ACT303 Principles of Auditing- Fraud Risk Factors

Part A

Consider the following independent situations:

1. You have established an audit practice with two separate divisions: account preparation and Each division has a different partner and staff team. Your firm commonly prepares financial accounts and conducts audits. Your firm has recently been provided with a trial balance from a listed client Red Ribbon Ltd, for whom your firm is preparing the financial accounts and conducting the audit. The client has significant expertise and approves all adjusting journal entries.

2. Daniel Jackson is part of the audit team for the current audit of Jupiter Ltd. After 2 weeks at theclient, he has advised you that he has been offered a job at Jupiter Ltd as soon as the current audit is finished.

3. One of your major clients, Fruity Juices Ltd, has talked to you about a consulting engagementnext year for you to do a complete review of the adequacy of the entity’s quality controls over the production of its fruit juices. However, the managing director has indicated that some of the Board are concerned about you taking up too much of their staff’s time asking unnecessary Therefore, he has suggested that your chances of getting the engagement will be significantly improved if you keep your questions of staff to a minimum during the current audit.

4. You have audited Apex Ltd, a stable engineering firm, for several years. At the start of thisyear, the finance director, Carol Ling, retired after 10 years with company and was replaced by Eric Lay, a long-time friend of the audit manager Bruce Li, who was best man at Eric’s recent marriage.

5. One of your audit clients, Super Trooper Ltd (STL) is a large superannuation fund. TheAustralian Taxation Office has advised STL that it has rejected its taxation treatment of a material amount of income from investments and that it disagrees with the taxation advice STL gave to its members. The matter has been referred to the Superannuation Complaints Tribunal and STL has requested that you represent them at the Superannuation Complaints Tribunal.

Required:

For each of the independent situations above:

a. Identifythe type of potential threat to independence. Justify your answer.

b. Explain what safeguards, if any, that could be implemented to reduce the independence threats.

c. Assesswhether audit independence can be achieved.

You may like to present your answer in the form of a table as below.

Situation

a) Threat

Justification

b) Safeguard

c) Assessment of audit

independence

Part B Background

WMD is the wealth management division of Eastpac Bank (Eastpac) and provides investment, superannuation, insurance and private wealth solutions to corporate and institutional customers. The following is a list of the auditor’s planning file notes in relation to fraud detection for the audit of the WMD unit.

1. Ensureall material fraud instances are detected.

2. The auditor is responsible for maintaining professional scepticism throughout the audit, considering the potential for management override of controls and recognising the fact that audit procedures that are effective for detecting error may not be effective in detecting fraud.

3. Respondappropriately to fraud or suspected fraud identified during the audit.

4. A discussion among all of the audit firm’s staff on how and where the entity’s financialstatements may be susceptible to material misstatements due to fraud, including how fraud might occur.

5. Make enquiries of management, and others within the entity as appropriate, to determinewhether they have knowledge of any actual, suspected or alleged fraud affecting the entity.

6. Obtain sufficient appropriate audit evidence to confirm all potential fraud instances have beenuncovered and their impacts considered.

7. Test the appropriateness of journal entries recorded in the general ledger and other adjustmentsmade in the preparation of the financial statements.

8. Determine whether management has sufficient skills to prevent and detect fraud (e.g. throughproof of attendance at appropriate industry seminars and workshops, or past experience with fraud).

9. Obtaina copy of the client’s code of ethics document, and ensure employees have access to it.

10. Evaluatewhether the accounting policies selected by the entity may be indicative of fraud.

Required:

Identify the activities that are part and the activities that are not part of the auditor’s responsibilities relating to fraud under ISA 240.

