Chapter 5

Planning, understanding the entity and evaluating business risk

Learning objectives
5.1 Explain why the decision to accept a client is important and describe the primary features of client
acceptance and continuance, including the purpose and content of an audit engagement letter.
5.2 Explain the importance of planning to the audit process.
5.3 Identify the important aspects of the auditor’s understanding of an entity and its environment.
5.4 Assess entity business risk.
5.5 Explain how an auditor develops an overall audit strategy and prepares a detailed audit plan or
audit program.
5.6 Describe the process of assigning and scheduling audit staff.
5.7 Outline the types and uses of analytical procedures and distinguish those that are useful in
obtaining an understanding of an entity and assessing business risk.

Major chapter sections

Client acceptance and continuance
Audit planning
Understanding the entity and its environment
Business risk
Developing an overall audit strategy

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Assigning and scheduling audit staff
Analytical procedures

Lecture plan
The emphasis in this lecture is on outlining the procedures undertaken at the beginning of an audit.
These include the client acceptance and continuance decision, preparing the audit strategy and audit
plan/audit program and the purpose and content of the engagement letter. The chapter also covers the
importance of understanding the client’s business and industry and making an assessment of the
client’s business risk. This approach places emphasis on business strategy as distinct from financial
risk.

With the emphasis on analytical procedure at this stage of the audit, the chapter also devotes
considerable attention to the types and uses of these procedures.

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

[Use slides 5-1 to 5-3]

LO 5.1: Client acceptance and continuance

The emphasis here is on the steps in accepting a client, discussing client evaluation procedures and
communications with the previous auditor.

The engagement letter is important because it is a letter from the auditor to the client to document the
arrangements made with the client and to clarify matters that may be misunderstood.
Issues that arise with initial engagements are also discussed.

[Use slides 5-4 to 5-12]

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LO 5.2: Audit planning
These slides outline the importance of proper audit planning.
It is important to explain to students the difference between the two major planning documents.
• Audit strategy: sets the scope, direction and timing of audit and guides the more detailed audit
plan/program.
• Audit plan/program: sets out the nature, timing and extent of audit procedures.

The overall timing of the audit engagement is also explained, with an indication of what occurs at the
planning, interim and final stages of the audit.
.

[Use slides 5-13 to 5-16]

LO 5.3: Understanding the entity and its environment

The business risk approach emphasises the importance of obtaining an understanding of the client’s
business and industry. These slides outline the purpose and the procedures involved in obtaining this
understanding.

[Use slides 5-17 to 5-23]

LO 5.4: Business risk

Business risk is the risk that an entity’s business objectives will not be attained and its assessment
requires obtaining knowledge of the client’s business. It involves understanding the client’s strategic
advantages in relation to its competitors, understanding key business processes and risks and
identifying and evaluating key performance indicators.

It is important that students understand that while most business risks have financial consequences
and therefore eventually affect the financial report, not all business risks result in risks of material
misstatement. Therefore, business risk is broader than the risk of material misstatement but includes
it.

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It is also important that students understand that the auditor is required to determine whether any
identified risk is a ‘significant risk’, a risk of material misstatement that requires special audit
consideration.

At this stage it is also necessary to explain to students how the auditor needs to respond to assessed
risks at both the financial report level and the assertion level.

[Use slides 5-24 to 5-35]

LO 5.5: Developing an overall audit strategy

At this stage consideration is given to introducing students to the different types of audit strategy, the
approach of relying on internal controls versus the predominantly substantive approach. This is done
before control risk is assessed.

[Use slides 5-36 to 5-39]

Preparing a detailed audit plan or program follows from the planned audit strategy and shows how the
audit strategy is documented.

[Use slides 5-40 to 5-44]

LO 5.6: Assigning and scheduling audit staff

As the audit strategy is developed, staff are assigned, including consultants, specialists and internal
audit.

[Use slides 5-45 and 5-46]

LO 5.7: Analytical procedures

Analytical procedures are also used extensively to gain an understanding of the client’s business and
place even greater emphasis on the business risk approach. It is important for students to recognise
that analytical procedures can be used at all stages of the audit, although at this point we are
concentrating on their use at the planning stage.

It is important to go through how the key ratios are calculated and how the auditor may use the results
to identify risk areas. It is also important to point out to students that there are a number of acceptable
ways of calculating some of these ratios and we have included the most common formulae.

[Use slides 5-47 to 5-60]

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

[Use slide 5-61]

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 SOLUTIONS

REVIEW QUESTIONS
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.

