Week 3: Elements of the financial report audit process

Tutorial Discussion Problems & Case Studies

A4.2 Distinguish between management’s and the auditor’s responsibility for the financial
statements being audited.

A4.3 Distinguish between the terms ‘error’ and ‘fraud’. What is the auditor’s responsibility
for finding each?

A4.6 List two main characteristics that are useful in predicting the likelihood of fraudulent
financial reporting in an audit. For each characteristics, state two things the auditor can
do to evaluate its significance in the engagement.

A5.2 List the four main evidence decisions that must be made on every audit.

A5.5 Explain what is meant by ‘sufficient appropriate audit evidence’?

A5.6 Explain why the auditor can only be persuaded with a reasonable level of assurance,
rather than convinced, that the financial statement are correct.

A5.8 Identify the six characteristics that determine the reliability of evidence. For each
characteristic, provide one example of a type of evidence that is likely to be reliable?

A5.13 Identify the most important reasons for performing analytical procedures?

A7.12 Define the audit risk model and explain each term in the model. Also describe which
two factors of the model when combined reflect the risk of material misstatement.

A7.13 What is meant by ‘planned detection risk’? What is the effect on the amount of
evidence the auditor must accumulate when planned detection risk is increased from
medium to high?

A7.14 Define what is meant by ‘inherent risk’. Identify four factors that make for high
inherent risks in audits.

A7.17 Explain what is meant by the term ‘acceptable audit risk’. What is its relevance to
evidence accumulation?
4.18 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) On 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 audit assertion at risk of material
misstatement in relation to the inventory account balance. Provide an explanation for
each assertion.

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, wholesales and retails men’s,
women’s and children’s clothing across Australia. BCL has approximately 65% of the
market in children’s school wear. It offers a full refund to all customers within 90 days
of purchase of they are not happy with their purchase.

BCL manufactures all of its clothing lines in 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 each 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 alleges that employees at BCL’s Korean factory are
severely underpaid and are working in very poor conditions. 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% 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.
Week 3: Elements of the financial report audit process
Tutorial Discussion Problems & Case Studies
4.20 Select which of the following types of evidence-gathering procedures (1-7) is used for
each of the audit procedures listed below (a-i):

1. Inspection
2. Recalculation
3. Confirmation
4. Analytical procedures
5. Enquiries
6. Observation
7. Re-performance

a) Performing test counts of the warehouse personnel’s count of the raw material.
b) Watching the client’s warehouse personnel count the finished good inventory.
c) Sending a written request to the client’s customers requesting that they indicate
whether they agree with the amount listed as owing to the client
d) Checking the additions on the inventory 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 the client has conducted
their sequence check correctly
i) Examining a new bottling machine to ensure that this major acquisition of plant
was received.
Week 3: Elements of the financial report audit process
Tutorial Discussion Problems & Case Studies

4.23 It is essential for an auditor to understand audit risk and its components when
planning a financial report audit.
REQURIED
For each situation in the table below, identify the component of audit risk that is most
directly illustrated.

Situation Component of
audit risk

(a) Technological innovations within the industry have

(b) Cash is more susceptible to theft than an inventory of

(c) Segregation of duties is inadequate

(d) Cash disbursements have occurred without proper approval

(e) A necessary substantive audit procedure is omitted

(f) Bank accounts are not reconciled monthly, resulting in a

(g) An auditor has complied with the auditing standards on

(h) Confirmation of receivables by an auditor fails to detect

(i) Notes receivable are susceptible to material

(j) A client, Lemon Ltd, has insufficient working capital to

Week 3: Elements of the financial report audit process

4.25 Consider the following independent situations, identify the specific component(s) of
audit risk that would be affected and explain how they would be affected.

a) One of Kitchen Ltd’s major product lines is the Quick Serve, a ‘no frills’
microwave oven. Over the last 3 months, warranty claims on the Quick Serve
have tripled from 3% of sales to 9% of sales. The problem appears to relate to the
glass turntable, which may shatter if the oven is used constantly at full power.
b) Wings Pty Ltd (Wings) is a small primary producer specialising in the production
of vacuum-packed emu meat. Wings’ recent display at a trade show has seen
orders flood in from overseas buyers. The accountant, Louise, has done her best
to satisfy the orders as quickly as possible while maintaining appropriate (foreign
currency) accounting records. However based on some of the questions she has
been asking you, it appears that she is out of her depth.
c) Alpha Ltd (Alpha) distributes and markets snack foods to major supermarket
chains around Australia. During the year, four members of staff were dismissed
for stealing inventory and selling it to a small convenience store at discount
prices. It is believed that the practice had been carried out for at least 18 months.
The four staff members were working in different departments and had been able
to cover their activities through fraudulent journal entries. The CEO of Alpha,
Graham Handley, is confident that all parties involved have been identified and
legal action has been taken.

REQUIRED
For each of the independent situations above, identify the specific component(s) of
audit risk that would be affected and explain how they would be affected.
Week 3: Elements of the financial report audit process
Tutorial Discussion Problems & Case Studies
4.28 Fast Feet Pty Ltd (Fast Feet) manufactures and distributes a range of sports shoes
across Australia, and has done so since 2004. Fast Feet was originally 100% owned by
the Tam family, but in the last 12 months the Tams have taken on a new investor to
inject capital into the business.

It is now August 2015 and you are undertaking the audit fieldwork for the 2015
financial year audit of Fast Feet. You become aware of the following three issues,
which were not known at the planning stage of the audit, when the initial materiality
level was established:

a) The Board of Fast Feet is comprised of members of the Tam family, who also
occupy key management positions. Following the resignation of two independent
directors on 30 June 2014, there were no independent directors on the Board
during the 2015 financial year.
b) The remuneration structure of Fast Feet’s sales staff changed for the 2015
financial year, whereby base salaries were reduced and commission components
substantially increased.
c) The Tam family intends to list on the Australian Securities Exchange by way of
an initial public offering in the following (2016) financial year.

REQUIRED
For each issue identified above, determine its impact on initial materiality. Explain
your answer.
Special Question – Materiality
Explain the term ‘materiality’ in the context of financial reporting?