Part C

Background

You are the senior auditor on the audit of Amistad Furniture Manufacturers Pty Ltd (Amistad). Your firm has recently been appointed as the first auditors of the company. You interview the managing director of the company to obtain background information on Amistad and to understand its business operations, its environment and system of internal control. Amistad was founded 30 years ago and

makes ‘grandfather’ clocks (freestanding, weightdriven, pendulum clocks). The clocks are made in one factory (situated in the Blue Mountains) and are distributed through boutique homeware and antique furniture stores. The clocks are advertised mainly in local newspapers and through pamphlet drops.

In order to promote longer production runs and minimise finished goods stocks, Amistad’s retail distributors are offered stock on a ‘sale or return’ basis. This means that the homeware and antique furniture stores are invoiced immediately, subject to a 90-day term of payment, but are allowed to return the stock up to 30 days before payment is due. Only the marketing manager has been given the authority to make these offers. All of Amistad’s timber is obtained from offshore sources. Timber prices, which are denominated in US dollars, have risen substantially over the past two years and the recent drop in the value of the Australian dollar has caused them to rise even further. Timber purchases are secured by providing Amistad’s suppliers with letters of credit which become due when the container shipment of timber arrives in Australia. Labour costs are high due to the craftsmanship and quality required for the production of the grandfather clocks. Skilled labour is not easy to obtain and wage rates have recently risen. Amistad has found it difficult to pass on these timber and labour price increases to customers.

An analysis of costs indicates that there have been material negative purchase price variances in purchases of timber over the course of the year. You have compiled the following information from Amistad’s financials:

thecurrent ratio as at 30 June 2016 is 24
onan annualised basis, net sales are $350,000
theshareholders’ funds to total assets ratio is 30%
gross profit margins and net profit margins for the year ended 30 June 2016 have dropped tothe level where losses are being

Amistad’s bank finances the company’s timber purchases using bills of exchange drawn at 90 days from the date of payment of the shipment. It has also extended loan finance to Amistad. The bank covenant, which is due for review shortly, requires Amistad to:

maintaina current ratio of 1.2
maintaina shareholders’ funds to total assets ratio of at least 30%
maintainnet sales of a minimum of $100,000 per quarter
prepare a general purpose financial report for the year ended 30 June 2016 and have it auditedaccording to Australian Auditing Standards. (Note that this is a requirement of the bank covenant as Amistad is not required to produce a general purpose financial report under the Corporations Act 2001.)

1. Required:

For parts (a), (b) and (c) of this question, please disregard all going concern considerations. Based on the background information above and your use of preliminary analytical procedures, answer the following questions:

a. Identifyand explain two asset accounts at risk of material misstatement.

b. Describeone issue regarding the prior year’s figures.

c. Describe three factors that may bring into question the going concern assumption for Amistad

d. Disregarding the evaluation of management’s assessment of the going concern assumption,briefly describe the effect of the facts on your audit planning.

2. Required:

After examining Amistad’s detailed trial balance, you notice that one of the expenses of the sales and marketing department is ‘sales bonuses’. You question this expense and the company’s accountant informs you that a monthly bonus of 10% of salary is paid to all sales and marketing staff if sales for the month exceed the budgeted target. The marketing manager is entitled to a 20% bonus if the targets are achieved. This incentive was implemented during the previous financial year and was in place for the last six months of the year. You note that the bonus has been paid every month since the incentive was implemented (except for the previous month, when sales were much lower than expected). This seems a little unusual because Amistad had only achieved its budgeted sales targets in two out of the six months prior to the start of the scheme. You investigate results for the last six months of the year

and find that:

saleswere above the monthly budget figure when bonuses were paid
therewas no significant change in gross margins
returns of stock sold on the ‘sale or return’ basis were well below those in the first six monthsexcept in the final month of the year
debtors’ levels (measured in days outstanding) were above their budgeted levels but returned toa more normal level at year end.

On further enquiry, the accountant advises that the marketing manager is authorised to do the following with regard to the stock sold on a ‘sale or return’ basis:

offer customers a ‘sale or return’ deal as long as the deal is within the company’s pricingstructures and the terms of the scheme
initiate and approve the invoicing of customers when a sale is made (i.e. if the stock is notreturned within 60 days)
initiate and approve the issue of credit notes for these customers when returns are made within60 days or when pricing or quality issues arise.

