Auditing Tutorial Questions: Weeks 1-5 Essay.

Types of Engagements and Levels of Assurance

Your task is to answer a selection of tutorial questions for weeks 1 to 5 inclusive and give these answers.

You are the audit manager of Overseas Explorer Ltd (OEL), which acquired the small proprietary company Local Pty Ltd (Local) on 30 June 2018. The price of the acquisition was agreed at $5 million, on the condition that OEL is satisfied with the financial records of Local. As Local is a small proprietary company, it has not prepared statutory financial reports or undergone an audit since its incorporation in 2016. However, Local has agreed to allow your firm, which is the auditor of OEL, to access its books and records. The CEO of OEL, Wendy Champion, has requested that your firm provide assurance on the following three items:

• The management accounts for the year ended 30 June 2017

• All transactions occurring from the date negotiations commenced until the settlement date, to ensure that all transactions were within the normal course of operations

• The financial report prepared at the acquisition date of 30 June 2018

In order to clarify your responsibilities, you requested that OEL indicate the level of assurance that they require for each item. Wendy replied that the financial report as at acquisition date is very important, as are the transactions since negotiations commenced, but that she is willing to have less work done on the previous year’s management accounts.

Required:

Indicate the type of engagement that will most likely be undertaken for each of the three tasks and the level of assurance to be provided. Explain your selections.

You have been the auditor of Data Ltd for two years. Your auditor’s report for Data for the year ended 30 June 2018 was unmodified, indicating that in your opinion the financial report gave a true and fair view. In August 2018, Data obtained a large loan from Better Bank Ltd, to provide additional working capital. Subsequently Data suffered severe trading difficulties and was placed into liquidation in late December 2018, with insufficient funds to repay the loan to Better Bank.

Required:

Outline a defense for your audit firm to any legal action taken by Better Bank to recover its loss.

You are an audit manager at Hall & Associates, who have been approached to conduct the audit of Computer Games Ltd (CGL), a manufacturer of interactive computer games, for the year ended 30 June 2013.

Hall & Associates has not previously audited CGL’s financial report, although it has undertaken other types of engagements for CGL. Last year CGL hired Hall & Associates to assist in the redesign of CGL’s accounting software to ensure that internal controls over internet sales were adequate to ensure the confidentiality of customer data and accuracy of recording. The new software was implemented at the beginning of the current year and appears to be working satisfactorily. As part of this year’s audit, you expect to review the internal controls at CGL, including the controls within the IT systems.

Defending against legal action

As part of CGL’s financing arrangements with its bank, Easymoney Ltd, it has a loan covenant that stipulates that the quick asset ratio cannot be less than 1:1 or Easymoney Ltd has the right to withdraw all funding. The board has advised you that CGL’s quick asset ratio is currently at 0.9:1 due to industrial action holding up the sale of goods imported from overseas. The board has asked you to ignore this temporary breach of the loan covenant, explaining that CGL is a stable and financially sound company, and that the ratio will return to a positive level on resolution of the industrial dispute. The board has indicated that unnecessarily disclosing this within the audit report would force it to reconsider its plans to use your audit firm for other engagements.

As a result of CGL’s current cash flow difficulties, the board has requested that Hall & Associate’s audit fee for 2013 be paid in CGL shares. The board has indicated that the market value of the shares will equate to the value of the audit fee charged by Hall & Associates.

The management of CGL is currently reviewing the structure of its audit committee to ensure that it complies with the requirements of the ASX Corporate Governance Principles and Recommendations. However, the board is confused by the reference in the ASX Corporate Governance Principles and Recommendations to both independent directors and non-executive directors, as they thought that they were the same thing. As a result, they have sought your advice concerning the structure of their audit committee.

Required:

a) Identify and explain three separate key threats to Hall & Associates’ independence that may arise under APES 110.

b) For each independence threat identified in a) above, describe the course of action Hall & Associates needs to take to ensure compliance with APES 110.

You are the audit senior responsible for the audit of Sampson Limited. You are currently planning the audit for the year ended 31 December 20X7. During your initial planning meeting held with the financial controller, he told you of the following changes in the company’s operations.

(i) Due to the financial controller’s workload, the company has employed a treasurer. The financial controller is excited about the appointment because in the two months that the treasurer has been with the company he has realised a small profit for the company through foreign-exchange transactions in yen.

(ii) Sampson has planned to close an inefficient factory in country New South Wales before the end of 20X7. It is expected that the redeployment and disposal of the factory’s assets will not be completed until the end of the following year. However, the financial controller is confident that he will be able to determine reasonably accurate closure provisions.

(iii) To help achieve the budgeted sales for the year, Sampson is about to introduce bonuses for its sales staff. The bonuses will be an increasing percentage of the gross sales made, by each salesperson, above certain monthly targets.

