Auditing Assignment Exploring Different Business Scenarios & Their Concerns

Question

Task:
Write an auditing assignment addressing the following questions:

QUESTION 1 : Consider the following independent situations which arose in respect of your firm, ATB Partners. In each case Mr Abbot is the audit partner, Ms Tan is the tax partner, and Mr Bell is the business advisory partner.

1. Holiday Motels Ltd is a chain of ten motels operating on the far south coast of NSW. Your firm performs both audit and tax work for Holiday Motels. The audit fees comprise around 10% of total audit fee revenue, while the tax work comprises around 5% of total tax related revenue. Holiday Motels has not paid any of its fees for the last three years, citing cash flow problems. However, in actual fact, Holiday Motels has made impressive profits over the last few years and has significant cash reserves. The partners have been reluctant to push the issue further, as Holiday Motels is a high-profile client who they wish to retain. Last month, your firm agreed to hold their annual staff retreat at one of Holiday Motel’s new motels, as a partial contra against the outstanding fees. Half of the outstanding fees will be waived, even though the reasonable market value of the services to be provided is only 30% of the total outstanding amount.
2. Ms Tan has just been appointed a director of Discount Travel Pty Ltd, a large proprietary company which is a travel agent. Mr Abbot performs the audit of Discount Travel in accordance with the relevant legislation. Mr Bell recently assisted Discount Travel in selecting and installing ABC Brand accounting software. ABC pay the firm a commission for every software package sold, and this fact was verbally disclosed to Discount Travel. In addition, Mr Bell has just performed a valuation of Discount Travel’s business for the purposes of a Family Law Court dispute.
3. Several of Mr Abbot’s staff recently completed a review of the internal controls at Expo Pty Ltd, a large proprietary company which is also an audit client. The work was charged at 120% of the usual consulting fees to partially recoup the lower audit fees brought about by a competitive tender. Audit staff implemented all the recommended changes in procedures by updating the company’s accounting manual and running a two-hour training session for the accounting staff. As the audit staff has already performed significant work on Expo’s internal controls, the audit manager has decided to assess control risk as low and not perform any tests of control.

REQUIRED:

1. For each of the above independent situations, identify any professional standards and regulatory requirements which have been breached and explain the impact of the breaches.
2. APES 110 adopts a conceptual approach to audit independence. Briefly outline the framework adopted.
3. Identify the factors necessary for a third party to sue an auditor for negligence.

QUESTION 2 : You are the audit senior on the audit of EasyFit Pty Limited, a large manufacturer of shoes. EasyFit Pty Limited’s main market lies with 18 to 24 year olds.

This is the first year in which your firm has performed the audit. As part of the planning work, you have performed analytical procedures on an annualised basis and compared the results to industry averages and last year’s audited financial information. The results are given below: Industry average

REQUIRED:
Explain the general meaning of each of the above ratios, discuss the conclusions that you can draw about EasyFit’s financial position and identify potential audit risks to be investigated further.

QUESTION 3 : You are the audit senior on the Pet Care Pty Limited (Pet Care) audit. Pet Care is a distributor of pet care products including shampoos, lotions and a small range of toys.

Pet Care uses an on-line computer system. No goods are manufactured in-house; rather, Pet Care maintains a stock of raw materials and sub-contracts the manufacture of its products to third parties. Approximately 50 suppliers and sub-contractors are used and all have proven to be reliable. You have made the following notes about the inventory system:

Procedures for raw materials

• Separate systems, staff and warehouses are maintained for both raw materials and finished goods.
• Purchase orders are automatically generated by the computer when stocks of any raw material fall below 70% of the prior month’s usage. The purchase orders contain the following details:
  • date;
  • supplier name and address;
  • raw material needed.
• Three copies of the purchase order are produced and distributed as follows:

  Copy 1—to warehouse to enable follow up of late orders.

  Copy 2—filed by accounts clerk in date order.

  Copy 3—sent to supplier.

• When raw material stocks are received, the bar codes attached to the delivery boxes by the supplier are scanned into the system. A two-part Goods Received Note (GRN) is then produced:

  Copy 1—matched to warehouse copy of purchase order by stores staff.

  Copy 2—filed by accounts clerk.

