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ACCT601 Semester 2 2016

Chapter Five:
5.1, 5.2, 5.4, 5.6, 5.7, 5.8, 5.14, 5.16, 5.21, 5.23, 5.25

5.1

5.2

The auditor will be seeking information about the reasons for the change to
determine if there is a professional reason why the appointment should not be
accepted. Therefore, communication between the parties serves to protect:

an auditor from accepting a nomination when they are not fully aware of all
the circumstances

shareholders, who may not be fully informed of the circumstances


surrounding the proposed change

the interests of the existing auditor, where the proposed change arises
from, or is an attempt to interfere with, the conscientious exercise by the
existing auditor of their duty as an independent professional.

Engagement letters are used to document the arrangements made with the
client and to clarify matters that might be misunderstood. They usually cover
matters such as
(a) a description of the scope of services
(b) an explanation of the auditors responsibility for such matters as fraud
detection
(c) procedural arrangements such as billing of fees. Refer to ASA 210 (IS 210).

5.3.

Proper planning helps to ensure that important and potential risk areas of the
audit are given appropriate attention and problems are identified and dealt
with. It also helps to ensure that the audit is efficient and effective by
allocating the appropriate quality and quantity of audit staff to the
engagement and coordinating resources and work done by component
auditors or experts.

5.4

Audit procedures that are used to obtain knowledge of the clients business
include the following.

Read manuals and other specifications of formal organizational structure.

Inquire about organizational policies and procedures.

Observe actions of employees and top management.

Review last years correspondence files, permanent files and working


papers.

Tour the clients physical facilities.

Review legal documents, such as corporate charter and by-laws, minute


book, tax returns, and major contracts and correspondence.

Review trade journals, industry publications and statistics, pertinent


government regulations, and the relevant industry audit guide, if available.
.

5.6

5.7

As outlined in ASA 315.11 (ISA 315.11), an auditors 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 entitys selection and application of accounting policies

the entitys objectives and strategies, and those related business risks that
may result in risks of material misstatement

the measurement and review of the entitys financial performance.

Business risk is the risk that an entitys business objectives will not be attained
as a result of the external and internal factors, pressures and forces brought to
bear on the entity and, ultimately, the risk associated with the entitys
profitability and survival.
In order to understand the business and assess whether the financial report is
fairly presented, the auditor must understand the entitys business strategy
and risks and its ability to respond to changing environmental conditions. The
auditor assesses the specific business risks that the entity faces in achieving
these strategies to determine if they could result in a materially misstated
financial report.

5.8

An audit strategy sets the scope, direction and timing of the audit and guides
the more detailed audit plan. An audit plan or program sets out the nature,
timing and extent of risk assessment procedures and evidence collection
procedures at the assertion level and any other audit procedures necessary to
meet Australian auditing standards.

5.14

(a) The risks to the audit firm of accepting this engagement include:

it may not be possible to obtain sufficient appropriate audit evidence to


form an opinion, especially given doubts regarding management integrity

IPL may not have the resources to pay the audit fee, as it has limited
customers and assets

the audit firm may become a party to legal action if the directors
behaviour leads to further prosecutions, or if IPL is wound up or made
bankrupt

the reputation of the audit firm may be adversely affected if the public
becomes aware of the legal action being taken against the directors.

(b) Guidance on information to be sought when evaluating a prospective client


can be found in ASA 220 (ISA 220).

Further information to be sought should include:

obtain and review available financial information, such as results to date


and budgets

obtain a copy of the business plan and check areas such as the marketing
plan: how IPL plans to compete against much larger companies

obtain information about their new sunscreen product to determine if there


is any basis for their claim that it is a superior product

make inquiries of third parties as to any information that might have a


bearing on evaluating the client (e.g. make inquiries of lenders and legal
advisers)

follow up the prosecutions and see if any outcome has been reached; if so,
determine its effect on the audit acceptance/rejection decision

ensure the decision of whether to accept or reject the engagement is made


in accordance with the firms policies and procedures

evaluate the firms independence and ability to serve the prospective client

determine that acceptance of the client would not violate the ethical code
of professional conduct.

It is unlikely that the potential auditor would gain much from the evaluation of
available financial information, given this is the first year that the company
has operated and this has been highlighted as one of the reasons the
prospective client is assessed as being high risk. However, the information still
should be reviewed.
5.16 Matters that need to be considered by the auditor as part of audit planning
include:
(a) Staff turnover: The high staff turnover rate and the increased pressure to
process payments promptly to reduce delays might result in additional errors
being made. Tests of control may need to be increased in the accounts
payable area, to ensure that they are operating effectively; otherwise a
substantive approach would need to be adopted. New staff might not be fully
competent and aware of required procedures. This could increase the auditors
inherent risk assessment.
(b) Retrenchment of internal audit department: The impact on the audit plan
will depend on the auditors use of the work of the internal audit department.
The removal of internal audit means the removal of a control function and so
is likely to increase control risk. It might also reflect a poor attitude to controls
by management and result in an increase in both control risk and inherent
risk.
(c) Conversion to the new software package: The auditor should consider the
possibility of errors being made in the conversion process. The auditor will
need to obtain an understanding of the internal controls in the new software
package and make a new assessment of control risk. The auditor will need to
determine if the same or similar information and reports will be available from
the new ledger for use.
(d) Tax: The auditor needs to pay special attention to the provision for tax and
related accounts. The auditor should examine all documentation and might
need to use an expert to ensure the provision for tax is fairly stated.