(iv) The company is using a new general ledger software package. The financial controller is impressed with the new system, because management accounts are easily produced and allow detailed comparisons with budgets and prior-period figures across product lines and geographical areas. The conversion to the new system occurred with a minimum of fuss. As it is a popular computer package, it required only minor modifications.

(v) As part of the conversion, the position of systems administrator was created. This position is responsible for all systems maintenance, including data backups and modifications. These tasks were the responsibility of the accountant.

Required:

For each of the scenarios above, explain how the components of audit risk (inherent, control or detection risk) are affected.

The following financial ratios have been calculated for Nova Ltd for the year ended 30 June 2008:

	Actual	Budgeted	Previous year	Industry average
	results	results
Current ratio	1.97	1.92	1.87	1.92
Quick asset ratio	1.06	1.06	1.06	1.11
Inventory turnover	4.21	4.91	4.86	4.76
Net profit ratio	0.05	0.03	0.03	0.03
Gross margin	0.65	0.59	0.61	0.61

Required:

Provide four (4) possible explanations for the results for the various ratios for Solar Ltd and outline their implications for the audit.

Types of Engagements and Levels of Assurance

Auditing is the process of checking and inspecting all the books of accounts in order to find errors and manipulations in them if any and to make an assurance about the true and fair view of the financial statements. There are various types of audit according to its functions and objectives and an individual person having competent knowledge can be appointed for such audit. In the given case study, it can be observed that the Overseas Explorer Ltd has acquired the business of the Local Pty Ltd at an agreed price of $5million. The Local Pty Ltd is a small property company has not prepared any financial statements properly. Before making a decision of acquisition of any business the acquirer company must investigate and evaluate the financial feasibility and financial performance of the target company. In the given case  study, as the Local Pty Ltd is small company and has not prepared any financial statements properly, it is quite difficult the check and evaluate the financial performance, financial position and management efficiency of the Local Pty Ltd. Hence, the audit firm of the Overseas Explorer Ltd can be appointed to check the management accounting records, financial transactions and the financial reports (Appelbaum Kogan and Vasarhelyi 2017).

While the acquisition was negotiated with the target company Local Pty Ltd, the acquiring company Overseas Explorer Ltd must check all the management accounting records and activities, all the transactions that have been occurred from the negotiation of the acquisition till the date of settlement and the financial reports as at the date of acquisition. Therefore, to complete the task and based on the level of assurance in each of these task, the type of engagement of auditors would be different (Appelbaum Kogan and Vasarhelyi 2017).

Checking of the management accounting records and reports would take a considerable period of time, and it mainly focuses on the management efficiency of the company. It analyses and assesses the management culture and management accounting system of the company. Hence, for assurance on the management accounts of the Local Pty Ltd as on 30 June 2017, the Management Audit ngagement would be more preferable.

Checking and scrutinising all the transactions for a given period of time would require a longer period of time and intense study and analysis of all the transactions. Generally, internal audit is applied while such detail inspection and checking is required. In the given case study, the internal audit engagement can be applied for making assurance on the transactions of the Local Pty Ltd form the date of negotiation till the date of settlement. It would help the auditor to check all the transactions for that period with the suspect that the target company might have involved in such unfair transactions so that the value of the business gets inflated. Therefore, for checking all the transactions for that period the Internal Audit engagement would be preferred (Appelbaum Kogan and Vasarhelyi 2017).

Defending against legal action

Lastly for checking and giving assurance on the final financial reports of the Local Pty Ltd as on 30 June 2018, the Compliance Audit engagement can be more preferred. Compliance audit engagement focuses on the sound and true representation of the financial performance and financial position of a company following the respective accounting and reporting standards. In the given case study, reporting true financial position of the Local Pty Ltd is very significant as all the assets and liabilities will be incorporate in the parent company’s books based on the financial statement as on 30 June 2018. Hence, a compliance audit engagement could give more assurance on the true and fair representation of the financial performance and financial position of the Local Pty Ltd in their financial reports as on 30 June 2018 (Appelbaum Kogan and Vasarhelyi 2017).

Auditing is the process of checking financial records and reports of a company and making a comment about the true and fair representation of the financial performance and financial position of a company as on a particular date. In an organisation numerous transactions are occurring and all are being recorded in the financial books of accounts. While conducting the auditing process, it might not be possible for the auditor for checking all the transaction on a hundred percent basis (Popescu and Popescu 2018). They have to check such transactions on a sample basis. Moreover, the management of the company is responsible for disclosing all the information and records to the auditor and if any such information is hided from the auditor then the management of the company would be responsible. After checking and inspecting all these financial records and reports if the auditor becomes satisfied about the true and fairness of the financial reports then the auditors gives assurance about the true and faire representation of the financial performance and financial position of the company in the audit report. Therefore, the auditor is never responsible for any future downfall in the company’s financial performance or financial position and as he makes the comment based on the information provided by the management, in no such cases the company can make the auditor liable for future downfall in financial performance and financial position of a company (Popescu and Popescu 2018).