  The scanning process is aborted if the codes do not match those on the masterfile.

Procedures for finished goods

• Production orders are automatically generated when finished goods fall below 60% of the prior month’s sales. The production orders contain the following details:
  • date;
  • sub-contractor’s name;
  • raw materials required;
  • finished goods needed.
• Two copies of the production order are produced:

  Copy 1—to raw materials store for use as a picking slip, then it is packed with goods and sent to the supplier.

  Copy 2—filed by production controller in date order.

• When the finished goods stocks are received, the bar codes attached to the delivery boxes by the supplier are scanned into the system. A two-part GRN is then produced:

  Copy 1—matched to production controller’s copy of production order.

  Copy 2—filed by accounts clerk.

  The scanning process is aborted if the codes to not match those on the masterfile.

General notes

• The computer automatically selects the supplier of both raw materials and finished goods based on:
  • the latest price (as per their most recent invoice).
  • their delivery times (based on the number of days between the date the purchase/ production order is raised and the date the goods are scanned by the warehouse).
• Password access is as follows:

  Stores staff (raw materials): Purchase order printing for raw materials only.
  GRN printing for raw materials.

  Stores staff (finished goods): GRN printing for finished goods.

  Production controller: Production order printing, masterfile amendments.

  Accounts clerk: Masterfile amendments.

Masterfile amendments

• The stock masterfile contains details of:
  • existing stock items including codes and warehouse location;
  • approved suppliers and sub-contractors.
• Orders will only be generated to suppliers and sub-contractors recorded on the masterfile.
• Masterfile changes are made by the production controller for both raw materials and finished goods inventory. A masterfile amendment form is completed by the production controller as a record of the changes made.

REQUIRED:

1. Identify six (6) weaknesses in the internal controls described. Discuss the implications of each of the weaknesses you have identified. (b) Assume your IT audit division is to perform testing of controls for the inventory systems described. Identify two tests that you would recommend they perform.
2. Assume your IT audit division is to perform testing of controls for the inventory systems described. Identify two tests that you would recommend they perform.

QUESTION 4
In February 2012, the Australian Accounting Standards Boards decided at its meeting to propose the withdrawal of AASB 1031 Materiality. There were several reasons for this proposal which includes: there is no International Reporting Standard equivalent and it does not look like there will be, since 2005 there has been the gradual withdrawal of additional Australian guidance from a number of Australian Accounting Standards, and there is now an updated guidance on materiality in the IASB Conceptual Framework.

The major impact of the withdrawal of AASB 1031 is the removal of the specific quantitative guidance for materiality. The withdrawal of AASB 1031 became effective to annual reporting beginning on or after 1 July 2015.

REQUIRED:

1. Summarize the significant changes and impact on financial reporting with AASB 1031 Materiality (issued by the Australian Accounting Standards Boards - AASB) from 1995 to 2015. (8 Marks)

   You can present your answer using a table format:

   Year/Years or Time period	Changes in AASB1031 Materiality Standard	Impact on financial reporting

    

2. Prior to the withdrawal of AASB 1031 and with reference to the AASB 1031 Materiality (issued by the Australian Accounting Standards Boards - AASB) and the ASA 320 Materiality in Planning and Performing an Audit and ASA 450 Evaluation of Misstatements Identified during an Audit (issued by the Auditing and Assurance Standards Board – AUASB), (12 Marks):
   1. Define materiality.
   2. Outline the qualitative and quantitative guidelines of materiality.
   3. How the concepts and constructs of “materiality” influence the auditors’ professional judgment on misstatements?
3. Post withdrawal of AASB 1031, would this withdrawal of AASB1031 Materiality Standards:
   1. harmonise/bring uniformity to auditors’ assessment of materiality misstatements or would this bring disparity to auditors’ assessment of misstatements? Why so?
   2. What other influence, if any, this would bring to the auditors’ judgment on misstatements and what impacts or implications this would have on the usefulness of financial reports? Discuss your answer and rationale.

