Act303 Principles Of Auditing - Assessment Answers

You are an audit partner with Billings & Associates, a large and experienced audit firm. You have been approached to accept the audit of Pharmaceuticals Ltd (Pharmaceuticals), a medium?sized chemical manufacturer. The manufacture of the chemicals results in highly toxic waste and Pharmaceuticals is currently under investigation by the Environmental Protection Agency for a significant spill of toxic chemicals into a nearby river. The media have reported that senior employees were allegedly involved in trying to cover up the spill.

Required:

Identify and explain the key ethical matter regarding Pharmaceuticals and its management that you should consider before making the decision to accept the engagement.

Pharmaceuticals Ltd (Pharmaceuticals) imports a number of pharmaceutical products. In order to hedge its foreign currency transactions, Pharmaceuticals entered into a number of forward rate agreements this year. Prior to this time Pharmaceuticals had had little exposure to derivative instruments, but a series of bad experiences resulting from fluctuating exchange rates convinced the company that a hedging strategy was necessary. During planning for the audit of Pharmaceuticals, the company’s hedging arrangements were identified as inherently risky and increased testing was carried out in this area. A number of small errors were noted in accounting for hedge transactions, but there did not appear to be any material errors and as such no adjustments were made. A review of the audit file suggests that the errors noted were a result of inexperience and poor controls in the area. While all of the errors were brought to the attention of the treasurer, who is responsible for the company’s hedging strategy, no further action has been taken to date.

Required:

Outline what further action the auditor should take in response to the errors and control weaknesses identified. Justify your response.

Billings & Associates has agreed to take on a new audit client, Reaction Pty Ltd, a small garage door manufacturer that has never previously been audited. Billings & Associates has issued an engagement letter prior to commencing work for the current year. While conducting the audit, the audit team is unable to gain sufficient appropriate audit evidence around accounts receivable due to a lack of documentation. You have informed client management that you need to issue a modified auditor’s report due to the scope limitation. In response, management has requested that the engagement become a review engagement with the associated lower level of assurance, as they are not required to have an audit.

Required:

Outline the appropriate response to this situation. Provide reasons to support your response.

Consider the following independent situations:

1. You are the auditor of Hail Pty Ltd a medium sized furniture manufacturer. Your audit firm has finalised the financial statements after the client has substantially prepared the accounting records. However, the client admits to having limited knowledge of identifying and calculating impairment and has asked for your assistance. You have proposed a number of adjustments to account for the impairment of assets.

2. You are the auditor of Travel Time Ltd, a large travel agent that also handles all your audit firms travel arrangements on normal commercial rates and provides excellent service. The managing director of Travel Time has indicated that the company is having a tough time of it due to the lack of consumer confidence in the economy at the moment and has asked if you could help by recommending their services to your other audit clients. He has said that he will understand if you are not able to do so. You happily agree to provide the recommendation, as you have always been satisfied with their service.

3. Your audit firm has been approached by a new client, Civil Constructions Ltd, to conduct the audit for the coming year. As part of your client acceptance procedures, you identify that the wife of one of the audit firm’s partners has a substantial shareholding in Civil Constructions Ltd.4. Your audit client, Pleasure Cruises Ltd, is having cash flow problems and has not paid any of the current year’s fee by the time the auditor’s report is due to be issued. They expect business to pick up in the coming year and have requested an additional time to pay the bill.

Required:
For each of the independent situations above:
a) Identify the type of potential threat to independence. Justify your answer.
b) Describe a safeguard, if any, which could be implemented to reduce each of the independence threats.

Answer:

Introduction:

As per APES 110, Section 210, Professional Appointment, while accepting the audit engagement, it is necessary for the auditors to determine whether there is any negative effect of this engagement on the ethical and fundamental principles of the profession or not (Chapple et al. 2014). This aspect leads the auditors to obtain sufficient understanding and knowledge about the client and its management for ascertaining any corporate governance or ethical issue. As per this standard, the auditor of Billing and Associates is required to take into consideration two ethical aspects. First, the auditor is required to take into consideration the toxic chemical spill from the manufacturing process into the river. Second, the auditor also needs to consider Pharmaceuticals management’s involvement in covering up the unethical situation. Thus, both the scenario clearly shows breach of ethical code of conduct that has negative impact on the fundamental as well as ethical principles of auditing (Chapple et al. 2014).

The next step for the auditor of Pharmaceuticals after identifying the errors and control weakness is to suggest the management of Pharmaceuticals on how they can strengthen the internal control so that the repeat in the errors can be avoided. The next step is the issue of qualified audit opinion that is not much different from the unqualified audit report. The main aim of the issue of qualified audit opinion is to inform the key stakeholders of Pharmaceuticals about the hedging related issues faced by Pharmaceuticals. As a part of qualified audit opinion, the auditor will provide the explanation of issuing qualified audit opinion in the audit report (Czerney, Schmidt and Thompson 2014).