The first threat to the Hall & Associates is that they have to understand the accounting process and the company policies properly first. They had not audited the company’s financial system and financial record previously, if that would have been done, there would be no difficulty in understanding the financial information requirement of the company. Secondly, they have to collect all the papers and contracts related with such loan agreements which might be very difficult for them to check the transaction independently. Lastly, as the audit fees will be paid through the issue of share, there would be some issues relating to the related party transaction, the auditor might not be able to accept such proposal.

Threats to Independence and Compliance

Hall & Associates first check the financial information requirement and understand the accounting process and company policies. They must carefully asses the information requirement and accordingly advice about the financial information system. Lastly, they have to check all the loan agreements and papers and their records in the financial statement to give assurance about the compliance on the same.

4:

In the first case the risk involved is an inherent risk as the transaction involves foreign exchange. It depends on the fluctuation in the foreign exchange rate and the individual treasurer has no influence on that.

In the second case, the inherent risk is that the time bound of the closure of the inefficient factory, while the control risk is that the financial controller has to determine the reasonably accurate closure provision for the factory, if he makes any mistake in that then the provision created for the closure of the factory might be affecting the financial position of the company (DeFond and Zhang 2014).

In the third case the control risk will be reduced as the automated software would help the professionals to record financial transactions more efficiently and correctly. The inherent risk will be increase as any malfunction in the software may create a complete data loss for the company.

The control risk and the inherent risk both are high in the last case. As in the process of date backup there is a chance of complete data loss and inefficient control may lead to a loss of data.

It can be observed that the current ratio was 1.87 in the previous year which was much near to the industry average. In the current year the current ratio has been increased to 1.97 over and above the budgeted figure of 1.92. There might be over stacking of inventory resulting into the increase in current ratio. Another reason behind increase in current ratio could be increased trade receivables of increased credit terms allowed to the debtors. It can also be assumed that the cash management of the company have become so efficient that they are able to realise cash in a very shorter period of time from their debtors (Popescu and Popescu 2018).

The quick ratio represents the short term debt paying ability of the company using readily available assets. It can be observed that the company is having a quick ratio same in the previous year as well as in the current year. There is no change in the quick ratio in both the years and the budget figures was also the same. Hence, it can be suspected that some of the information might be manipulated by the management to hide the actual current financial position of the company.

Audit Risk for Sampson Limited

Inventory turnover of the company has been decreased for 4.86 in the previous year to 4.21 in the current year. As the current assets have been increased, the inventory of the company has also been increased. Hence, with the increase in inventory the inventory turnover has been fallen further.

Net profit margin of the company was same as the industry average in the previous year, but in the current year it has been increased by 2%. Increase in net profit margin might be due to decreased operating cost of the company or some information might have been manipulated by the company to show a better financial performance.

Lastly, it can be observed that the gross profit margin of the company have been increased significantly and it has increased beyond the budgeted figure as well as the industry average. Increased efficiency in operations or decreased cost of inputs might be the reason behind increase in gross profit margin.

References:

Appelbaum, D., Kogan, A. and Vasarhelyi, M.A., 2017. Big Data and analytics in the modern audit engagement: Research needs. Auditing: A Journal of Practice & Theory, 36(4), pp.1-27.

Chi, W., Myers, L.A., Omer, T.C. and Xie, H., 2017. The effects of audit partner pre-client and client-specific experience on audit quality and on perceptions of audit quality. Review of Accounting Studies, 22(1), pp.361-391.

Coetzee, P. and Lubbe, D., 2014. Improving the efficiency and effectiveness of risk?based internal audit engagements. International journal of auditing, 18(2), pp.115-125.

De Villiers, C., Hay, D. and Zhang, Z.J., 2014. Audit fee stickiness. Managerial Auditing Journal.

DeFond, M. and Zhang, J., 2014. A review of archival auditing research. Journal of accounting and economics, 58(2-3), pp.275-326.

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.

Ladda, R.L., 2014. Nature of the Audit. Lulu. com.

Minnis, M. and Shroff, N., 2017. Why regulate private firm disclosure and auditing?. Accounting and Business Research, 47(5), pp.473-502.

Pham, H., Amaria, P., Bui, T. and Tran, S., 2014. A STUDY OF AUDIT QUALITY IN VIETNAM. International Journal of Business, Accounting, & Finance, 8(2).

Popescu, C.R.G. and Popescu, G.N., 2018. Risks of cyber attacks on financial audit activity. The Audit Financiar journal, 16(149), pp.140-140.

Salleh, K. and Jasmani, H., 2014. Audit rotation and audit report: Empirical evidence from Malaysian PLCs over the period of ten years. Procedia-Social and Behavioral Sciences, 145, pp.40-50.

Vovchenko, N.G., Holina, M.G., Orobinskiy, A.S. and Sichev, R., 2017. Ensuring financial stability of companies on the basis of international experience in construction of risks maps, internal control and audit.