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Session 3 Solutions

Self-Study Questions

4.11

Explain the approach adopted by auditors of identifying accounts and related


assertions at risk of material misstatement. How does this approach help reduce
audit risk to an acceptably low level?

Audit risk is the risk that the auditor gives an inappropriate opinion on the financial report.
The auditor tries to keep this risk to an acceptably low level by planning the audit according
to the key risks faced by the client and allocating more audit time where the risk of material
misstatement is highest. This means that the auditor tailors the audit work to the clients
characteristics. If the client has characteristics which suggest that the greater risk of material
misstatement is in a particular account or transaction cycle, the auditor will plan to do more
audit work on that account or transaction cycle than would be done for another client with
different characteristics and lower risk in that area.
The auditor identifies the specific accounts that are most at risk, and how those accounts are
likely to be misstated. For example, one client may have a greater risk that fictitious credit
sales are included in the balance of accounts receivable, while another client may have a
greater risk that accounts receivable balance includes balances that are not likely to be
collected. The first client has ineffective controls over processing credit sales and the second
client has ineffective controls over granting credit to customers. The auditor would spend
more time gathering evidence over the validity of credit sales transactions for the first client,
and more time gathering evidence about the collectability of accounts receivable for the
second client.
4.12

How does the auditors preliminary assessment of materiality affect audit


planning? What does an auditor consider when making the preliminary
assessment of materiality?

The auditors preliminary assessment of materiality is made early in the audit and is used to
guide planning of the audit and the audit testing based on the plan. The auditor will set
materiality higher when client risk (inherent risk and control risk) is lower, i.e. there is an
inverse relationship between client risk and the preliminary assessment of materiality. This
means that the materiality assessment is set lower for riskier clients. The auditor must
specifically consider the three components of audit risk when making the preliminary
assessment of materiality. At this stage, the auditor has not completed testing, so the
assessment of control risk is also preliminary.
A low preliminary assessment of materiality means that the auditor must plan to detect
misstatements of low materiality. A high preliminary assessment of materiality (for a low risk
client) means that the auditor plans to detect misstatements that have a high level of
materiality. It takes more audit work to be reasonably sure that smaller misstatements are
detected, than the amount of audit work required to be reasonably sure that larger
misstatements are detected. This is because the lower the materiality level set, the more items
will fall into this definition. In addition, because the auditor will be combining all testing
results together, a lower materiality level is more sensitive to a potential material
misstatement.

4.14

If an auditor adopts a predominantly substantive approach to the audit, do they


have to consider and test the clients internal controls? Explain your answer

A predominantly substantive approach is adopted by the auditor when the assessed level
of internal control risk is high. There is high control risk if the operating systems and
procedures are poor and ineffective. However, the auditor will still perform tests of
controls to obtain sufficient appropriate audit evidence on effectiveness of relevant
controls if substantive procedures alone cannot provide sufficient appropriate audit
evidence at assertion level (see ASA 330 Para 8b).
There are also instances when the auditor may perform test of control and perform
substantive test of details on the same transaction but the purpose of performing test of
control is different from the purpose of performing substantive test of details (see ASA
330 Para A23)
For example, the auditor may examine whether a particular overtime payment
has been authorised at the same time gather substantive evidence through test of
details of balances by recalculating payroll liabilities

4.15 If an auditor adopts a lower assessed level of control risk approach, do they have to
perform any substantive procedures? Explain.
If the auditor adopts a lower assessed level of control risk approach there will be increased
reliance on tests of controls and reduced reliance on substantive tests of transactions and
account balances. In this case, the auditor has assessed the clients control risk as low and
detection risk as high. However, an auditor can never completely rely on a clients system of
internal controls and will always conduct some substantive procedures to gather independent
evidence about the amounts in the clients financial report.
items continue to be carried at full cost instead of being written down to NRV. There could be
errors in cut-off, so that inventory purchases made prior to the end of the financial year are
not recorded in the inventory records as at the end of the year.
The auditor would need to explicitly all the risks to the inventory balance and how these
would be prevented or detected by the clients controls before concluding that inventory was
not likely to be misstated.

