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Engagement approach for auditing Local Pty Ltd

Learning Outcomes:

1.Demonstrate an understanding of the reporting requirements and auditing standards;

2.Demonstrate an understanding of the auditor's professional, legal and ethical responsibilities to their clients and third parties;

3.Identify the elements of the financial report audit process;

4.Understand the audit planning procedures, evaluate the business risk and assess the internal control;

5.Prepare auditing procedures for transactions and balances by conducting control and substantive tests;

6.Understand the auditor’s reporting obligations.

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.

Defense against legal action by Better Bank Ltd

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.

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.

Week 5

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 possible explanations for the results for the various ratios for Solar Ltd and outline their implications for the audit.

Engagement approach for auditing Local Pty Ltd

Q1) Type of engagements required and level of assurance needed on Audit of

  • Management accounts for the year ended 30thJune 2017

As an audit manager for OEL, my role is to show whether the management accounts for Local Pty Ltd for the year ended 30th June 2017 reflect a true and fair position of the company. Three major assurances are ordered in the increasing level of rigor. They include compilations, reviews and audits for the company. As an auditor, I will carry out compilations to see if the company accounts comply with the Generally Accepted Accounting Principles (GAAP); Reviews of the financial statements which are analytical procedures to identify the anomalies in the books of Local Pty Ltd and lastly an audit to provide reasonable assurance to OEL that local Pty financial statements do not have any material misstatements (Farooq, and De Villiers, 2018.).

  • All transactions occurring from the date negotiations commenced until the settlement date,

It is important to carry out analytical procedures of Local Pty ltd to verify the type of transactions and level of assurance. As an auditor, I would require financial statement of Local Pty form the beginning of 2017 FY to the end that is 30th June 2018. I would require all receipts of transactions for verification purposes. This would give me the rue position and the risk involved before acquisition of Local (Lu, Simnett, and Zhou, 2019).

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

For reasonable assurance in engagement I would

  1. Look into Local Pty compliance with GAAP
  2. Ensure that Local complies with various contractual agreements such as licensing bodies for the year (Shalimova, and Androshchuk, 2018).
  3. That the company complied with requirements of auditing bodies and external auditor.
  4. I would lastly form an opinion based on the financial reports and their level of compliance and give an opinion to the OEL CEO.
  1. Q) Outline a defense for your audit firm

Traditionally, the view for most people is that the auditor only owes the legal duties to the primary shareholders of the company only. However, this notion has been deconstructed and recently the perception is that the auditor’s liability extends to other stakeholders beyond the client-auditor nexus. Other stakeholders in this case include creditors such as banks and micro lending institutions. The scope of the auditor has extended and they have the legal obligation to protect anyone who might use the books of accounts so they are expected to uphold certain standards in their work(Annunziata, 2018). A breach of duty or careless acts will only lead to negligence by the auditor and this actions has to make them liable for their actions. Negligence by auditors will lead to economic losses to creditors who rely on the audited books to give loan facilities. However, duty of care and legal obligations to third parties occurs only when

  1. Loss has been suffered by third parties is mostly due to the negligent actions by the auditors action
  2. There is sufficient proof and evidence of a close relationship between the company and the auditor which led to a lose
  3. If it is reasonable and just and fair to have the liability on the auditor

Before imposing these rules the company’s act notes that an auditor is only liable in case they breached duty of care and did not have competence or had professional competence to act independently. There should be little argument for an auditor to face legal consequences if there is glaring evidence showing that the auditor breached duty of care and professional negligence. Third parties in this case are allowed to seek compensation from the auditor. Having been an auditor for two years with data Limited, the audited report for the financial year ended 30th June 2018 were unmodified showing that they reflected the true and fair position for the company.

Defense against legal action by Better Bank Ltd

In August 2018, Data Limited took a huge loan from Better Bank as working capital. They were unable to repay the loan due to harsh economic conditions (Laing, and Hoy, 2018). Better bank as creditors have no legal right to sue the auditor for their loss as they used the audited reports to give credit and to measure the credit risk for the company. The financial reports for the year ended 30th June 2018 showed the true and fair value of the company and therefore were unmodified. Lastly, auditors are only liable if they breached the duty of care and performed their duty without professional competences. As an auditor for Data Limited, I performed duty of care and there was no evidence that I breached duty of care due to my action.  

Better Bank has no capacity to seek legal redress against the auditor. The loss suffered by the creditor is attributable to the economic hardships suffered by Data Limited which led to their inability to repay the loan(Liao, and Radhakrishnan, 2019). There is no proven case for negligence or material misstatement from the part of the auditor which led to the loss and therefore warrant an actionable legal course from the creditor. Better bank as creditors have no legal right to sue the auditor for their loss as they used the audited reports to give credit and to measure the credit risk for the company.

