HOLMES INSTITUTE FACULTY OF HIGHER EDUCATION

HA3032 Auditing Trimester 1 / 2010

TUTORIAL ACTIVITES
Wk 6 Topics scheduled Chapters 7&8 Tutorial Activities (for the following tutorial)

Materiality and risk

Qu 7.17, 7.19, 7.21, 7.26 8.12, 8.15, 8.26, 8.27

Suggested solutions 7.17 Audit risk is said to be a function of inherent risk, control risk and detection risk. Explain audit risk and 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 entitys internal control structure. Control risk is a function of the effectiveness of the clients internal control structure policies and procedures. Detection risk (DR) is the risk that any remaining misstatements will not be detected by the auditors substantive procedures. Detection risk is a function of the effectiveness of audit procedures and their application by the auditor. 7.19 For each specific audit objective, identify the management assertion from which it was derived.

Assertions from ASA 500. 1. Valuation and allocation 2. Existence 3. Completeness 4. This could relate to all presentation and disclosure assertions but in particular classification and understandability 5. Rights and obligations 6. Existence / valuation and allocation 7. Classification and understandability of disclosure
HA3032 Auditing T1 2010 ___________________________________________________________________________________________________ ___

8. Completeness / classification and understandability of disclosure 9. Accuracy / valuation and allocation 10. Accuracy / valuation and allocation would also form part of the testing of the completeness and occurrence / existence assertions 7.21 (a) Indicate the category of control activity applicable to each of the above twelve procedures. (b) Identify an assertion to which each procedure applies. Procedure 1 2 3 4 5 6 7 8 9 10 11 12 (a) Category A2(a) A2(c) (C) A2(a) A2(b) A2(c) C D B A2(b) C A2(c) (b) Assertion Occurrence Occurrence Completeness Occurrence Completeness Accuracy Occurrence Classification Occurrence Occurrence Occurrence Accuracy

7.26

(a) (b)

Discuss why each of these situations represents a risk. Identify the main account or group of accounts affected by this risks and how the specific aspects of the audit plan would be affected by these risks.

1. Unlisted public company / Significant bank debts It appears that the purpose of these financial reports is to meet the requirements of the bank loan contracts. In this situation there is an increased level of inherent risk because the management will have incentives to make the financial statements look good for the bank and to comply with any applicable loan covenants. Audit plan In the audit plan the focus will be on accounts that are relatively easy to manipulate by management to increase income. The auditor should take particular care to ensure that accruals have been completely recorded, inventory is fairly stated, and sales cut-off has been properly performed. 2. Additional machinery In this case there is increased inherent risk associated with the account balance class of machinery because of the potential for obsolescence after three years. Audit plan In the audit plan the auditor should perform extra work on the machinery associated with this road maintenance work. The auditor should consider the likelihood of the company obtaining further contracts to utilise the machinery and the potential resale value of the machinery. Although the useful life is potentially 10 years it may be effectively 3 years if there is little likelihood of further work from the government. The residual value will be very low if there is not a reasonable
Undergraduate Program HA2032 Corporate Accounting

market to sell the machinery. Allocating depreciation over 3 years instead of 10 years would have a significant effect on profit for the year. 3. Backyard water tanks The introduction of this new competitor will possibly have a significant impact on the profitability of Elliott relative to the industry. This will increase the overall inherent risk for the company and could affect a number of account balances and transaction classes. Audit plan In the audit plan the auditor should consider some of the issues associated with ensuring the company remains a going concern. The auditor should look at forecasted financial statement data and discuss with management the potential impact of this change in the market. The auditor should also consider the effect of this change on the values of the property, plant and equipment held by Elliott. However, the effect on this years audit will probably be just a note to the financial statements as the company would probably not feel the main effects of this change until the following year. 8.12 Explain the term materiality in the context of financial reporting? What is the audit significance of the concept of materiality?

In relation to financial information, materiality means: the information which, if omitted, misstated or not disclosed, has the potential to adversely affect decisions about the allocation of scarce resources made by users of the financial report or the discharge of accountability by the management, including the governing body of the entity. (AASB 1031) In applying this definition, the auditor is required to consider both: the circumstances pertaining to the entity; and the information needs of those who will rely on the audited financial report; when: determining the nature, timing and extent of audit procedures; and evaluating the effect of misstatements on the fair presentation of the financial report (ASA 320). Describe the two main alternative audit strategies that may be adopted in performing an audit.

8.15

ASA 330 describes requirements for auditors to follow in addressing risks identified. The two main alternative audit strategies are a predominantly substantive approach and a lower assessed level of control risk approach. A predominantly substantive approach is one where the majority of audit evidence is obtained by substantive audit procedures that provide direct evidence as to the fairness of managements financial statement assertions. A lower assessed level of control risk approach is one that relies on internal controls to support the use of a reduced level of substantive procedures. This approach requires that the auditor tests internal controls to verify that control procedures are actually operating as laid down. 8.26 (a) (b) Identify the key assertion(s) at risk in relation to the balances described in each of the situations above. Describe the audit procedures you would perform in order to gather sufficient, appropriate audit evidence on each of these assertions.

1. (a) Existence / Valuation and allocation

Undergraduate Program HA2032 Corporate Accounting

(b) In this case an independent expert has performed the work on the key risk areas. The auditor would need to consider ASA 620, Using the Work of an Expert:

The auditor should assess the appropriateness of the experts work. The auditor should review the source data used by the expert and ensure that it is sufficient, relevant and reliable. The auditor should also test the data used by the expert. If the results of the experts work do not provide sufficient appropriate audit evidence, or if the results are not consistent with other audit evidence, the auditor should resolve the matter (e.g. more work or audit qualification etc.)

Other Work Select a sample of fixed asset additions and disposals and vouch to supporting documentation. 2. (a) Existence / Valuation and allocation (b) The main problem here is existence. The following alternatives are possible when direct confirmation with debtors is unlikely to provide satisfactory results:

Review for subsequent payments by the debtors payment of the amount owing is good evidence to suggest that the amount exists and is fairly stated. Review for evidence of delivery of goods to customer. Review invoices (very weak evidence) When the auditor does not carry out a debtors confirmation, the reasons for doing so should be documented in the audit workpapers.

Valuation Select a sample of long outstanding and doubtful accounts and review collectability by reference to correspondence files and discussions with client staff. 3. (a) Valuation and allocation (b) Obtain copies of the latest accounts of the investee companies (audited if possible). Compare the percentage shareholding with the percentage value of net assets to ascertain reasonableness. 8.27 Indicate (a) the type of evidence obtained by each procedure, and (b) the assertion or assertions to which it pertains. (a) Type of Evidence 1. 2. 3. 4. 5. 6. 7. Confirmation Mathematical Analytical Oral Documentary Electronic Oral (b) Assertion Existence / valuation and allocation Accuracy / valuation and allocation Completeness / occurrence / accuracy / cutoff Valuation and allocation Rights and obligations Completeness Related to presentation and disclosure assertions of completeness / classification and understandability Valuation and allocation Completeness / existence Classification of transaction completeness of balance and

8. 9. 10 .

Written representation Physical Documentary

Undergraduate Program HA2032 Corporate Accounting

Undergraduate Program HA2032 Corporate Accounting