The main aim of auditing is the examination of financial statements of business entities in order to find out any kind of material misstatements in them. In this process, it is the obligation on the auditors to obtain sufficient audit evidence. The audit engagement letter includes all the terms and conditions about the audit engagement and the audit clients need to read this engagement letter (Blay et al. 2014). In the provided scenario of Reaction Pty Ltd, the auditor of Billions & Associates has provided the engagement type in the audit engagement letter along with other terms and conditions of audit engagement. Due to this, Billions & Associates is responsible for the audit operation of Reaction Pty Ltd but not undertaking the review engagement.

Based on the provided situation, the auditors of Billions & Associates are needed to provide the Disclaimer of Audit Opinion that is the part of the modified audit opinion. The main reason behind the issue of modified audit opinion is the restriction of the management of audit client on the auditor not to obtain all required financial information. In the provided scenario of Reaction Pty Ltd, lack of documentation in the organizations has put a restriction on the auditors in obtaining the necessary information (Tsipouridou and Spathis 2014). Thus, in the presence of all these issues, the auditors will provide disclaimer of audit opinion.

APES 110, Section 290.167 indicates towards the obligation of the companies to follow the required accounting standards for the preparation and presentation of financial statements. Section 290.167 indicates the creation of Self-review Threat of audit independence while providing the services of accounting and bookkeeping for preparing financial statements (apesb.org.au 2018). In case of Hail Pty Ltd, the auditors create self-review threat of audit independence by proposing number of accounting adjustments for impairment.

Removing the particular auditor from the engagement team is the main remedy of this scenario. Apart from this, Hail Pry Ltd can seek the help of accounting bodies for accounting issues (apesb.org.au 2018).

APES 110, Section 100.12 indicates towards the creation of Advocacy Threat of audit independence while an auditor is promoting the business of audit client (apesb.org.au 2018). In the provided scenario, after satisfying with the work of Travel Time Ltd, the auditor agrees in recommending the services of the firm to others. This action of the auditor of Travel Time Ltd breaks the professional objectivity and leads to the development of advocacy threat.

The introduction and implementation of effective corporate governance policies in audit profession is the major remedy or safeguard in this situation (apesb.org.au 2018).

APES 110, Section 100.12 indicates towards the creation of Familiarity Threat of audit independence in case there is any close and longstanding relationship between the auditor and other audit client (apesb.org.au 2018). The provide scenario indicates toward the presence of longstanding relationship between the auditor and audit client due to the major shareholding of one of the auditor’s wife in Civil Constriction Ltd and the whole situation can lead to biased audit opinion. Hence, it can create the familiarity threat of audit independence.

The removal of the particular audit partner from the engagement team can is the major safeguard in of this situation (apesb.org.au 2018).

APES 110, Section 100.12 indicates towards the creation of Intimidation Threat of audit independence in case the auditors cannot perform the correct audit procedure due to any actual or perceived influence or pressure (apesb.org.au 2018). As per the provided scenario, Pleasure Cruises Ltd is requesting the auditors for extra time that is creating indirect pressure on the auditor. Thus, the acceptance of the request of Pleasure Cruises Ltd by the auditor will lead to the creation of intimidation threat of audit independence.

The implementation of efficient corporate governance policies and procedures is the major safeguard of this situation (apesb.org.au 2018).

Deficiency	Explanation	Control	Test of Control
Lack of integration between inventory mechanism and website	It can contribute to the placement of order and full payment in the absence of enough inventories.	TUPL needs to consider the implementation of accurate Accounting Information System as it will allow the website to take order in the presence of sufficient inventory by integrating the website with the inventory (William Jr, Glover and Prawitt 2016).	Re-performance of the order placement process can be used for test this control.
Lack of mechanism for recording the customer signature as a goods delivery proof	Some customers can take advantage of this lack of control by denying the delivery of goods.	TUPL needs to consider the introduction of digital signature system in order to obtain the proof of delivery (Skaife, Veenman and Wangerin 2013).	By inspecting the introduced process, auditors can test this control.
Non-forwarding the sales order to dispatch department	This scenario can lead to late delivery of products to the customers that can affect the company goodwill.	TUPL is required to consider the appointment of specific department that will have the responsibility of delivering the sales order to the dispatch department at correct time (Vovchenko et al. 2017).	In order to test this control, the auditor is needed to observe the whole process starting from the sales to the delivery of the sales orders to the dispatch department.
Non-including the area sales manager and the sales director in the process of credit checking	This scenario can contribute towards the ineffective and incorrect setting of credit limit that can end up in company loss.	As a remedial mechanism, TUPL needs to consider assigning the area sales management and the sales director in the credit setting process that will require the approval of both of these officials (Vasarhelyi and Halper 2018).	The strategies of observation as well as inspection can be used for testing this introduced control process.
More than required plant and equipment	This scenario can contribute to the business loss for TUPL due to non-usage of additional plant and equipment.	TUPL is required to consider the replacement of existing production supervisor with an efficient one who will be responsible for providing the correct requirement of plant and equipment as per business operations (Mock and Turner 2013).	In order to test this control, the auditor can take the help of both inspection and observation of the whole process.

