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4.1 What is professional scepticism and why is it important to an auditor? LO 4.1

4.1 What is professional scepticism and why is it important to an auditor? LO 4.1

Answer:

4.1       According to the AUASB Glossary, professional scepticism is ‘an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence’.

Further, ASA 200.A18-20 (ISA 200.A18-20) indicates that professional scepticism includes:

 + questioning the reliability of documents and information and explanations provided by management

 + being alert to contradictory evidence

 + questioning the sufficiency and appropriateness of audit evidence and not necessarily accepting the most readily available audit evidence

 + being alert to conditions that may indicate risks of fraud

 + critically challenging management judgments, assumptions and estimates.

Professional scepticism is important, as it enhances the auditor’s ability to exercise professional judgement in identifying and responding to conditions that may indicate possible misstatements in the financial report. Therefore, professional scepticism is critical to enabling auditors to draw appropriate conclusions in the conduct of their work. It is also essential to auditors fulfilling their ethical requirements of objectivity and independence.

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4.4 Outline management's questions about the entity's account balances, classes of transactions and events, and presentation and disclosure that would be of interest to the auditor. LO 4.2

4.4 Outline management's questions about the entity's account balances, classes of transactions and events, and presentation and disclosure that would be of interest to the auditor. LO 4.2

Answer:

4.4       The broad categories of assertions contained in ASA 315.A124 (ISA 315.A124) are as follows:

Assertions about classes of transaction and events

 + Occurrence: Transactions and events that have been recorded have occurred and pertain to the entity.

 + Completeness: All transactions and accounts that should have been recorded have been recorded.

 + Accuracy: Amounts and other data relating to recorded transactions and events have been recorded appropriately.

 + Cut-off: Transactions and events have been recorded in the correct accounting period.

 + Classification: Transactions and events have been recorded in the proper accounts.

 

Assertions about account balances

 + Existence: Assets, liabilities and equity interests exist.

 + Rights and obligations: The entity holds or controls the rights to assets and liabilities are the obligations of the entity.

 + Completeness: All assets, liabilities and equity interests that should have been recorded have been recorded.

 + Valuation and allocation: Assets, liabilities and equity interests are included in the financial report at appropriate amounts and any resulting valuation adjustments are appropriately recorded.

 

Assertions about presentation and disclosure

 + Occurrence and rights and obligations: Disclosed events, transactions and other matters have occurred and pertain to the entity.

 + Completeness: All disclosures that should have been included in the financial report have been included.

 + Classification and understandability: Financial information is appropriately presented and described, and disclosures are clearly expressed.

 + Accuracy and valuation: Financial and other information is disclosed fairly and at appropriate amounts.

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4.5 Describe the seven general types of audit procedures LO 4.3

4.5 Describe the seven general types of audit procedures LO 4.3

Answer:

4.5       The seven general audit procedures are:

1.         Inspection

Inspection involves the examination of documents, records or tangible assets.

2.         Observation

By physically observing phenomena, the auditor gains first-hand knowledge of their existence. Behaviour of operating personnel and the functioning of the business in operation are observed, such as evidence of control activities being carried out.

3.         Enquiry

The auditor must ask many questions during the course of an examination. The question-and-answer process includes interviewing and obtaining statements in writing from management and employees. Explanations of significant variations in accounting data are frequently obtained from employees.

4.         Confirmation

Confirmation is a type of enquiry by which an auditor normally obtains a written statement from outside parties such as banks, solicitors or accounts receivable on information that they are qualified to give.

5.         Recalculation

The arithmetical accuracy of the many calculations required in the processing of data can be proved by recalculating the results. Examples of typical calculations include additions of ledger account balances, depreciation calculations, amortisation calculations and inventory extensions and additions.

6.         Re-performance

The auditor may independently execute procedures or controls that were originally performed as part of the entity’s internal control.

7.         Analytical procedures

Analytical procedures involve the investigation of fluctuations in relationships to ascertain whether there are inconsistencies in relation to other relevant information or variations from predicted amounts.

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4.7 What is the difference between sufficiency and appropriateness of audit evidence? LO 4.4

4.7 What is the difference between sufficiency and appropriateness of audit evidence? LO 4.4

Answer

Sufficiency relates to the quantity or amount of audit evidence necessary to provide the auditor with a reasonable basis for an opinion on the financial report.

Appropriateness relates to the quality of the audit evidence, including both its relevance and reliability. Relevance is largely concerned with the relationship between the evidence and the financial report assertion involved, while the reliability of audit evidence is determined by the nature and source of the evidence.