5.2 In accordance with ASA 210.10 (ISA 210.10), an audit engagement letter should include:

1 the objective and scope of the audit of the financial report

2 the responsibilities of the auditor

3 the responsibilities of management

4 identification of the applicable financial reporting framework for the preparation of the financial
report

5 reference to the expected form and content of any reports to be issued by the auditor and a
statement that there may be circumstances under which a report may differ from its expected form
and content.

5.3 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.

5.4 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.

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

 identifying accounting or auditing matters that need special attention

 assessing the conditions under which accounting data are prepared

 evaluating the reasonableness of management’s estimates and other representations

 making judgments about management’s selection and application of accounting principles.

5.5 As per ASA 315.11 (ISA 315.11), the auditor’s understanding of the entity and its environment consists
of an understanding of:

 industry, regulatory and other external factors, including the applicable financial reporting
framework

 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.

5.6 Three types of risk-assessment procedures that the auditor needs to perform under ASA 315.6 (ISA
315.6) are:

 enquiries of those charged with governance, management and others within the entity who may
have useful information

 analytical procedures

 observation and inspection.

5.7 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)

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  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).

5.8 Advanced data analytics provides opportunities for the auditor to obtain a more effective and robust
understanding of the entity and its environment, thus enhancing the quality of the auditor’s business risk
assessment and response, and resulting in a more efficient and effective audit.

5.9 The development of an audit strategy is important to the efficiency and effectiveness of an audit. It is
necessary for the auditor to make judgments regarding the scope of the audit, the general evidence
requirements and the initial choice as to the nature, timing and extent of audit procedures. Two
alternative strategies are a lower assessed level of control risk or a predominately substantive approach.
The development of this overall strategy then enables the detailed audit plan or program to be developed.

5.10 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.

5.11 Three important aspects of establishing and coordinating the staffing requirements of an audit are:

 selecting competent people

 preparing a time budget and work schedule

 supervising audit staff.

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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.

5.13 The use of data aggregated at a high level means that analytical procedures only provide a broad initial
indication about whether a material misstatement may exist. In those cases the auditor needs to consider
such analytical procedures in conjunction with other information that has been gathered when identifying
the risks of a material misstatement. Disaggregated data allows more powerful analytical procedures to
be applied.

DISCUSSION PROBLEMS AND CASE STUDIES

5.14 (Easy)

ASA 210.10 (ISA 210.10) states that the auditor and client must agree to the terms of the engagement
in writing and recommends the use of a written engagement letter. The use of such a letter does have a
number of advantages, including ensuring both parties are aware of and acknowledge their
responsibilities under the audit engagement.

As a first step, the audit partner could explain to the CEO the purpose of the engagement letter and
allow the CEO time to review the contents of the letter and discuss the matter with fellow directors. If
the managing director, or the board of directors, refuses to acknowledge the terms of the engagement in
writing, the audit partner should consider the possible reasons for such a refusal and the implications
for the engagement. For example, the board might not provide the auditors with timely access to
company records. As a result, the auditor might need to re-evaluate their acceptance of the audit
engagement.

5.15 (Medium)

(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.

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 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)

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?

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  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?

5.17 (Medium)

Matters that would influence the scope of the audit may include (five only required):

 the financial reporting framework—Stone is a large proprietary company and therefore is required
to lodge its accounts with the Australian Securities and Investments Commission (ASIC) and
must follow Australian accounting standards

 the extent to which components are to be audited by other auditors (if applicable), as Stone has
two subsidiaries located in different states

 the nature of the business—one of its subsidiaries, Agate Pty Ltd, runs a quarry, so specialised
knowledge might be needed (for example, valuing unearthed assets)

 the effect of information technology on the audit—a new computer system was implemented
during the year and there is a lack of staff continuity, which will affect internal control

 matters that may affect the audit firm personnel—consider any independence implications in light
of the number of years that the audit has had the same engagement partner and of the engagement
partner’s close personal relationship with the previous assistant accountant/bookkeeper.

5.18 (Medium)

Major audit concerns to be addressed in the planning documents include the following.

(a) The software should be reviewed to assess whether it can be used to make the audit more
efficient, particularly in the area of analytical procedures.

The veracity of the output from the system should be examined before any reliance is placed on
reports generated. The extent of management’s use and reliance may give some indication of its

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 reliability; however, management’s reliance may be misplaced. Management may have been
making erroneous decisions if the output is unreliable.

Consider areas of potential use, such as:

 ratio analysis

 comparative analysis to prior period and budget

 trend analysis.