3. Required:

Based on the information to , answer the following questions:

a. Explainone internal control issue at Amistad.

b. Identify two fraud risk factors at Amistad.

c. Identify one account balance at risk and its two assertions at risk as a result of the fraudrisk factors identified in (b) above. Justify your answer with reference to the background scenario.

d. Describe two audit procedures that would address potential misstatements arising fromfraudulent financial reporting. Ensure that your procedures are specific to the scenario and the fraud risk factors identified in (b) above

Answers

Part A

Situation	a) Threat	Justification	b) Safeguards	c) Assessment of Audit Independence
Preparation of Financial account and conduct audit under same firm	Self Review Threat present in financial statements as the amount of audit and non audit services are disclosed. (Barizah,2016),	In the given situation, the two divisions of the same audit firm are doing accounting and auditing services. The firm has presented the financial statements of one of his listed client Red Ribbon Limited and also done the financial accounts preparation. The client bas approved the all the adjustments and assumptions made by the accounting division of the audit firm. Although, the staff is different but the ultimate responsible person is one for both accounting and auditing.	· Disclose the interest of the auditor before the taking engagement to the stakeholders of the company · All the assumptions taken in preparation of accounts should be enumerated to in the financial statements to adhere with corporate governance	· Level of Objectivity lost by auditor.
Job Offer by management of Jupiter Limited to the audit team member	Threat of Self Interest of auditor independence as the audit team member may have personal interest in Jupiter Ltd. (Edwin, 2015)	In the given situation, the audit team member Daniel Jackson is working from two weeks to the client place Jupiter Limited for conducting audit. And the management of the client assurance him an offer of job after audit finalization. This assurance will create the personal financial interest of Daniel in the client business and his reporting can be hampered.	· The auditor should restrict the responsibilities of the audit member or remove that team member from audit assignment after getting the knowledge of the financial interest of the audit team member.	· Level of Financial and Personal Interest in the Client Business.
Offer of consultancy engagement for next year by the managing director of the company	Threat of Intimidation as there is fear of losing financial revenue in the mind of the auditor. Some existence of Self Interest threat is also present in this situation. (Livine,2015)	In the given situation, the managing director of Fruit Juices limited gossip to auditor about his engagement for having the complete review about the quality controls of the company only if he does not ask so many questions about the audit queries to staff member. The managing director inadvertently creates dominance on the auditor and his team by making him lucrative offers to the auditor.	· Involvement of new Professional member to review the work done by the member of audit team. · Discussion of same issue to the stakeholders of the company and to the regulatory bodies those charged with corporate governance. · Decrease the extent of the relationship with the client and employees of the client.	· Level of Dominance created by the client on the reporting of auditor
Relationship with the New Finance Director of the Apex Limited	Threat of Familiarity as risk of high mutual trust which can hamper auditor independence (Parker,2015),	In the given case, the finance director of the company is retired and new finance director Eric Lay has been appointed by the company Apex Limited. The Eric has long lasting personal relationship with audit manager Bruce Li who was the best man in his marriage and can affect the reporting of the audit manager. This personal relationship can create the sympathetic ground in the heart of audit manager and he will not point out the mistakes of the employee of the company.	· Rotation of senior audit manger over a period of term by the audit firm · Decrease the responsibilities of the audit member and may be remove the same from this assignment. · Appointment quality appraisal by the audit firm	· Level of Sympathy in the mind of audit team member · Degree of hiding the mistake of related employee of the company
Presentation of the taxation matter of client at the Superannuation Complaints Tribunal	Threat of Advocacy as the auditor has a fear that reporting done by him may has legal implications (UK Essays, 2013)	In the case under study, the client Super Trooper Limited maintain retirement fund and is superannuation company and the taxation treatment in relation to tax on income from investments has been rejected by the assessing officer and he also said that the taxation policies are wrong as adopted by the company. The company approach to the audit firm for presenting the case in tribunal and the assist the company in representing the case may lead to creating the threat to the objectivity level of the auditor.	· Taking an advice from the independent qualified professional in relation to taxation matter litigation · Restriction of audit firm member in providing legal service · Disclosure of fees charges for legal services simultaneously with those charged to corporate governance	· Level of Objectivity lost by the Auditor · Level of Integrity hurt by the company