Answer

Auditing Assignment Answer-1
(a) Identification of professional standards
There are few fundamental principles that a professional accountant is expected to follow which include integrity, professional competence along with due care, objectivity, due confidentiality, and professional behavior. In a professional environment, there may exist different kinds of threats to the fundamental principles as mentioned above. The threats may be related to self-interest, self-review, advocacy threats, familiarity threats & intimidation threats.

1. In the given case of Holiday Motels Ltd., the auditors have faced self-interest threat as their professional fees have been compromised due to varied reasons by the client. Also, the audit firm has not received fees for three years and they have neither pushed the client for that, only as to retain the clients. The audit firm has also adjusted some fees against a party hosted at the client hotel, although the services of the hotel valued only 30% of the half outstanding amount. This clearly shows self-interest threat as it inculcates the interest of the audit professionals in retaining a big client. Also if the professional continues to do bear this self-interest threat, they ought to breach the fundamental principle of objectivity. The impact of the breach should be that the professional should disclose the matter to the top governing authority in the client form and he should charge sufficient reasonable fees from the client which shall justify the amount of work done. If no action is taken and his dues are not paid, then he shall resign and serve legal notice to the firm for reimbursement of his professional dues.
2. In the given case of Discount Travel Pty Ltd., the firm ATB Partners have faced self-interest threat as one of the partners has arranged accounting software for the client company for earning commission from the software company. This may impact the working of the company as the software may not be up to the mark and just to earn a commission, Mr. Bell has pushed the client to get it installed. This shows that the audit firm as a whole is having a self-interest threat. This may lead to a breach of the fundamental principle of objectivity. The impact should be that any member of the audit firm should not be involved in any of such matters of the client firm which may involve any earnings other than professional remuneration and fees, as this may lead to biased opinions in their audit report.
3. In the given case of Expo Pty. Ltd., the audit firm is charging unusually high professional fees for reviewing the internal audit done. This unusual high fee was treated by the audit firm as compensation for lower audit fees quoted by them. Secondly, the audit manager should check the work done by staff and then only proceed towards making any comments on control. He has not performed any tests on internal control himself, not even on a sample basis. Here there has been a breach of professional competence and due care and integrity as well. This would impact the audit report as there may be some material irregularities in the internal controls report as submitted by the audit staff. Hence, the auditor should perform suitable procedures before preparing his audit report and giving an opinion on the financial statements.

APES 110
APES -110 states that there may be various possible threats to the fundamental principles while performing the work by professionals. The fundamental principles are objectivity, integrity, professional competence, professional behavior, and confidentiality (Welsh et al 2015). Every entity has a different work environment and there may arise different kinds of threats and it may not be possible for the professional to define safeguards against all kinds of threats. Hence APES-110 has established a conceptual framework to help the professionals in identifying, evaluating, and addressing threats to fundamental principles’ compliance. This approach aims to help the professionals in performing his duties along with complying with the ethics of the code. It provides various circumstances that may be threats to independence and the suitable safeguards available against those threats. So when a professional is stuck in such a situation where any fundamental principle is compromised, the reference should be made to the code for further actions if the threat is of an unacceptable level.

Factors necessary for a third party to sue an auditor for negligence The factors that are necessary for a third party to sue the auditors include to major extent negligence on his part due to which the third party has suffered losses. This negligence may be in his performance of due care while auditing the statements and giving his opinion especially when he could not identify some material misstatements (Gay & Simnett 2018). Various factors or grounds through which the third party may sue the auditors are:

• Auditor has not performed his duties with due care while conducting audit.
• The third party has suffered monetary losses or such loss which can be calculated in monetary terms (Traistaru 2016).
• The auditor has some personal interest in hiding the true picture of his client and this fact has been revealed.
• The auditor can be sued if the audit was conducted in a negligent manner and misstatements were of the nature which could be detected in normal course of audit (Grayston 2019).

