Conversation 1: Here, Chris who is the CEO of LTH communicates that the board is quite happy with the audit firm but would like a small favor for extension of the audit contract further. The favor demanded is that the Audit Partner (Geoff) would have to deliver a speech in a promotional seminar which would enable the company to enhance the overall interest garnered by taxpayers. It is highly likely that Chris is aware that such deviation are not allowed and hence trying to trade it in lieu of the contract. Hence, in the current situation advocacy threat [Section 200-6, APES Ethics Code] would be applicable. This is applicable since auditor must not involve in any activity which amounts to promote the business interest of the client or else the outsiders may consider that the independence of the auditor is compromised and audit neutrality would not be achieved. Therefore, this is a vital threat which needs to be addressed through imposition of requisite safeguards (APES, 2010).
Conversation 2 – LTH CEO extends that the company plans to reward Geoff and myself with a 14 days paid travel package inclusive of family in order to ensure that things keep keeping smoothly between the client and audit firm. Hence, in the current situation familiarity threat [Section 200-7, APES Ethics Code] would be applicable. This subsection clearly prevents the members to accept any gift as the same may prove to have an adverse effect on the underlying objectivity as independence may be compromised. Only gifts with token value should be entertained and all others should be turned down by the professional who adheres with APES code of ethics (APES, 2010).
Conversation 3- The audit team for LTH for the current is being formed and Michael has been chosen by Geoff to be a new entrant in the team. Michael was overjoyed on being informed about the same and expressed that his inclusion in the audit team would be highly valuable as the financial controller of LTH was his father only. Hence, in the current situation familiarity threat [Section 200-7, APES Ethics Code] would be applicable. In accordance with this section, the family members of any of the individuals involved in the audit team must have occupy any employment position of significance at the end of the client. It is quite possible that y objectivity of Michael may be impaired due to the inherent conflict of interest in the situation. On the one hand, he must conduct the audit of the company in a professional and ethical manner but on the other he must take actions to prevent any damage to his father’s reputation or employment. However, any material misstatements in the financial statements may result in issuance of a qualified remark and thus may adversely impact the position of his father (CPA, 2013).
Conversation 4: The audit team for LTH for the current is being formed and Annette has been chosen by Geoff to be a new entrant in the team. Annette was overjoyed on being informed about the same and expressed that the LTH audit would be done minimal time devotion since she had a working relationship with the company and only stopped working for the client about a month back. The scope of services provided included book keeping and accounting services. Hence, in the current situation self review threat [Section 200-5, APES Ethics Code] would be applicable. This is quite reflected from the statement Annette makes when she becomes cognizant of the fact that she would be doing audit of LTH. She concludes that it should be done in a short amount of time which indicates that she already thinks that the statements would be free from material errors as she has personally prepared them. But this attitude is clearly not acceptable from an auditor who is expected to critically analyze the available documents in order to minimize audit risk (CPA, 2013).
In light of the threats that have been identified above, the objective here is to offer certain credible safeguards to tackle the above threats in various conversations.
Conversation 1 – The primary safeguard that applies in this situation would be firm level. It requires that internal policy must be formulated by the audit firm so as to ensure that no employee should entertain any promotional talks or participation in such events for enhancing the business potential or investor base of clients. Also, strict enforcement must be practiced for the same. Also, at the level of the client, the corporate governance practices in relation to selection of external auditor need to be improved (Arens et. al., 2012).
Conversation 2– The applicable safeguard to ward off the threat present here needs to be applied at two levels namely the firm and the client. The firm must endorse and implement an internal policy whereby no gifts higher than a well defined token value could be accepted by the employee of the firm under any circumstances irrespective of the intention of the client. Further, to avoid any ambiguity, it is essential that the company must also ensure that strict disclosures be made in this regard. Considering the nature of expected relationship between the client and the external auditor, it is pivotal that the client also has an enabling policy in place which ensure steps so as to avoid formation of any quid pro quo relationship of management with the auditors (Gay and Simnett, 2012).
Conversation 3: The requisite safeguard need to ward off the identified threat in the given case is firm specific. As part of the internal policy the audit firm must require the members to submit s declaration about the employment status, details of employer and position for the immediate family members for the period of last 5 years. Besides, in case of any changes for the concerned members, the same must be updated by the employee with the company. An additional undertaking should be asked for when any given member joins any audit team certifying that he/she has no close relative who is currently sharing any employment relationship with the client (Leung, Coram and Cooper, 2012).