Part B

International Auditing Standard 240 defines that the primary responsibilities towards the preparation and presentation of financial statements are of the management of the company which are free from the material frauds and the responsibilities of the auditor are giving opinion of these financial statements whether they depict true and fair view. The detection risk is majorly present as audit risk in situation of frauds and the inherent limitations of audit deploys the auditor from detection of frauds. The material misstatement from frauds are full planned and sophisticated and auditor has to take professional sue and care in identifies this type of material misstatements in financial statements of client. The auditing standard establishes the responsibilities of auditor in not only identifying the frauds but also fraud factors so that the frauds cannot be taken place in future as well. The requirements of the ISA 240 for auditor’s responsibilities for detection of frauds listed according the audit procedures followed by the auditor.

Activities that are part of auditor’s responsibility relationg to frauds under isa 240

1. The auditor should examine the irregularity in the management of the company before making the engagement

2. The auditor has maintain the due professional care and professional uncertainty while doing the audit

3. Discuss and train the audit team member about the level material misstatement and area where the marital misstatements can be found in the financial statements

4. Evaluate the nature , timing and extent of evaluation of risk by the management of the company

5. Management responses to the frauds identifies in past and their actions and disclosures of the same in books of account and board report by the management

6. The auditor should perform the detailed procedures for detection of frauds that contains checking of journal entries, reviewing the accounting estimates and checking new policies adopted apart from the policies of normal business

7. The auditor shall to do the testing of internal control systems of the client and maintain the documentation for the same.

8. Make certain that the management have the knowledge of the frauds guess in the company

9. Make sure that those charged with Governance have the knowledge of the actual and frauds that guess in the company.

10. Ensuring have the those charged with Governance have overriding effect over management of the company in relation to frauds

Activities that are part of auditor’s responsibility relationg to frauds under isa 240

1. The implementation of internal control system in the company in relation of finding of frauds

2. Ensuring the effectiveness of the internal control systems in detection frauds

3. The opportunity of hidden frauds in the financial statements to the minimum level

4. Application of the Risk assessment and corporate governance procedures in the company

5. Ensuring the effectiveness of the corporate governance procedures with methods of risk of frauds assessment

6. The assessment of the possibility of the of frauds

7. The board of the company is responsible for the assessment of the effect of the frauds identified in the company

8. The preventive actions of the future to avoid the detected frauds in the company. ( IFAC, 2017)

Part C

1a. Two asset accounts at risk of material misstatement:

Stock of Clocks– First asset account which is at the risk of the material misstatement is the stock. It is because in the case study it is mentioned that the retail distributors of the company have been offered to transact the sale of clock on sale or return basis. The benefit that has been extended to the retail distributors is in the way that payment terms are allowed for 90 days credit and the return can be made any time within 60 days and shall be at least 30 days before the payment became due. It imposes the risk of having the defective stock at the quarter end or the year end higher which may tend the managers to indulge in the practice which may lead to variation in stock items and thus leading to material misstatement.