Answer-2
The general meaning of ratios are given below:

1. Current Ratio: It is the ratio of Current Assets divided by Current Liabilities whereby the Current Assets include stock, Debtors, Cash & bank & prepaid assets while current liabilities include Creditors, Bank Loans & other payables (Kim 2013).
2. Debtors/Receivable turnover ratio: This ratio is the time required of credit sales of the company to get it converted in cash & its equivalents. The formula is credit sales of the company divided by average receivables. Higher the ratio better shall be for the company (Kim 2013).
3. Inventory turnover ratio: This ratio depicts the efficiency of the conversion of average stock into the cost of goods sold(COGS). The formula for the same is COGS divided by average inventory. A higher ratio shows the company’s efficiency to convert and sell stock quickly (Needles & Powers 2013).
4. Return on total assets: This ratio is the return received back on the investments made in assets by the company (Kim 2013). The formula for the same is earnings before interest & taxes divided by Total Assets. This is shown in percentage form.
5. Net Profit ratio: This ratio reflects the net earnings divided by sales ratio. The earnings after taxes are used in this ratio and net sales (sales- sales return). This ratio is the net earnings capacity of the company.
6. Gross margin ratio: This ratio shows the trading earning capacity of the company. Gross profit divided the net sales (Kim 2013). The Gross profit is the profit earned from the sale of the product before deducting the other expenses: Gross profit: Sales – Cost of Goods sold.

The conclusion drawn from the financial data is shown. When compared with the industry averages are shown below:

• Current ratios of Easyfit Pty ltd are better than the industry ratios current because ratios below 2 show the efficiency of current ratios. It shows that the company has sufficient working capital (Needles & Powers 2013).
• Also, Debtors & Stock turnover ratios of Easyfit were better than the industry ratios. These ratios depict the efficiency of the company as higher debtors and stock turnover ratios show that the credit sales are converted quickly to cash and stock is converted to the cost of goods sold (Needles & Powers 2013).
• The return on assets of EasyFit is also better than the industry ratios. This shows that the company can receive a better return on the number of investments made by the company than the industry averages.
• Gross Margins have been more or less on the same grounds, there was not so much difference in them. However, the Net Profit margin of Easyfit was slightly less than the Industry Margins.

Overall we can say that the financial position of Easyfit was good as can be seen in the financial data. It exceeded the benchmarks set by the industry.

The potential threat which can be further investigated can be the Net profit margin which remains the same in both the year 2018 & 2019 that is 4%. Even as we see that the receivables and the stock turnover ratios have decreased which is an indicator that the credit sales and conversion of stock in sales have slowed and decreased, it is a bit strange to see that the Net profit margins have been same for both years. The lowering of Stock and Debtors turnover ratios are another area to be audited & its reasons for decline should be audited.

Answer-3

1. Identification of 6 weakness in the internal control system
   After an analysis of case study of Pet care Pty ltd, we can draw following conclusions as six major weaknesses:
   1. The number of suppliers & subcontractors: The company has a database of almost 50 suppliers & subcontractors which seems to be confusing and complex. This is a wrong practice as it is not possible at every possible ordering level to compares rates and delivery dates of every vendor. Ideally, there should be 5 each vendor of suppliers and sub-contractors. At every ordering levels, fresh rates/tenders and delivery dates can be procured by the vendors and which is very appropriate in terms of cost-cutting.
   2. Separate Systems of raw materials and warehousing: The company should use a consolidated system for both raw materials procure and manufacturing of finished goods. Better coordination and harmonization can be achieved as both departments will not be required to see each other operations and other levels (Matthew 2015). This will avoids situations like overstocking and bulk manufacturing at times also. This is very important for the company’s growth as a whole unit. The company will be able to save funds and less utilization of working capital if both procurement and manufacturing outsource can be integrated.
   3. The procedure of Raw materials: Once the suppliers are finalized, the store prepares the purchase order and sends 3 copies mainly to the warehouse, accounts, and supplier. Here lies a weakness because there is no coordination between the warehouse & accounts. The accounts enter the purchase orders as per the date received and no confirmation from the warehouse is received to the accounts clerk from the warehouse. The warehouse should receive the supply from the supplier as per the purchase order generated and in case the quality is appropriate, a final acknowledgment Goods receive note (GRN) should be sent from the warehouse department to the Accounts for the Accounts clerk to enter in the system.
   4. Procedure for Finished Goods: The subcontractor does not send any requirement order to the company and estimated levels of wastages and days of delivery. The Production slip is generated in two copies which are again not confirmed by the store and entered in date by the production controller. The store should issue an acknowledgment of goods received in order and only then it should be entered into the system.
   5. Choice of suppliers & subcontractor: The Company does not procure fresh prices from the suppliers and delivery dates as per last received orders. The company does not approach suppliers for fresh bids, the prices fluctuate and can create confusion later on. The company should also keep a level of order at the same levels like for example 50% of prior month usage and sales.
   6. Access of Passwords: The passwords should be accessible to the management only; no junior level staff should access the database and its amendment. Any amendments to the database should be authorized by management if required. This is also a major threat currently in the company.