4.18

What are some possible explanations of a change in the gross profit margin?
How could the auditor investigate which of these explanations is the most likely
cause of the change in the ratio?

A gross profit margin is the gross profit divided by net sales. Fully understanding this margin,
and the reasons for any change, requires an understanding of the components of the margin.
Gross profit = sales cost of goods sold.
If the gross profit margin increases, profit as a proportion of sales increases, which means that
cost of goods sold as a proportion of sales decreases.
Cost of goods sold = opening inventory plus net purchases minus closing inventory. This
means that any change in cost of goods sold could be due to changes in opening inventory,
net purchases (i.e. purchases less purchases returns), or closing inventory. Opening inventory
can be verified by comparing with closing inventory in the previous period. Net purchases
can be verified through detailed testing of transactions. Closing inventory can be verified
through stocktake testing procedures.
Increases in the gross profit margin are likely caused by either:
Increasing selling prices (at least increasing faster than cost of sales are increasing)
Decreasing cost of sales (at least decreasing faster than sales prices are decreasing)
Increasing Sales are possibly caused by:
Cut-off errors (sales in next period backdated to current period). Auditor will verify
dates of sales around the end of the financial year.
Fictitious sales. Auditor will seek evidence of sales, and test for sales returns being
used post the balance date to eliminate fictitious sales and debtors. Auditor will seek
evidence of inventory movement to customers.
Increasing selling prices. Auditor will check for evidence of increased prices on
approved price lists.
Errors in accuracy of sales. Auditor will test for correct calculations in sales invoices
and accounting records.
Decreasing cost of sales is possibly caused by:
Lower cost of purchases, e.g. buying goods for lower prices because of better
purchasing agreements, buying in bulk, favourable exchange rate movements for
imported goods etc. This can be verified through examining purchase agreements,
invoices, foreign exchange agreements and transactions.
Higher cost items being held as closing inventory and lower cost items being sold
(higher closing inventory reduces the cost of goods sold). This implies a change in the
product sales mix without lower selling prices. Auditor will analyse changes in
product mix.
Overstatement of closing inventory auditor will use stocktake testing to verify.
Failure to update inventory records for sales. Auditor will test details of inventory
movements.
Decreases in the gross profit margin are likely caused by either:
Decreasing selling prices (at least decreasing faster than cost of sales are decreasing)
Increasing cost of sales (at least increasing faster than sales prices are increasing)
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Decreasing Sales are possibly caused by:


Cut-off errors (sales in this period postdated to next period). Auditor will verify dates
of sales around the end of the financial year.
Omitting sales. Auditor will trace sales orders and invoices to accounting records,
evidence of sales returns made in error.
Decreasing selling prices. Auditor will check for evidence of lower prices on
approved price lists.
Errors in accuracy of sales. Auditor will test for correct calculations in sales invoices
and accounting records.
Increasing cost of sales is possibly caused by:
Higher cost of purchases
Lower cost items being held as closing inventory, higher cost items being sold
Understatement of closing inventory.
The auditor is likely to be more concerned about a potential misstatement which overstates
gross profit and closing inventory than one which understates gross profit and closing
inventory.

4.20

Consider the following statement: When inherent and control risk are assessed
as high, the risk of material misstatement is assessed as high and an auditor will
set detection risk as low, to reduce audit risk to an acceptably low level. Explain
what it means to set detection risk as low. What does this mean for the operation
of the audit?