Accounts Receivable – Second asset account which is at the risk of the material misstatement is accounts receivable. It is in the sense that due to increase in the valuation of Australian dollar and labor prices the customers are not willing to buy the clocks which in turn will induce the manager to create wrong sale and thus inflating the value of accounts receivable and thus leading to material misstatement.

b. Prior Years Figures– As per the given case study, the prior year figure will be the sale which will be booked at the yearend but the payment of which will be received within 90 days provided the goods are not returned and also goods can be returned before the 30 days of expiry of Ninety days. Hence, the goods which have been sold and at the year end and is retuned on the next year will be treated as prior year figures.

c. Factors affecting Going Concern Assumption-

Drop in Australian Dollar– Due to devaluation of the Australian dollar in terms of the US dollar there will be the chances of having the huge liability for the purchases made from off shores. If the situation remains the same then the liquidity position and in turn the current ratio will get decreased.
Drop in Sale– Due to extended offer of the company, the sales might get hurted and in turn may affect the turnover of the company for the whole year.
Increase in Labor price - Due to increase in labor price the company would not able to sell the product to the customers and hence if there are no sales the company will be total in position of bankruptcy.

d. Effect of the facts on Audit Planning

On the basis of the facts of the case, it has been observed that the company might tend to manipulate the account balances in order to have bank finance which may affect or audit plan. These are listed in these ways:

The company may tend to decrease the current assets or increase the current liabilities and hence the audit plan accordingly needs to be modified with additional procedures towards the debtor, stock and creditors.
The company might tend to change the proportion of shareholders funds to total assets ratio and thus the audit plan needs to be re modified otherwise the audit will serve no purpose.

2a. Internal Control Issue– All the power has been delegated to the Marketing Manager who himself receives the 20% bonus in case the targets are achieved. Thus, there shall be formal hierarchy which shall be followed by everyone and the delegation or particular work shall not be given to those officers who are already in receipt of the benefits out of that work.

b. Fraud Risk Factors –There are two fraud risk factors. One is sale bonuses which will induce the marketing manager and staff to increase the sales in view of having high bonuses and second issue in low level of internal control system which has not ensured the smooth and proper functioning of the operating system.

c. Account Balance at Risk –The risk will be relating to the Sales Account. The assertion that follows with the identified risk balance are

The sales figure is much higher than the budgeted figure. It means the sales account is totally at risk and is at high degree of risk of having manipulation.
Even though the sales figure has been increased but the corresponding gross profit margin has not been increased and has been kept intact.

d. Audit Procedures Addressing Potential Misstatement–

The comparative analysis is required to be made for the sales and debtors accounts for the current year under audit in comparison to the previous year to check the proper deviations or variations.
The confirmation from the debtors shall be obtained along with their ledgers so that the same can be checked with our books for any material misstatement.

Both of the above audit procedures are regarded as additional audit procedures.

References

Barizah N, (2016), “Threats to Auditor Independence”, available at

https://www.academia.edu/260449/Threats_to_Auditor_Independence accessed on 04/05/2017

Edwin M, (2015), “Analysis of Threats to Auditor Independence and Available Safeguards against those threats”, available at

https://www.academia.edu/9406967/THREATS_TO_AUDITORS_INDEPENDENCE accessed on 04/05/2017

IFAC Official Website, (2017), “Inetrnational Standard on Auditing 240-The auditor Responsibilities relating to fraud in Auditing of

Financial Staments”, available at https://www.ifac.org/system/files/downloads/a012-2010-iaasb-handbook-isa-240.pdf accessed on 04/05/2017

Livine G, (2015), “Threats to Auditor Independence and Possible Remedies”, available on

https://www.financepractitioner.com/auditing-best-practice/threats-to-auditor-independence-and-possible-remedies?full accessed on 04/05/2017

Parker A, (2015), “6 Key Threat to Auditor Independence”, available on https://www.intheblack.com/articles/2015/01/06/6-key

threats-to-auditor-independence accessed on 04/05/2017

UK Essays, (2013), “Threat To Auditor Independence Accounting Essay.” Available at https://www.uniassignment.com/essay

samples/accounting/threat-to-auditor-independence-accounting-essay.php?cref=1 Accessed on 04/05/2017

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