Consider reports that may be run specifically for the auditors, such as:

 stratification of account balances

 special report formats not previously available; for example, sales history on each
inventory line to assess inventory obsolescence.

(b) Going concern/cash flow

 Consider the ability of Luxury Apartments to remain a going concern if projects cannot
readily be realised for sufficient cash.

Valuation of work in progress

 Consider the ability of Luxury Apartments to recoup construction costs on the sale of
buildings.

 Obtain recent independent valuations considering depressed market conditions. Value of

work in progress should be provided against if a deficiency exists.

Profit recognition

 The audit must address the recognition of profit. Forecast costs to complete must be
closely scrutinised. For example, the downturn in the industry may cause go-slows by
labour on site, as future work may be perceived to be difficult to find, thereby causing
overruns in labour budgets.

(c) Points to consider:

 materiality of the overseas branch in Singapore to the company

 verification of existence of inventory

○ stocktake attendance (other auditors)

○ inventory in transit

 valuation of inventory

○ transfer pricing

○ internal profit in inventory

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 ○ net realisable value; samples may be given away free and some inventory lines may
be discounted as part of marketing campaigns

○ obsolescence—dumping of inventory to branch

○ exchange rate fluctuations.

5.19 (Easy)

During the tour of a client’s plant the auditor inspects inventory areas and makes a note of the locations,
types, security and general condition of the inventories. The auditor visits the receiving and shipping
departments and reviews the types of documents maintained. Observations in these areas enable the
auditor to form a preliminary assessment of control risk for inventories and identify problems with
respect to obsolete or slow-moving inventories. The auditor can also begin formulating plans for staffing
and carrying out the physical inventory observation.

The auditor’s observation of the productive processes helps to inform their understanding of the client’s
physical plant and layout, the nature of products and the documentation for production orders, raw materials
requisitioned to production, direct and indirect labour, and inspection and testing of finished products.

The auditor meets the supervisory personnel, engineers and other key personnel responsible for
production and, through enquiries and conversations, learns of any unique production problems,
including excessive spoilage and scrap. As a result, the auditor is able to make a decision as to the
necessity for a physical inventory of plant machinery and equipment, and is in a position to evaluate the
client’s cost accounting system during the course of the audit.

Any accounting records, such as perpetual inventories, job cost ledgers and timekeeping records, that are
maintained in the plant area are inspected by the auditor. In addition, the auditor ascertains whether
budgets or standards are used in production.

5.20 (Easy)

Industry-specific factors include the following:

 Is the industry cyclical or seasonal? Chic Fashions is in the summer-wear industry, which is
focused on the warmer months and subject to seasonal sales variations.

 Is the industry competitive? The background facts suggest that the industry is highly competitive,
with low-cost products available on the internet.

 Is the industry a high-risk industry? Chic Fashions’ summer wear is expensive, high-end fashion.
A bad season could materially impact Chic Fashions’ financial results.

 Is there evidence that companies in the industry are experiencing adverse conditions? The
background shows that several of Chic Fashions’ competitors have closed and the industry as a
whole is struggling.

5.21 (Medium)

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 (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)

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

misstatement

Pressure from larger, aggressive competitors Inventory may be overstated, as goods may
be being sold below cost, requiring a
write-down to net realisable value

Significant reduction in gross margins has resulted in Going concern may be affected due to
a movement away from its core business to new reduced margins
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 to
major suppliers reducing their credit limits. This may tighter terms of trade putting pressure on
create liquidity problems and also may indicate the liquidity
supplier’s concern about Whisky & Wines

5.23 (Medium)

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 (a) You will need to check on the internal auditor’s assessment of the total loss and 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.

(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 CEO casts doubt on its objectivity and therefore the extent of reliance that can be
placed on it.

5.24 (Medium)

(a) The deviations from control procedures will mean an increase in control risk and so less reliance
can be placed on the internal control system, and therefore greater substantive testing is required.
Also, because of the weaker internal control system, less reliance can be placed on analytical
procedures, as the data being used in the analytical procedures may be unreliable. Also, because of
the discounts, gross margins will vary more, and therefore less use can be made of analytical
procedures as part of the substantive testing of sales.

Greater attention will need to be paid to the provision for doubtful debts, due to credit ratings of
customers not being checked.

(b) There is a need for a review and evaluation of general and application controls for the new
computer system. There may be a greater opportunity to use CAATs in the audit approach.

There is increased opportunity to use analytical procedures as part of substantive testing, given
that gross margins and inventory items by product type and geographical area are available.