  1. Identify and explain three separate key threats to Hall & Associates’
  2. Self-interest threat- occurs when an auditor acts in his or her own personal interests whether financial, personal or emotional interest.
  3. Self-review threat- when an auditor audits his own work or reviews his own work either directly or indirectly.
  4. Familiarity- occurs when there is an intricate relationship between the auditor and the client. This includes relationships with employees and directors of the company.
  5. the course of action for threats identified

Self-interest threat compromises confidentiality and objectivity of an auditor. The remedy or course of action of this is to eliminate the threats or safeguarded himself by reducing the threats to acceptable levels. When the conflict of interest against the threat cannot be eliminated or reduced the auditor should resign or stop the engagement with the client (Mercuri,. and Neumann, 2016).

Self-review threats in section 290 says that independence is key to the principle of objectivity, integrity and compliance. The course of action is to have an independence in mind and independence in appearance. If the auditor cannot have these independence he should resign or stop the engagement with the client.

Familiarity can only be reduced if the auditor is independent if he cannot eliminate the threat of familiarity, he should resign or stop the engagement with the client in writing.

  1. q) Explain components of audit for the scenarios identified

Scenario i) due to financial employment of a treasure the company has realized a profit through transactions in yen.

In this case scenario, the inherent risk due to transaction exposure and account balances is what is in the audit risk. Putting the proposed approach into practice makes it possible to single out from the total set of risks those that are of primary importance for ensuring the normal functioning of the organization (the fourth type of risks), and to give them increased attention(Tysiac, 2016.).

Scenario ii) closure of inefficient factory in New South Wales

The activities of employees of the organization (especially this belongs to the category of middle and top level managers) can pose a potential threat to the stability of the organization (since its future depends on key management decisions), while the likelihood of making erroneous decisions and other adverse events in certain conditions may be high . Risks in the activities of the organization in accordance with ISA. Based on the foregoing, we will try to draw up our understanding of the risks inherent in the activities of any organization, and their assessment during the audit graphically.

Scenario (iii) increase in bonuses

The first barrier can be considered the activities of the organization’s officials who are directly responsible for the fulfillment of the functions entrusted to them (for example, the cashier receives and disburses money; the storekeeper accepts and releases inventory items, etc.) in the absence of a control system.

Scenario (iv) The company is using a new general ledger software package.

Evaluate the client control system have increased significantly, and now two standards are being applied instead of one independent regulatory documents, sufficiently voluminous in content.

Scenario (v) As part of the conversion, the position of systems administrator was created

Imagine that in the life of people who are responsible for performing certain operations and which no one checks, there was a “failure”: some of them did not go to work, someone due to a difficult life situation needed money ( Johnstone, et al,  2019) .

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

Nova Financial Rations for year ended 30th June 2008

Current ratio

It is the measure of a company’s ability to pay its short-term loans and obligations in one year. A ration greater than 1.5 shows a healthy company while a ratio of less than 1 shows a company that will struggle to keep afloat and pay its obligations(Din, Ghozali and Achmad, 2017).

Quick asset ratio

Shows how secure the company is financially. Stagnation in this company shows neither is the company growing or having a decrease in growth. In this case other perimeters can be used to measure the company’s financial viability.

Inventory turnover

The ratio shows that the company is properly managing its inventory as the inventory ratio is lower than the industry ratio and the budgeted ratio. It shows the level of efficiency in a company to manage its debt and loan obligation (Orozco, 2019.).

Profitability ratios; Net profit ratio and margin ratio

Shows how profitable the company is. If the company is profitable it can make decisions that will affect its future bottom line in a positive manner. An increase in gross margin and net profit ratio shows a company that is comfortable it handling its operations to realize profits.

References

Annunziata, A., 2018. The role of auditors in European union company law.

Din, M., Ghozali, I. and Achmad, T., 2017. The follow up of auditing results, accountability of financial reporting and mediating effect of financial loss rate: an empirical study in Indonesian local governments.

Farooq, M.B. and De Villiers, C., 2018. Assurance of sustainability and integrated reports. In Sustainability accounting and integrated reporting (Vol. 149, No. 162, pp. 149-162). ROUTLEDGE in association with GSE Research.

Johnstone, K.M., Rittenberg, L.E. and Gramling, A.A., 2019. Auditing: A Risk-based Approach. Cengage.

Laing, G.K. and Hoy, S., 2018. A Retrospective of Professional Liability of Auditors in Australia. The Journal of New Business Ideas & Trends, 16(1), pp.44-55.

Liao, P.C. and Radhakrishnan, S., 2019. Auditors’ Liability to Lenders and Auditor Conservatism. Management Science.

Lu, M., Simnett, R. and Zhou, S., 2019. Using the Same Provider for Financial Statement Audit and Assurance of Extended External Reports: Choices and Consequences. Available at SSRN 3361616.

Mercuri, R.T. and Neumann, P.G., 2016. The risks of self-auditing systems. Communications of the ACM, 59(6), pp.22-25.

Orozco, L., 2019. The negative effect of external auditing in the banking industry.

Shalimova, N. and Androshchuk, I., 2018. Approaches to the interpretation of the term" historical financial information" as the criterion of the classification of audit, review and other assurance engagements.

Tysiac, K., 2016. Auditing risks in culture. Journal of Accountancy, 221(4), p.20.

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