The statement is based on the audit risk model. Audit risk (AR), the risk of giving an
inappropriate audit opinion, is a function of the clients inherent risk (IR), control risk (CR)
and the auditors detection risk (DR). [AR = f(IR,CR,DR]
The auditor chooses a desired level of AR. The auditor cannot control IR and CR, so the only
way they can achieve the chosen level of AR is by setting DR at an appropriate level High
levels of IR and CR increase AR, so the auditor must plan for a low DR to achieve the
required AR. Low levels of IR and CR decrease AR, so the auditor can plan for a higher DR
before AR becomes unacceptable.
The mere act of setting DR low does not reduce actual AR. The auditor must perform the
appropriate audit procedures to have reasonable assurance of achieving the chosen DR. The
lower the DR, the more effective and extensive the audit procedures required.
4.21 Explain how setting a lower materiality level affects the number of items that are
material and the assessment of the sufficiency and appropriateness of audit evidence.
Auditors set the materiality level based on their professional judgement of the client and the
information needs of users of the clients financial statements ( ASA 320 Para 4
When planning materiality level is set at lower level, there will be more items considered to
be material than when planning materiality is set at higher level. For example, if the planning
materiality level is set at $10,000, then any error that has an effect $10,000 or more is
material. However, if planning materiality level is reduced to $5,000, then errors between
$5,000 and $10,000 are now material. Previously, they would have been regarded as
immaterial.
By setting a lower planning materiality level, an auditor increases the quantity of evidence
that needs to be gathered. It is also likely to increase the quality of evidence required because
the auditor will need greater assurance than an error with a lower effect has not occurred
(better evidence would be required to detect smaller errors, larger errors are likely to be more
obvious than smaller errors).
When gathering evidence, one of the criteria may be to test material items. The lower the
materiality level set, the more items will fall into this definition. Also, by setting a lower
materiality level, an auditor increases their sensitivity to a potential misstatement.
When analysing test results, an auditor will assess potential misstatements in aggregate with
reference to their planning materiality. The lower the materiality, the more likely the auditor
will conclude that misstatements are material and further testing is required.

Session 3 Solutions
Workshop questions
3.23 Audit planning
Required
What questions would you have for Michael before accepting his audit plan?
What work has been done to provide evidence that there are no related parties and that there
are no issues with the clients corporate governance structure?
Is the risk of misstatement the same for a dollar of hire revenue as a dollar of retail revenue?
The risk of material misstatement should drive the audit plan.
The client is new, what work has been done to understand the client, its industry (both hire
and retail elements) and the effect of the economy factors on the client?
What is the initial assessment of internal controls?
What are the significant transactions and accounts?
Is the risk of fraud directly proportional to revenue? If not, how should the work on fraud be
allocated?
What impact would IT have on the risks associated with the two segments of the business?
How does IT relate to the rest of the clients internal controls?
Are closing procedures the same for the two segments of the business?
Is there any going concern risk? What are the risks and mitigating factors that are likely to
occur in a hire and retail company?

3.26 Risk assessment considering going concern: operating


Required
Discuss whether there are any events or conditions that may cast significant doubt on
the new clients ability to continue as a going concern.
Factors that may cast doubt on going concern:
- Lack of maintenance on rides suggests sufficient cash flow not available to pay for
maintenance, or poor management of facilities (i.e. not required inspections, not
required qualified staff to operate rides
- Two popular rides have suffered major damage given proximity to salty conditions
(causing rust) are other rides all fully operational? Any further failures in facilities
could close theme park completely, severely damaging revenue and cash flows
- Minor injuries suffered by patrons is the client legally liable for damages as a result
of court cases against it for the injuries? If major damages awarded against the client,
does the client have capacity to pay?
- Most popular rides have major breakdowns taking them out of action for several
months until repairs are completed. Major impact on revenue because theme park
would be closed or severely restricted.
- Significant cost of replacement parts (more than 10% of profit) requires major
capital investment, is there sufficient cash flow to service the investment?
- Repairs are scheduled to be done during the period April July 2012 this would be
on-going at a balance date of June 2012 (balance date not stated in the question).
Auditor would not be able to gather evidence of the successful repairs before the
balance date. Major question about clients ability to continue at full capacity if
repairs are delayed or not successful.
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3.28 IT risk assessment