      The two controls we would like to recommend the company is as follows:

      1. Use of a consolidated System both for Store & warehouse using ERP system.
      2. Control on access of database & its amendment to the middle level management.

2. Recommendation of 2 tests
   In case of audit of testing controls for Inventory systems, we would test the IT system by sending a supplier bill twice to the accounts clerk with two different bills no. As the accounts clerk does not get a supplier bill with acknowledgment receipt from the stores and warehouse it is most likely that the same bill with two different no’s will be presented for payment twice. If this gets processed, there is a big weakness in IT controls as the system also does not have any criteria to check the processing of bills. The second testing of controls is the access of the database and its amendment by the middle-level staff like Accounts clerk. It is most likely that the clerk can forge the database and initiate some kind of fraud within the company and make some personal benefit out of it (Matthew 2015).

Answer-4

1. Significant changes and impact on financial reporting with AASB 1031 Materiality
   The accounting standard on Materiality was first issued in the year 1995 in Australia which was applicable for the entities that were to report on or after 30th June, 1996. The main purposes of introducing this accounting standard were to define materiality, defining the role of materiality in the preparation and presentation of financial reporting and wherever necessary, apply other accounting standards along with this standard according to materiality (AUASB 2019). Time to time, changes were made to the accounting standard to make it more effective. Following significant changes were made:

   Year/Years or Time period	Changes in AASB-1031 Materiality Standard	Impact on financial reporting
   2004 to 2005	The scope of materiality was enhanced with the adoption  of IFRS in 2005	Earlier, the Framework for financial statements presentation & preparation included materiality concept only to a limited extent, but now it was given a wide scope. The materiality concept was now to be studied along with IFRS.
   2010	The International Accounting Standard Board had issued a revised conceptual framework which included some updating in guidance on materiality which emphasised on how to enhance and assess the qualitative features of financial data.	The impact was that a greater emphasis was given on how to increase the useful information to be extracted out of the financial information using the materiality factors as emphasised in the conceptual framework.
   2012	In February 2012, the board considered the necessity of AASB 1031 to remain in action in light of already available accounting standards	The impact was to replace the duplicacy and the unwanted guidance available in AASB 1031 and existing accounting standards.
   2013	In June 2013, the exposure draft was introduced highlighting the need to withdraw AASB 1031 due to the existing guidance available in IASB conceptual framework and AAS. While other standards like AASB 108 were amended to give way to materiality consideration and in December 2013, it was finally withdrawn (AASB 2013).	The impact was such that AASB 1031 was withdrawn as the other standards had sufficient guidance notes related to materiality and AASB 1031 was no more required (AASB 2013).

    

2. Prior to the withdrawal of AASB 1031
   • Materiality
     Materiality is a concept or principle which applies to financial data and suggests that more emphasis should be given on the data which has a greater effect or is likely to have a significant effect on a stakeholder’s decision making and which cannot be ignored. This means that any financial transaction will not be judged or analyzed only based on its volume but also on its effect on the mindset of an investor (Cernusca & Balaciu 2015). For example, if a company is always late in filing its tax returns and pays a small sum of fine every time, this shows although the small amount of fine is not material it suggests that the company is lenient in its tax filings and is negligent over tax matters. This is indeed a material factor that may affect an investor’s decision making. So the materiality concept is also important for an auditor to consider where the number of transactions is huge and the entire transactions cannot be audited. In that case, the auditors should set a level of materiality below which the transactions will be ignored for auditing purposes. Setting up of materiality is a professional judgment and expertise and may differ from case to case.
   • Qualitative and quantitative guidelines of materiality.
     Qualitative factors that are considered as guidelines of materiality include matters which may affect the reputation and credibility arising out of any misstatements which remain undetected or unreported. Such qualitative factors may arise as a contingent liability in the future which overall affects the goodwill of the company (Cernusca & Balaciu 2015). Examples- any breach of government guidelines like pollution standards, infringement of copyrights, wrong reporting in the annual report, chances of frauds, etc.