5

4.9 Define each of the components of the audit risk model; explain how each component is set, and which components make up the risk of material misstatement LO 4.5

4.9 Define each of the components of the audit risk model; explain how each component is set, and which components make up the risk of material misstatement LO 4.5

Answer:

Audit risk is a function of the risks of material misstatement and of detection. The risk of material misstatement consists of two components: inherent risk and control risk. The audit risk model is a function of inherent risk, control risk and detection risk. The audit risk model is described as follows.

AR      =          f (IR, CR, DR), where:

AR = audit risk, which is the risk that the auditor will give an inappropriate auditor’s opinion when the financial report is materially misstated. Audit risk is set by the auditor and will always be relatively low, as the auditor does not want to give an inappropriate opinion. The level set by the auditor for a particular client will be affected by the engagement risk, which is the auditor’s exposure to loss or injury to the professional practice from litigation, adverse publicity or other events arising in connection with a financial report audit.

IR = inherent risk, which is the susceptibility of an assertion to material misstatement about a class of transactions, account balance or disclosure, given the inherent and environmental characteristics, but without regard to related internal controls. Inherent risk is determined by the characteristics of the entity and the environment in which it operates.

CR = control risk, which is the risk that a material misstatement in an assertion about a class of transactions, account balance or disclosure may not be prevented or may not be promptly detected and corrected by the entity’s internal control. Control risk is essentially determined by the entity’s internal control, although an auditor can set it at high if it they do not want to rely on internal control for cost benefit reasons, irrespective of the internal control system being strong.

DR = detection risk, which is the risk that an auditor’s substantive procedures performed to reduce audit risk to an acceptably low level, will not detect a material misstatement. The desired detection risk is effectively determined by the other factors in the model. The actual detection risk can then be altered to the required level by changing the nature, timing and extent of testing, as well as quality control factors on the audit, such as assignment of staffing and extent of supervision and review.

Assessment of each component is subjective and is based on the professional judgment of the auditor. The levels high, medium or low are generally used, rather than specific percentages. A detection risk matrix is shown as Exhibit 4.1 on page 163 of the textbook.

6

4.12 Distinguish between tests of controls and substantive tests LO 4.7

4.12 Distinguish between tests of controls and substantive tests LO 4.7

Answer:

The auditor performs tests of control to see whether the policies and procedures of internal control are effective. Substantive tests are performed on specific transactions and balances to see whether the dollar amount of the account balance is materially misstated.

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4.18 Financial report assertions

Car Cheap Ltd is a publicly listed company that retails budget-priced car parts and accessories to the public. The company has 45 stores across Australia, and six warehouses, one in each Australian state.

You are part of the audit team for the period ending 30 June 2015. While attending the Adelaide stocktake and performing test counts, you note the following:

(a) One three occasions, goods were counted correctly but recorded under the incorrect stock code. In each case, the incorrect stock code used related to a more expensive item than the good actually counted.

(b) A large amount of stock was transferred from Adelaide to the Melbourne and Sydney warehouses on the day of the stocktake. The items transferred have been recorded as inventory in Adelaide and also at the locations received.

REQUIRED

For each of the issues above, list the key assertion at risk of material misstatement in raltion to the inventory account balance. Provide an explanation for each assertion. LO 4.2

4.18 Financial report assertions

Car Cheap Ltd is a publicly listed company that retails budget-priced car parts and accessories to the public. The company has 45 stores across Australia, and six warehouses, one in each Australian state.

You are part of the audit team for the period ending 30 June 2015. While attending the Adelaide stocktake and performing test counts, you note the following:

(a) One three occasions, goods were counted correctly but recorded under the incorrect stock code. In each case, the incorrect stock code used related to a more expensive item than the good actually counted.

(b) A large amount of stock was transferred from Adelaide to the Melbourne and Sydney warehouses on the day of the stocktake. The items transferred have been recorded as inventory in Adelaide and also at the locations received.

REQUIRED

For each of the issues above, list the key assertion at risk of material misstatement in raltion to the inventory account balance. Provide an explanation for each assertion. LO 4.2

8

4.19 You are working on the audit for the year ending 30 June 2015 of Best Clothes Ltd (BCL) a publicly listed  company that manufactures, wholdsales and retails men's, women's and children's clothing across Australia. BCL has approximately 65 per cent of the market in children's school wear. It offers a full refund to all customers within 90 days of purchase if they are not happy with their purchase.

BCL manufactures all of its clothing lines n Korea, except for the high-end designer women's outfits, which are imported from France and branded under one of the BCL brands. BCL operates one corporate-owned store in eac state of Australia and distributes its clothing Australia-wide to major department stores and to some independently owned boutiques.

