ACCT3708 Auditing and Assurance Services

Lecture Discussion Questions: Solutions

Lecture Ten

1.

XYZ Ltd is an infrastructure company. It owns several liquefied natural gas (LNG)
pipelines, which it leases to gas distribution companies, at fixed rates per cubic metre
of gas that is transported through the pipelines. Maintenance is contracted out to an
engineering contractor for a fixed annual fee.
The two major expenses are
depreciation on the pipelines and interest on the debts that were incurred to raise the
cash to buy the pipelines. Profits are high and showing a slow but constant growth
rate. The industry is stable, with very little competition. However, there is a risk that
the ACCC may intervene to reduce the rates that XYZ can charge its customers.
Finally, the risk of interest rate movements has been eliminated by a comprehensive
hedging program.
XYZ has a staff of twenty. The accounts department consists of one accountant and
two accounts clerks. One clerk is responsible for cash receipts and payments, all of
which are electronic, while the other records all transactions in the journals, including
the calculation and recording of depreciation. The accountant reviews their work
regularly and provides assistance with more complex transactions, as well as
preparing the financial statements and liaising with the auditors, the CEO and the
board of directors. The valuation and useful life of the companys pipelines are
reviewed annually by external consultants and these results are reported to the board
and are used in the preparation of the financial statements.
Required:
a)

List four business risk factors, which would impact on the accuracy of
depreciation? Overall, is the business risk for accuracy of depreciation high
medium or low?
The four business risk factors are:
High and growing profits, so there is little incentive to manipulate
depreciation figures to increase profits,
The industry is stable with little competition. Again, there is little
incentive to manipulate depreciation,
Costs and revenues are very stable. Again, there is little incentive to
manipulate depreciation,
The ACCC investigation gives XTZ the incentive to increase
depreciation to suppress profits and so limit any possible rate
reductions.
Overall, there is a low risk of misstatement of depreciation.

b)

List two mitigating controls that would reduce the risk of error in the accuracy
of depreciation?
The two mitigating controls are:
The work of the accounts clerk is reviewed by the accountant, which
should reduce the incidence of errors in the calculation of
depreciation,

c)

For each control, list one test of control that could be performed to determine
the control operates effectively.

d)

The use of an experts report, for asset values ensures that the asset
values and useful lives, used to calculate depreciation, are more
likely to be correct.

The first control is hard to test. If the review is formal, the

accountant might sign off on the work of the accounts clerk and this
sign off can be sighted by the auditor. If not, the auditor will have to
ask the two parties about the nature and extent of the review.
The second control can be tested by examining the experts report
and noting that the recommended asset value adjustments and
useful life changes have been adopted through adjusting entries in
the journal and changes and the depreciation calculations.

Once the mitigating controls are taken into account, what is the residual risk
of error in the accuracy of depreciation (high medium or low)?
The residual risk of error is likely to be low, as there is little reason for
the company to misstate the rate of depreciation and the internal
controls should protect against the chance of errors or bad judgments.

e)

How much substantive analytical procedures and tests of detail should be

performed to reduce the risk of errors, in the accuracy of depreciation, to an
acceptable amount?
This is an excellent situation in which to use substantive analytical
procedures, as the underlying data (asset values and useful lives) is
likely to be largely free of error, due to the low business risk and good
controls. Furthermore, the nature of the account means that there are
analytical procedures that can be easily and accurately carried out.
Therefore, many substantive analytical procedures should be
performed. Given that the risk of error is low and that many substantive
procedures will be performed, there is little need for tests of detail,
though some will always be perfumed.

f)

List two substantive procedures that should be performed to test the accuracy
of depreciation for XYZ Ltd.

Select a sample of assets and check that their values and useful
lives are the same as those that were recommended in the most
recent external experts report.
Select a sample of assets and recalculate their depreciation expense
and check that these figures are the same as the depreciation
expenses that are recorded in the general journal.

2.

ABC Ltd owns a chain of computer retail stores. The company is suffering from
strong competition from major department stores and online computer retailers. In
addition, the mix of products that consumers buy is constantly changing, with more
demand for personal digital music players, such as iPods, and digital cameras, and
less demand for personal computers. Because of this, the companys profits have
fallen in recent years and cash flow is weak. While the company is still able to pay
the interest on its debts, it is in danger of violating the debt covenant, which requires
it to maintain a certain level of return on equity and a certain gearing ratio.
Furthermore, it is likely to struggle to make large loan principal repayments, which
are due at the end of the year. To overcome this, the company has engaged an
investment bank to try and find investors for a private equity capital raising.
As inventory is a major asset class, ABC has several controls in place for it. All
inventory is stored in a central warehouse, which is guarded by a major security firm.
The companys stores are all in shopping centres and are protected by the shopping
centre security systems. Once a month, an inventory stocktake is conducted at the
warehouse and at all stores, to check for missing or damaged inventory and
adjusting entries are posted to the journal to deal with any problems? Furthermore,
the purchasing manger reviews the sales of all inventory liens on a monthly basis
and only orders new stock of the exiting stock is selling well and the quantity on hand
is falling.
Required
a)