As per the provided scenario, there are two accounts at the risk of material misstatements in Unique. One of them is the Trade Receivable account. The scenario shows 1.24 as the current ratio of Unique while the bank’s requirement is 1.2 as the current ratio. An efficient policy for debtors is there in Unique and in the presence of this well-crafted debtor policy, the deficiency in the current ratio indicates towards the presence of material misstatements (Lobo and Zhao 2013).

Another account is the Sales account. As per the given information, Unique has $350,000 as net sales for the whole year where the bank wants Unique to maintain a sales amount of $100,000 per quarter. Thus, major deficiency is there in the sales account of Unique that indicates towards the presence of the risk of material misstatements (Lobo and Zhao 2013).

As per the provided scenario, the profit margin of Unique has major issue related to the prior year. Major decline in the net profit as well as gross profit can be seen that can be regarded as a crucial issue in Unique (Lobo and Zhao 2013).

As per the going concern assumption, a business entity will continue its operation for the unforeseeable future and no one will force the entity to put a halt in the operation and liquidate its assets in the future. It is the obligation on the entities to follow the going concern assumption to prepare the financial statements (AICPA 2017). In Unique, three major factors are there that can stop Unique from operating as a going concern in near future.

Major decline in both the gross profit and the net profit can be considered as the first factors that can lead Unique towards liquidation or winding up business. The rise in the price of timber as a result of increase and decrease in the values of US dollar and Australian dollars respectively is the second factors as it can lead the company towards huge loss. The increase in labour cost due to high wage rate is the third factor that can contribute towards huge business loss of Unique (AICPA 2017).

It is required for the auditors to consider the above factors in audit planning. For the accounts at material misstatements risk, to obtain sufficient information is required for the auditors in order to ensure the presence of material misstatements. In addition, the auditors need to consider the application of analytical audit procedures for obtaining information about the going concern assumption (Chan and Vasarhelyi 2018). Thus, on a whole, the auditors are needed to take into consideration all the accounts at material misstatement risk while planning the audit actitiviteis.

The payment of sales bonus involves an internal control issue in Unique. As per the provided scenario, there has been the payment of sales bonuses in spite of the non-fulfilment desired criteria. This situation indicates towards the weakness in internal control of Unique due to fraudulent activities (Mock and Turner 2013).

There are two fraud risk factors in Unique. No change in the gross margin can be considered as one of them. Decline in the gross profit leads to decline in the gross margin. However, there is not any change in the gross margin in Unique in spite of the decline in gross profit that indicates towards any fraudulent activity in the company (Mock and Turner 2013). The balance of debtors can be considered as the second factors. As per the provided scenario, Unique witnessed a large change in debtor level between the last day of the year and the next six months that is unusual. It indicates towards the fraud risk in this account (Mock and Turner 2013).

The above discussion indicates that the balance of debtors in Unique is at risk and the potential fraud actitiviteis in the account can be held responsible for this. The main intention to manipulate the balance of debtors could be to earn sales bonuses (Power 2013). For this reason, two major assertions related to the debtors in Unique can be also at risk. The initiation and approval of the customer invoice while sales take place is the first assertion. The approval and issue of credit note to the customers within the return of 60 days is the second assertion. It might happen that the management of Unique has made these assertions to make manipulation in the debtor account (Power 2013).

The introduction and implementation of test of control is one audit procedure to address material misstatements where the auditors are responsible for implementing different test of control for obtaining sufficient audit evidences in order to measure the internal control of Unique (Guénin-Paracini, Malsch and Paillé 2014). The introduction of substantive audit procedures is another major audit procedure to address material misstatements. In this process, it is the obligation on the auditors to design and perform different substantive audit procedures for all management assertions to test the internal control of Unique (Guénin-Paracini, Malsch and Paillé 2014).