     Quantitative factors are those which include matters which are in monetary terms and can affect the financial misstatements if not covered under materiality and can affect the profitability and decision making of the investors as well. For example- downfall in sales targets despite an increase in the volume of sales.

   • Concepts and constructs of materiality
     An auditor’s judgment to set materiality levels depends upon his judgment of business operations, availability of information and documents, use of external confirmations, and internal controls of the company (Gay & Simnett 2018). The auditor should set a materiality level in such a way that covers the major part of transactions and no misstatements are likely to occur below the materiality levels. For example, in an audit of bank, loans and advances are the primary operations of the bank and audit of every loan account is not possible (Parker 2019). Here, the level of materiality can be set on the basis of the amount of loan, segment loan, secured or unsecured loan, etc.

Answer 3

1. The withdrawal of AASB 1031 has been done after several meetings and discussions among the authority which have discontinued it as the matters considered in AASB 1031- Materiality was discussed in other standards and conceptual frameworks simultaneously. The presence of AASB 1031 was immaterial as the same guidelines were prescribed elsewhere as well. Also, the Board amended AASB 108 to incorporate matters with greater weightage than AASB 1031.

   This will avoid duplicity and confusion in the adoption of standards on auditing and accounting. This discontinuance of AASB 1031 has been widely discussed and the decision has been taken by the majority. So this will bring uniformity in the auditors’ assessment related to material misstatements as there will be lesser confusion.

2. Other than removing duplicity of guidelines, the discontinuance of AASB 1031 will help the auditor to limit his audit procedures to find out the material misstatements and any intentional or unintentional mistakes made by the management. The reason being that the auditor shall have to refer to a limited set of guidelines when it comes to checking of material misstatements. Further, the AASB 1031 was not in conscience with IFRS which are required to be followed by the entities and auditors now. Hence, the reporting requirements shall also decrease and the users of financial statements shall also have concise and precise data to refer to.

References
AASB 2013, First-time Adoption of Australian Accounting Standards, Available from: https://www.aasb.gov.au/admin/file/content105/c9/AASB1_05-09_COMPdec13_01-14.pdf [Accessed 30 April 2020]

AUASB 2019, Australian Auditing Standards. Available from: https://www.auasb.gov.au/Pronouncements/Australian-Auditing-Standards.aspx [Accessed 30 April 2020]

Cernusca, L and Balaciu, D.E 2015, The Perception of the Accounting Students on the Image of the Accountant and the Accounting Profession. Journal of Economics and Business Research, 21(1), 7-24. doi: 10.1515/sues-2016-0010

Gay, G., & Simnett, R 2018, Auditing and Assurance Service in Australia, McGraw-Hill Education (Australia)

Grayston, C 2019, Audit quality: is it time for a different approach? Available from: https://www.intheblack.com/articles/2019/02/01/audit-quality-time-for-new-approach [Accessed 30 April 2020]

Kim, S 2013, Accounting quality, corporate acquisition, and financing decisions, auditing assignment The University of North Carolina

Matthew, S. E 2015, Does Internal Audit Function Quality Deter Management Misconduct?. The Accounting Review 90(2), 495-527.

Needles, B.E & Powers, M 2013, Principles of Financial Accounting, Financial Accounting Series: Cengage Learning.

Parker, D 2019, Seeing audit quality in Australia in a new light. Available from: https://www.intheblack.com/articles/2019/10/01/seeing-audit-quality-in-australia-in-a-new-light [Accessed 30 April 2020]

Traistaru, D.A., 2016. Perceptions concerning professional judgement and ethics in the evolution of the accounting profession. European Journal of Business and Social Sciences, 4(10), pp.126-135.

Welsh, D.T., Ordonez, L.D., Snyder, D.G. and Christian, M.S., 2015, The slippery slope: How small ethical transgressions pave the way for larger future transgressions, Journal of Applied Psychology, 100(1), p.114.