(e) Accounts receivable confirmation letters: Additional work would need to be


performed regarding debtors' confirmations to determine whether the use of
external confirmations is necessary to obtain sufficient appropriate audit
evidence in relation to receivables or whether receivables can be verified by
other procedures, such as subsequent cash receipts. It would also be
necessary to determine how, if at all, the client's offer of assistance could be
utilised.
5.21
(a) Business risks

(b) How they might lead to


risk of material
misstatement

Pressure from larger, aggressive


competitors.

Inventory valuation and


allocation is at risk, as
aggressive competition is
likely to lead to price
discounting and so may lead
to selling prices being below
cost for some lines, resulting
in a need to write inventory
down to net realisable value.

Reduction in gross margins/cost


of value-added services.

Movement away from core


business to new products in an
attempt to claw back margins
this has had limited success to
date. May distract management
from core business.

Going concern may be at risk


due to reduced margins,
tighter terms of trade and
likely rent increases. This
may lead to a risk of material
misstatement of the carrying
value of items in the financial
report.

Apparent deterioration in terms


of trade with one of its major
suppliers.

Three leases are up for renewal


prior to the end of the financial
year, with steep rises in costs
foreshadowed.

Legal action commenced


against a much larger rival that
is likely to be expensive and the
case difficult to prove.

This may result in an


increased risk of
understatement of lease
commitments in the
financial report.

This leads to the risk of an


understatement of legal
costs associated with this
action.

Also need to consider


whether any contingent
asset needs to be disclosed
in accordance with AASB 137
(IAS 37).

5.23
(a) Business risk

(b) Audit risk

(b) Account
balance

As there are
purchase contracts
with overseas-based
suppliers, there is a
risk that the foreign
currency rates
applied may be
incorrect, leading to
loss of profits and
loss of cash
outflows.

The risk that the translated


values posted to the general
ledger accounts are
misstated (asset, liabilities,
and income statement
accounts could be over or
understated). This could be
material given the main
purchasing expenditure
relates to the overseas
suppliers.

Purchases/cost
of sales

Inventory

Accounts
payable

Foreign
exchange
gain/loss

As the inventory
comes from
overseas, there is a
risk that if there are
any delays in
meeting shipment
dates the delays will
be significant, which
may impact MSLs
business (e.g.
unable to sell or
perform services, as
no parts are
available). This has
an impact on the
financial report
results (cash,
profits).

The audit risk will be about


the impact of potential
delays on year-end values,
such as debtors and
inventory if there are
concerns from customers
about delayed or unfilled
orders. Customers may not
pay if they cannot get
maintenance, service or
replacements parts, or they
may go elsewhere for
equipment maintenance,
which may affect the resale
of the equipment.

Accounts
receivable or
allowance for
doubtful debts

Inventory

The quality of the


equipment and the
spare parts ordered
may not always be
at the same
consistent level
across the suppliers.
Any defect in the
inventory may lead
to customer
complaints, loss of
business, or
refunds/returns on
sales. This impacts
the financial results.

The audit risk is associated


with the impact on the
valuation of various
accounts that may be
overstated, such as
customers refusing to pay
outstanding invoices or no
longer being prepared to
pay the set sale price for the
equipment or spare parts,
due to quality issues
impacting the effective life,
or other factors.

Accounts
receivable or
allowance for
doubtful debts

Inventory

5.25

(a) The impact on the audit strategy would include:

the new computer system provides additional information that increases


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

(b) The impact on the audit strategy would include:

less reliance can be placed on the internal control system, therefore


greater substantive testing is required

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

follow up the explanation for the changes (difficulty in maintaining past


sales levels) and evaluate the implications for other audit areas (for
example, future viability, inventory valuation)

greater attention should be paid to the provision for doubtful debts due to
credit ratings not being checked

because of the discounts, gross margins will vary more and less use can be
made of analytical procedures as part of the substantive testing of sales.

(c) The impact on the audit strategy would be to perform work on the fixed
assets register so that it can be relied upon. Additional work to be performed
regarding new fixed assets register would include:

check the assets were correctly transferred to the new system; that is that
assets are complete and only the assets in existence have been recorded
in the new register

update systems notes on fixed assets to reflect the introduction of the new
register

consider whether depreciation calculation complies with AASB 116 (IAS 16)

obtain a list of reports produced by the new system and determine their
use for audit purposes the more detailed reports might give greater
scope for use of analytical procedures during the audit.