Required
What concerns would you have about the payroll applications integration with the
general ledger application?
Concerns include:
- New payroll system is more complex than the old system how does this affect its
integration with the general ledger (can the general ledger interface completely with
the new payroll system, have undocumented changes been made to the general ledger
system to enable the interface?)?
- Have staff been adequately trained in the new system, including inputting data and
acting on reports?
- Limited testing of new system why did this happen (was installation rushed, were
there problems with the new system, are there adequately trained staff operating the
system)?
- Lack of evidence of the integrity of the new system due to limited testing, there could
be undetected problems with the new system
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3.29 Fraud risk


Required
Explain why the revenue from passenger accounts in the income statement is at
significant risk of fraudulent financial reporting by management.
Factors that increase risk of fraudulent financial reporting:
- Lower demand and increased competition, especially relating to business travel,
increases pressure on management to meet revenue targets
- Accounting policy involves use of revenue received in advance account with
subsequent transfer to revenue. This required control over procedures to recognise
when flights are taken and match with the appropriate transfer to revenue.
Opportunity to corrupt this system to allow revenue to be transferred at a time that
suits management (i.e. to meet forecasts). This type of accounting policy is more
easily overridden by management than by more junior staff. Management also usually
have greater incentives to manage revenue.
- Passenger revenue is 8% of total revenue, potentially material, creating an opportunity
to use this revenue stream to affect total profit targets.
- Change in revenue from passengers is less than change in revenue in advance,
suggesting that some receipts are being channelled into revenue rather than revenue in
advance. Alternatively, forward bookings (which would be credited to revenue in
advance) are falling much more than current revenue, signifying even greater falls in
revenue in future periods, creating even more pressure on management to manipulate
revenue.

3.34 Impact of closing procedures on performance


Required
(a) Explain why and how the circumstances described above could affect your risk
assessment.
(b) How would you audit Dunks closing procedures? What potential errors would be of
most interest? Explain.
(a)
The auditor is required as per ASA 315 to understand the aspects of the clients
business risk that increase the likelihood of material misstatement. Dunks has experienced
consistent growth but there are doubts about its ability to continue to grow in the current
economic climate. There is a risk that these conditions could place financial stress on the
company through falling revenue and cash collections from customers and increased costs
from adverse currency movements. There could also be difficulty sourcing products from
other companies in financial stress. There is increased risk of doubtful debts, and improper
revenue recognition. If currency exchange rates are more volatile because of the recession
there is increased risk of incorrect purchase costs and exposure to foreign currency exchange
risk (which could be hedged).
Senior managers remunerated through bonuses could be under pressure to find ways to
increase revenues and cut costs. These pressures could increase the risk of fraudulent
financial reporting. Also, the general attitude within the company towards profit targets could
be interpreted as a poor attitude towards preventing fraudulent financial reporting.
The slower monthly reporting is a concern. It increases the risk that exceptions and
performance evaluation are not being dealt with on a timely basis. It also suggests that the
reporting system is under pressure for some reason, increasing the risk that the reports are not
accurate, particularly with respect to monthly closing entries.
(b)
Given the above risk statements, specific focus would be on making sure that
revenues are not overstated and expenses are not understated. This means that there would be
a search for backdated revenues and postdated expenses. Documents (invoices, cash receipts
and payments) related to sales for the first weeks of the new year and expenses for the last
few weeks of the old year would be inspected. The auditor would vouch sales journal entries
for the old year and trace expense documents to the journals for the new year.
Interim audit procedures would be directed towards investigating monthly closing
procedures. Although these monthly closing entries will not impact on the overall profit for
the year (except the first and last month entries), they provide a guide to the managements
attitude towards closing entries in general and the adequacy of the closing entry system
controls.

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