Conversation 4: The requisite safeguard need to ward off the identified threat in the given case is firm specific. As part of the internal policy the audit firm must require the members to submit s declaration about the employment status, details of employer and position for a period of atleast 5 years. An additional undertaking should be asked for when any given member joins any audit team certifying that he/she has not shared any employment relationship with the client n the past ever. The violations should be severe dealt with so as to ensure that the members adhere to te same with requisite seriousness and this is not discarded as a mere formality (Caanz, 2016).
It is clear that MSL, the client tends to deal with mining companies an provides them with the requisite equipments that mining requires. Additionally, the company also extends professional maintenance of the equipments and provides spare parts in case of any technical snags. Based on the information extended about the business of the client, the two pivotal business risks worth highlighting are indicated below.
Errors in spare parts demand estimation – Based on the given case information, it is evident that with the purchase of equipment, the company tends to offer the buyers with one free service on a yearly basis for a period of two years. Considering the fact that mechanics have to travel to remote corners where mine is located in order to provide maintenance to the equipment, it is essential that the spare parts must be present with the mechanic or else there would be huge logistics cost and inconvenience to the customer specially because the spare parts are imported from supplies based globally and thus would require a sizable lead time before the part is delivered. However, if the company would maintain a high inventory of the spare costs then also there would be additional costs required to carry this incremental inventory coupled with the funds being blocked in the inventory which otherwise could have been put to productive use and has a opportunity cost (Gay and Simnett, 2012).
Spare parts related theft and fraud – In the given case, a very high business risk is represent with regards to fraud in terms of the spare parts used. This is especially the case where the mechanics are travelling to far flung places in order to provide services to the client and service their equipment. The mechanic and the client can potentially collude whereby the mechanic can provide a particular part as sizable discount while communicating to the supervisor that it was require for the serviced equipment under warranty period. Also, there could be instances of theft in relation to the spare parts which are quite valuable and the same then may be sold to the clients at discounted rate thus causing harm to the legitimate interests of the business. This would be especially the case if the company did not have a insurance policy to deal with this issue (Arens et. al., 2012).
The various component of audit risk that would tend to be adversely impacted due to risks identified above are briefly discussed below.
The errors in spare parts estimation could lead to higher audit risk primarily on account of higher inherent and detection risk. The increase in inherent risk can be explained on the basis of relevant accounting treatment which ought to be extended to spare parts. Spare parts that would be used in the maintenance of the equipments under warranty would be recorded in the books of account as expenses while any spare part which is deployed in equipment not covered by warranty would be recorded in the books as revenues. Due to the nature of the business, it might be difficult to record each of the spare parts in the right manner and also to maintain a proper stock of the inventory (Gay & Simnett, 2012). The rise in detection risk could arise on the part of the auditor since due to inherently complex nature of treatment of spare parts, the auditor may face inconvenience in understanding the appropriate treatment of every potential spare part in the correct account which would impact the expense and the revenue accounts in terms of accuracy (Caanz, 2016).
With regards to the risk of fraud and theft in relation to the spare parts, the two risks worth mentioned that would contribute to a higher audit risk would be the control and inherent risk. Inherent risk in the given business is high as it provides opportunities to te mechanics to conduct fraud especially when serving an equipment under warranty at a remote location. Also, in such cases, the company has limited risk to control the same by monitoring or other means which further leads to the rise in audit risk (Arens et. al., 2012). Inventory account and expense account are potentially the two accounts that will get affected in this process. Misrepresentation in the inventory account may be possible in case of incidences of theft and the degree of the same would depend on the inventory system deployed by the company. Also, in cases of fraud a spare part which should not have been used in providing the maintenance is booked falsely as expenses on the books of account thus resulting in misrepresentation of the same (Leung, Coram and Cooper, 2012).
APES (2010), APES 110 Code of Ethics for Professional Accountants, APESB Website, [Online] Available at https://www.apesb.org.au/uploads/standards/apesb_standards/standard1.pdf [Accessed April 27, 2017]
Arens, A., Best, P., Shailer, G. & Fiedler,I. (2013). Auditing, Assurance Services and Ethics in Australia, 2nd ed, Sydney: Pearson Australia
Caanz, S. (2016), Auditing And Assurance Handbook 2016 Australia, 3rd ed., Sydney: John Wiley &Sons
CPA (2013), Independence Guide, CPA Website, [Online] Available at https://www.cpaaustralia.com.au/~/media/corporate/allfiles/document/professional-resources/auditing-assurance/independence-guide.pdf?la=en [Accessed April 27, 2017]
Gay, G. & Simnett, R. (2012), Auditing and Assurance Services in Australia, 5th ed., Sydney: McGraw-Hill Education
Leung, P., Coram, P. & Cooper, B.J. (2012), Modern Auditing and Assurance Services, 4th ed, New York: John Wiley and Sonsa
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