On 7 June 2015 and while completing the field work on the audit of BCL you come across an online newspaper article alleging BCL has been exploiting workers at its Korean factory. The article suggests that concerned customers should boycott BCL's products.

Upon further investigation, the CFO reveals that since the article's publication, large numbers of clothes have been returned by customers, including the department stores. As at 30 June 2015, the CFO estimates that of the clothes sold that are still eligible for a full refund, 35 per cent were expected to be returned.

REQUIRED

(a) List the key accounts that are likely to be impacted by this discovery.

(b) For each of the accounts you listed, state the key assertion at risk and explain your answer. LO 4.2

4.19 You are working on the audit for the year ending 30 June 2015 of Best Clothes Ltd (BCL) a publicly listed  company that manufactures, wholdsales and retails men's, women's and children's clothing across Australia. BCL has approximately 65 per cent of the market in children's school wear. It offers a full refund to all customers within 90 days of purchase if they are not happy with their purchase.

BCL manufactures all of its clothing lines n Korea, except for the high-end designer women's outfits, which are imported from France and branded under one of the BCL brands. BCL operates one corporate-owned store in eac state of Australia and distributes its clothing Australia-wide to major department stores and to some independently owned boutiques.

On 7 June 2015 and while completing the field work on the audit of BCL you come across an online newspaper article alleging BCL has been exploiting workers at its Korean factory. The article suggests that concerned customers should boycott BCL's products.

Upon further investigation, the CFO reveals that since the article's publication, large numbers of clothes have been returned by customers, including the department stores. As at 30 June 2015, the CFO estimates that of the clothes sold that are still eligible for a full refund, 35 per cent were expected to be returned.

REQUIRED

(a) List the key accounts that are likely to be impacted by this discovery.

(b) For each of the accounts you listed, state the key assertion at risk and explain your answer. LO 4.2

9

Audit Procedures

4.20 Select which of the following types of evidence-garthering procedure (1-7) is used for each of the audit procedures listed below (a-i):

1 Inspection

2 Recalculation

3 Confirmation

4 Ananlytical procedures

5 Enquiries

(a) Performing test counts of the warehouse personnel's count of the raw material

(b) Watching the client's warehouse personnel count the finished goods inventory

(c) Sending a written request to the client's customers requestng that they indicate whether they agree with the amount listed as owning to the client

(d) Checking the additions on the investory listing

(e) Comparing the current-year gross profit percentage with the gross profit percentage for the past four years

(f) Examining large sales invoices for a period of two days before and after year end to determine whether sales are recorded in the correct period

(g) Discussing the adequacy of the allowance for doubtful accounts with the credit manager

(h) Completing a sequence check of invoice numbers to see if client has conducted their sequence check correctly

(i) Examining a new bottling machine to ensure that this major acquisition of plant was received LO 4.3

(a)        1 Inspection

(b)        6 Observation

(c)        3 Confirmation

(d)       2 Recalculation

(e)        4 Analytical procedures

(f)        1 Inspection

(g)        5 Enquiries

(h)        7 Re-performance

(i)         1 Inspection

10

Sufficient appropriate audit  evidence

4.22 You are the audit senior on Sun Ltd (Sun) and have just been given the audit file to review by your assistant. Sun has a balance date of 30 June 2015 and materiality for this client has been set at $250 000. The following information has been obtained from reading the audit file and talking with the assistant:

(a) The balance of cash was tested using a lower assessed level of control risk approach. One of the key controls relied upon was the monthly bank reconciliations. For the last three months there was a 'net miscellaneous reconciling item' of $30 000.

The assistant questioned the accountant about this item and was told that the client did not have time to follow up on this matter. As the reconciling item was immaterial, the assistant had performed no further work in this area.

(b) The testing on payroll expense was completed using analytical procedures (comparing this year's expense with that of last year). As the current expense was within a few thousand dollars of last year's amount, the assistant concluded that expense was reasonableand that no further testing was necessary.

REQUIRED

For each of the two situations outlined above, explain whether the audit assistant has obtained sufficient appropriate audit evidence LO 4.4

(1) When testing controls, we are trying to see whether the control is operating effectively. The fact that the net miscellaneous reconciling item was not followed up on a timely basis means that it is difficult for us to justify reliance on this control. The fact that the reconciling item is immaterial is irrelevant when testing controls.

(2) The assistant has not considered whether there are factors that should have caused the payroll expense to differ from the prior year. The work performed by the assistant to date is not sufficient. When using analytical procedures as part of substantive testing, it is necessary to compare actuals with expectations. Also, the payroll expense is likely to be very material and so additional evidence is likely to be required.