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8.30 Audit risk, components of audit risk 

Audrey Pearce is an audit partner of Pearce Green, a firm of accountants. She is
considering audit risk at the overall financial statement level in planning the audit
for the finance company Homes South Ltd (HS) for the year ending 30 June 2020.
This risk is influenced by a combination of factors related to management, the
industry and the entity. Audrey has gathered the following information concerning
HS’s environment.
1. HS has been consistently more profitable than the industry average by marketing
mortgages on properties in a prosperous rural area which has experienced
considerable growth in recent years. HS packages and sells mortgages to large
investment trusts. Despite recent volatility of interest rates, HS has been able to
continue selling its mortgages as a source of new lendable funds.
2. HS’s board of directors is controlled by George Watson, the majority
shareholder, who also acts as the chief executive officer. Management at the
company’s branch offices has authority for directing and controlling HS’s
operations, and is compensated according to branch profitability. The internal
auditor reports directly to Henry Stevenson, a minority shareholder, who is
chairman of the audit committee.
3. The accounting department has experienced little turnover in personnel during
the five years for which Audrey has audited HS. HS’s formula constantly
underestimates the allowance for loan losses, but its financial controller has
always been receptive to Audrey’s suggestions to increase the allowance.
4. During 2019, HS opened a branch office in a metropolitan area 30 kilometres
from its principal place of business. Although this branch is not yet profitable (as
a result of competition from several well-established banks), management
believes it will be profitable by 2021.
5. During 2019, the company increased the efficiency of its operations by installing
a new computer system.
Required
Based only on the information provided, indicate the factors that would affect the
risk of material misstatement and explain why.

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The factors that most likely would increase the risk of material misstatements are:
• Interest rates have been volatile recently (inherent risk).
• The principal shareholder is also the chief executive officer and controls the
board of directors (weakness in control environment – control risk).
• Branch management is compensated based on branch profitability (unusual
pressure on management providing incentives for management to misstate
financial reports – inherent risk).
• Management fails to establish proper procedures to provide reasonable
assurance of reliable accounting estimates (Accounting estimates are more
likely to be misstated than routine factual data and require a greater degree of
judgement – inherent risk; constant underestimation of the allowance for loan
losses questions control consciousness of management (control environment) –
control risk).
• HS recently opened a new branch office that is not yet profitable (unusual
pressure on management providing incentives for management to misstate
financial reports – inherent risk).
• HS recently installed a new sophisticated computer system (increases risk during
break-in or debugging period) (significant changes in IT may increase inherent
risk since errors may occur through incorrect conversion of a new system or
because information in the system may be unacceptable to the new system;
there may also be greater chances of material misstatement since staff may not
be adequately trained in the new system and/or controls built in the system
may not be working adequately increasing control risk).
The factors that most likely would decrease the risk of material misstatements are:
• Government regulation over the finance sector is extensive.
• HS operates profitably in a growing prosperous area.
• Overall demand for the industry’s product is high.
• The availability of funds for additional mortgages is promising.
• The internal auditor reports directly to the chairman of the board’s audit
committee, a minority shareholder.
• The accounting department has experienced little turnover in personnel recently.
• HS is a continuing audit client.
• Management has been receptive to Audrey’s suggestions relating to accounting
adjustments.

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