5.25 (Easy)

(a) The auditor should not follow their client’s suggestions regarding the conduct of an audit, unless
the suggestions are of such a nature that they clearly do not conflict with the auditor’s professional

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 judgment and independence. The auditor must decide on the scope and conduct of their work,
including the staff required to carry out the work.

(b) The reasons against dividing the assignment of audit work solely according to assets, liabilities,
and income and expenses include the following:

 Work should be assigned to staff members by considering the degree of difficulty in

relation to the technical competence and experience of individual staff members.

 The sequence of work performed should be in accordance with the audit plan.

 It is impossible to segregate work areas by financial report captions, because often a close
relationship exists among a number of accounts in more than one category; for example,
when revenues are based on assets or expenses are based on liabilities.

 Often the scope of work for a single account requires simultaneous participation by the
staff, such as in the observation of inventories.

5.26 (Medium)

What the ratio means Conclusions to draw and potential risks

to be investigated

1 Current 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 of 2,
position of the entity. Therefore, it indicates
the current level does not indicate cause
the entity’s ability to meet its current
for immediate concern; however, it needs
obligations (that is, its short-term liquidity). A
to be monitored to ensure that it doesn’t
benchmark figure of 2 is generally accepted
deteriorate further.
as a minimum requirement.
Enquire of management as to their
Current assets
Current ratio = procedures for managing working capital,
Current liabilities
and review current and projected cash
flows for future liquidity problems.

2 Net profit ratio Ratio is lower than that of the industry

and, like the industry ratio, has increased
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 whether
Net sales
this generates enough cash to comfortably
continue operations. It is also inconsistent
with ROTA, which indicates that Gleam

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 is performing better than others in the
industry.

3 Gross margin Gross profit ratio is equal to that of the

industry, although the trends are in opposite
This indicates the amount of gross profit each
directions. Need to investigate why Gleam
dollar of sales earns.
is able to increase its margins when others in
Gross profit the industry are dropping their margins.
Gross profit ratio =
Net sales 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 the
net profit ratio is lower (this might, for
example, indicate higher operating
expenses).

4 Inventory turnover ratio Inventory turnover is faster than that of

the industry and is following the
This ratio shows the number of times
industry’s trend to slow slightly. The fast
inventory turns over in a year.
turnover indicates good inventory
COGS management practices. However, you
Inventory turnover =
Average inventory 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.

5 Receivables turnover ratio Receivables turnover is faster than that of

This ratio shows the number of times
receivables turn over in a year.
Net credit sales
Debtors turnover =
Average accounts receivable
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

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 of potential bad debts.

6 Return on total assets Gleam is generating a much higher return

This ratio shows whether sufficient profits are
being generated for the assets employed.
Net profit before interest & taxes
ROTA =
Total assets
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.

5.27 (Hard)

Unusual trend Risk Financial Assertion

statement item

Interest income has Overstatement of interest Interest income Occurrence

increased markedly in income
2018, both absolutely and
as a percentage of
receivables

Unearned income has Understatement of Unearned income Completeness

decreased as a percentage unearned income
of receivables

Allowance for doubtful Overstatement of Receivables Accuracy,

debts has not increased in receivables due to valuation and
line with the overall uncollectible accounts allocation
Doubtful debts
increase in receivables and understating of
Accuracy
expense
doubtful debts expense

The split between current Variation in current and Receivables Classification

and non-current non-current receivables
receivables is unusual in balances indicates a risk
2018 that they have been
inappropriately classified

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5.28 (Hard)

(a) Ratio Explanation (b) Account (c) Key Explanation

balance assertion
at risk at risk

Current The change in current Inventory Existence By overstating inventory,

ratio ratio compared to the management can reduce the
previous year and cost of goods sold and
Accuracy
budget, together with increase profit. In order to
valuation and
the quick asset ratio overstate inventory,
allocation
being almost the same, management may book
indicates a build-up of inventory that does not
inventory exist, allocate costs
incorrectly for the existing
inventory or fail to write
off obsolete stock

Days in The increase in days in Inventory Accuracy, Taking longer to turn over
inventory inventory valuation and inventory may indicate
allocation obsolete stock problems

Marketing The increase in Marketing Accuracy The increase in marketing

expenses / marketing expenses as expenses expenses, offset by a
Classification
sales % a percentage of sales corresponding decrease in
Admin
offset by a decrease in admin expenses, may
Expenses
admin expenses as a indicate that marketing and
Admin
percentage of sales, admin expenses have been
expenses /
may indicate that misclassified
sales %
marketing and admin
expenses have been
misclassified

CONTINUOUS CASE STUDY

5.29

Matters to include in engagement Background reference

letter

Arrangements concerning the RPL has established an internal audit department whose