Event	Description	Impact of Materiality	Explanation
1	The scenario indicates towards the abrupt resignation of the finance manager of Sali in June 20X7 and the inability of the company to find the replacement of him.	There will be increase in materiality due to this scenario.	The finance manager of Sali was responsible for correctly carrying on the finance operations and his presence will affect the financial reporting of Sali. In addition, the halt in financial reporting may increase the scope of fraud and manipulation in the financial reporting of Sali. These whole scenario can lead to material misstatements of financial statements of Sali (Legoria, Melendrez and Reynolds 2013).
2	This event shows the resignation of Human Resource (HR) manager of Sali in June 20X7 and the ability of Sali to find the replacement of him in correct time.	There will not be any effect on materiality due to this event.	Fraud, manipulation or errors lead to the creation of material misstatement in the financial statements that indicates towards the contribution of only financial factors in material misstatements. HR managers do not have any responsibility in financial reporting as their responsibility is to manager human resources in the companies. For these reasons, the resignation and appointment of HR manager does not have any effects on materiality in Sali (Christensen, Glover and Wood 2013).
3	This scenario indicates that the auditors of Sali have encountered with two material variance at the time to reconcile data on SuperD to SuperB as a result of fixable errors.	The initial stage will increase materiality; after that, materiality will be decreased.	As per the situation, presence of errors is responsible for material variance and this error is fixable from the management side of Sali. Thus, in the initial stage, the presence of materiality is there due to errors. However, with the assurance from the management to fix this error will contribute to the reduction of materiality (Eilifsen and Messier Jr 2014).
4	The provided scenario indicates towards absence of purchase document for the purchase of 14% unlisted investment.	The initial stage will increase materiality; after that, materiality will be decreased.	There is a risk of material misstatement of the financial statements in the absence of legal documents of financial transactions. There is a high risk of material misstatements in the financial statements of Sali due to the purchase of unlisted investment without any document. Later, Sali obtained the purchase document from Dune Ltd. Thus, in the presence of correct document, there will be decrease in the materiality of the financial statements of Sali (Ruhnke, Pronobis and Michel 2014).

References

AICPA, 2017. Statement on Auditing Standards, Number 126: The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern (No. 126). John Wiley & Sons.

Apesb.org.au. (2018). APES 110 Code of Ethics for Professional Accountants. [online] Available at: https://www.apesb.org.au/uploads/standards/apesb_standards/standard1.pdf [Accessed 8 May 2018].

Blay, A.D., Notbohm, M., Schelleman, C. and Valencia, A., 2014. Audit quality effects of an individual audit engagement partner signature mandate. International Journal of Auditing, 18(3), pp.172-192.

Chan, D.Y. and Vasarhelyi, M.A., 2018. Innovation and practice of continuous auditing. In Continuous Auditing: Theory and Application (pp. 271-283). Emerald Publishing Limited.

Chapple, L., Crofts, P., Ferguson, C. and Hronsky, J., 2014. Professional independence and attachment bias: an exploratory study.

Christensen, B.E., Glover, S.M. and Wood, D.A., 2013. Extreme estimation uncertainty and audit assurance. Current Issues in Auditing, 7(1), pp.P36-P42.

Czerney, K., Schmidt, J.J. and Thompson, A.M., 2014. Does auditor explanatory language in unqualified audit reports indicate increased financial misstatement risk?. The Accounting Review, 89(6), pp.2115-2149.

Eilifsen, A. and Messier Jr, W.F., 2014. Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), pp.3-26.

Guénin-Paracini, H., Malsch, B. and Paillé, A.M., 2014. Fear and risk in the audit process. Accounting, Organizations and Society, 39(4), pp.264-288.

Legoria, J., Melendrez, K.D. and Reynolds, J.K., 2013. Qualitative audit materiality and earnings management. Review of Accounting Studies, 18(2), pp.414-442.

Lobo, G.J. and Zhao, Y., 2013. Relation between audit effort and financial report misstatements: Evidence from quarterly and annual restatements. The Accounting Review, 88(4), pp.1385-1412.

Mock, T.J. and Turner, J.L., 2013. Internal Accounting Control Evaluation and Auditor Judgement: An Anthology. Routledge.

Power, M., 2013. The apparatus of fraud risk. Accounting, Organizations and Society, 38(6-7), pp.525-543.

Ruhnke, K., Pronobis, P. and Michel, M., 2014. Audit materiality disclosures and credit lending decisions.

Skaife, H.A., Veenman, D. and Wangerin, D., 2013. Internal control over financial reporting and managerial rent extraction: Evidence from the profitability of insider trading. Journal of Accounting and Economics, 55(1), pp.91-110.

Tsipouridou, M. and Spathis, C., 2014, March. Audit opinion and earnings management: Evidence from Greece. In Accounting Forum (Vol. 38, No. 1, pp. 38-54). Elsevier.

Vasarhelyi, M.A. and Halper, F.B., 2018. The continuous audit of online systems. In Continuous Auditing: Theory and Application (pp. 87-104). Emerald Publishing Limited.

Vovchenko, G.N., Holina, G.M., Orobinskiy, S.A. and Sichev, A.R., 2017. Ensuring financial stability of companies on the basis of international experience in construction of risks maps, internal control and audit. European Research Studies Journal, 20(1), pp.350-368.

William Jr, M., Glover, S. and Prawitt, D., 2016. Auditing and assurance services: A systematic approach. McGraw-Hill Education.

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