List five business risk factors, which would impact on the valuation of
inventory? Overall, is the business risk, for valuation of inventory high
medium or low?
Technology Constant change could lead to obsolete inventory.
Competition Will force prices and inventory values down.
Changing in consumer demand Could be left with unwanted stock.
Debt covenant Incentive to boost assets and ROE by not writing down
inventory.
Loan repayments/Capital raising Company ahs an incentive to lie
about its position.
Business risk is high

b)

List two mitigating controls that would reduce the risk of error in the valuation
of inventory?
1) Checks for missing or damaged inventory
2) Purchasing manager only places an order when the quantity on hand
falls below a certain level

c)

For each control, list one test of control that could be performed to determine
the control operates effectively.
1) Observe stocktake or sight documents. Look for adjusting entries in
journal.
2) Enquiry of purchasing manager, Look for authorised documents and
see that they have been signed by purchasing manager. If possible,
check inventory levels on dates of order, to see that they are below
threshold levels.

d)

Once the mitigating controls are taken into account, what is the residual risk
of error in the valuation of inventory (high medium or low)?
Still medium to high; the greatest problem is that there are no direct
checks for obsolete or overpriced inventory.

e)

How much substantive analytical procedures and tests of detail should be

performed to reduce the risk of errors, in the valuation of inventory, to an
acceptable amount?
Very few substantive analytics; there is not much that can be done for
this problem.
Lots of tests of details should be done.

f)

List three substantive procedures that should be performed to test the

valuation of inventory assertion for ABC Ltd?
Physically inspect inventory and look for obsolete inventory.
Compare last sales price of inventory to its cost
Check for last dispatch dates of inventory.

3.

Outline and justify the audit opinion that the auditor should issue in each of the
following independent situations.
With the exception of the issues outlined, assume that the auditor is satisfied in all
other material respects.
(i)

After XYZ had issued its financial statements, it was discovered that the chief
accountant had stolen a material amount of money from the company and had
covered this up by creating false payroll records. XYZ reissues the financial
statements with revised figures, to reflect the effect of the fraud. You believe
that the revised financial statements present a true and fair view.
Unqualified with an Emphasis of Matter Paragraph - There are no errors in
the financial statements but you need to inform the users that this is a
new audit report on a revised set of financial statements.

(ii)

A number of ratios shown in the 5 year statistical summary within your clients
annual report have been prepared on a basis which is inconsistent with other
information in the financial statements. You are happy with the financial
statements and Annual Report disclosures in all other respects.
Unqualified Opinion with an Other Matter Paragraph There are no errors
in the financial statements so the opinion is unqualified. The statistical
summary is not part of the financial statements but, as it is in the annual
report, we have to review it and inform the users of the inconsistency in
an emphasis of matter paragraph.

4.

Your client has intangible assets, being trademarks, which are recorded in the
accounts at $4,500,000. The value is the same as in the prior year. During the year,
your client commissioned an independent valuation of the trademarks. This valued
them at $2,850,000. Management refuses to adjust the financial statements to reflect
the revised valuation. The materiality for the client has been set at $1,200,000.
Assume that, with the exception of this issue, the auditor is satisfied in all other
material respects. Outline and justify the audit opinion that the auditor should issue.
Qualified - There has been a material misstatement of an asset account.

5.

Outline and justify the audit opinion that the auditor should issue om each of the
independent situations described below. With the exception of the issues outlined,
assume that the auditor is satisfied in all other material respects.
(i)

A company loses most if its accounting records due to a fire in its accounts
department. Although it is able to reconstruct its financial statements due to an
asset stocktake, third party confirmation procedures and inquiries from
creditors, there is no documentation to support transactions for the year.
Disclaimer - It is impossible to audit the income statement due to lack of
evidence.

(ii)

A cut-off error is identified by the auditor which results in an understatement of

sales, debtors and profit. The client decides not to adjust the accounts on the
basis of this error and the auditor determines that the error is not material to the
financial statements.
Unqualified The error is immaterial.

(iii)

Your client has determined that the cash basis of accounting provides a more
faithful representation of its financial position than accrual accounting, as it is a
cash rich business. Based on your audit work you have determined that the
difference between cash and accrual accounting, if adjusted, would significantly
change the net assets and profit.
Adverse Accounting standards do not permit the use of cash based
accounting and it will result in many material errors throughout the
financial statements.