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 involvement of internal auditors organisational status, scope of function, technical
(ASA 210.A26/ISA 210.A26) competence and due professional care will require
assessment to determine the extent to which its work can be
relied upon

Arrangements to be made with You will need to communicate with Jones & Associates to
previous auditor (ASA 210.A26/ISA ascertain whether there is any professional reason why you
210.A26) should not accept the appointment as auditors of RPL

5.30

Ratios 2016 2017 2018

Current ratio 1.42 1.47 1.50

Quick asset ratio 0.83 0.94 0.85

Receivables turnover ratio * 10.79** 9.12**

Days in receivables * 33.83 days** 40.02 days**

Inventory turnover ratio * 12.26 10.56

Return on total assets 0.267 0.211 0.148

Return on shareholders’ equity 0.258 0.212 0.179

Times interest earned 40.94 times 40.13 times 4.79 times

Debt/Equity 0.10 0.08 0.68

Gross profit ratio 0.176 0.161 0.152

Net profit ratio 0.069 0.061 0.050

* Turnover ratios have not been calculated for 2016, as opening balances are not available to calculate
average receivables or average inventory. Gross figures have been used for receivables and inventory,
i.e. figures before deduction of allowance for doubtful debts and allowance for obsolescence
respectively.

** Credit sales used in the calculations include revenue from operations and storage fees. Commission
revenue is collected on a cash basis and therefore is not included.

An analysis of these ratios and the financial report indicates that:

 The inventory turnover ratio has deteriorated from 12.26 to 10.56. This indicates the possibility of
obsolete or slow-moving inventory. Further, while inventory has increased significantly in 2018 by

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 $1 383 262 or 49%, the allowance for obsolescence of $125 876 has been written back as no
longer being required. Therefore, extra audit attention will need to be given to the accuracy,
valuation and allocation of inventory, particularly as the accounting method has also changed
during the year from average cost to FIFO.

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  The receivables turnover ratio has decreased significantly, with days in receivables going out from
33.83 days to 40.02 days, indicating possible collection problems, resulting in possible bad or
doubtful debts. Further, while accounts receivable has increased significantly in 2018 by $783 309
or 17%, the allowance for doubtful debts has increased by only $30 000. Therefore, extra audit
attention will need to be given to the accuracy, valuation and allocation of accounts receivable.

 The gross profit ratio has decreased, indicating a possibility that some inventory is obsolete or
slow-moving and can only be sold at discounted prices, supporting the conclusion drawn from the
inventory turnover ratio.

 The reduction in the net profit ratio is in line with the drop in the gross profit ratio and so does not
indicate any unexpected movements in operating expenses. The significant drop in the return on
total assets and the return on equity is due to the significant increase in property, plant and
equipment of $7 177 312 or 85.5%, partly financed by an increase in equity of $1 466 841 or
13.6%, but a slight decrease in net profit after tax of $103 171. Audit attention will need to be
given to verifying the significant amount of fixed asset additions and also investigating why this
investment in property, plant and equipment has not generated additional profit.

 The debt/equity ratio has increased significantly to finance the investment in property, plant and
equipment, but is still at a relatively low level, being less than 1, and meets the loan covenant
requirements. The times interest earned has dropped due to the significant increase in interest
expense of $724 375 related to the increase in long-term debt of $7 500 000. Audit attention will
need to be directed at confirming the long-term debt and interest charge. However, there is no
indication of any problems relating to debt dependence.

 The current ratio has improved slightly, but this is due to the build-up in inventory discussed
above. It is slightly below the usual benchmark of 2, but also only just meets the loan covenant
requirement of 1.5. Therefore, additional audit attention will need to be given to potential
manipulation of the current ratio to meet the loan covenant, particularly based on the possible
overstatement of receivables and inventory discussed above and the change in accounting method
for inventory from average cost to FIFO, which is likely to have contributed to part of the increase
in the value of inventory.

 The quick asset ratio has decreased slightly and is slightly below the usual benchmark of 1 for this
ratio. Therefore, it needs to be monitored as any further decline could indicate problems with
paying creditors and hence potential going-concern problems. In addition, the ratio may actually
be worse given the possible overstatement of receivables discussed above. Therefore, audit
attention should be given to cash flows.

 Deferred revenue of $697 500 has been recognised for the first time. This is due to a change in
accounting method and so will require additional audit attention.

 Intangible assets of $975 000 have been recognised for the first time and will require audit
attention to ensure that they meet the recognition requirements of the accounting standards. An

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 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.

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