AF304

Auditing
Tutorial 5 Answers
Chapter 6
6.13 Why is independence cr ucial for an exter nal auditor ?

Independence is crucial for an external (independent) auditor because one of the key reasons
for appointing an auditor is associated with agency theory. Agency theory suggests that there
will be a demand for monitoring by someone outside of the entity being audited. The value of
the auditor to the entity is that the auditor is from outside of the entity and can therefore
comment objectively on the behaviour of management. Therefore the auditor’s
independence is crucial. It should also be noted that independence is important in both fact
and appearance and this is reinforced by APES 110, Code of Ethics for Professional
Accountants. Regulators also see the value of independence and therefore have included
some statutory protection in relation to the removal of auditors in the Corporations Act.

Independence is required so that the auditor will report in an unbiased manner to the
members and on any required regulatory matters to ASIC.

Independence is particularly needed in dealings with management. ASA 200 states in
paragraph 15 “The auditor shall plan and perform an audit with professional scepticism
recognising that circumstances may exist that cause the financial report to be materially
misstated.”

6.20 What ar e the differ ent phases in the audit pr ocess?

Phase I: Perform risk assessment procedures
Phase II: Assess the risk of material misstatement
Phase III: Respond to assessed risks
Phase IV: Perform further audit procedures
Phase V: Evaluate audit evidence
Phase VI: Communicate audit findings

6.23 Management and Auditor r esponsibilities

You are a newly qualified accountant who works for the audit firm Fulford & Co. You
have been approached by a potential new client, Bishopthorpe Electronics Pty Ltd, who
is looking for an audit firm to carry out an audit on its annual financial report prepared
in accordance with the Corporations Act. The managing director, Bob Fleming, is not
sure exactly what an audit involves and what are the responsibilities of the auditor.

Required
Pr epar e notes for a meeting with Bob Fleming which identifies the r esponsibilities of the
auditor and the r esponsibilities of management.

The notes should cover the following:
Ÿ Distribution of the annual report to shareholders.
 Ÿ Delivery of the audit report to the entity.
Ÿ Obtaining and evaluating evidence concerning the financial report.
Ÿ Preparation and presentation of the financial report.
Ÿ Maintaining adequate internal controls.
Ÿ Testing internal control procedures.
Ÿ Expressing an opinion on the financial report.
Ÿ Selecting appropriate accounting policies.
Ÿ Ensuring the financial report is presented in accordance with standards.

Responsibilities of the auditor

• Understand internal control and test internal control procedures.
• Obtain and evaluate evidence concerning the financial reports.
• Verify that financial information has been presented fairly in accordance with an
identified financial reporting framework.
• Express an opinion on the financial report.
• Deliver the auditor’s report to the entity.

Responsibilities of management
• Analyse events and transactions.
• Measure and record transaction data.
• Select appropriate accounting policies.
• Classify and summarise recorded data.
• Maintain adequate internal controls.
• Prepare the financial reports and other reports in accordance with the identified
financial reporting framework.
• Distribute the annual report, including financial reports and the auditor’s report, to
shareholders.

6.24 Removal of an auditor

On 31 March 2014, Black and Black (a firm of certified practising accountants)

completed the audit of E-Wine Pty Ltd for the year ended 31 December 2013. E-Wine is
a wine store that operates solely on the internet. On 15 May 2014, Tom Black (the audit
partner responsible for E-Wine) received a phone call from the financial controller of
E-Wine, Ms Chong, who was very angry. Ms Chong said that their accounts receivable
clerk suddenly resigned a month ago. This sudden departure raised suspicions and,
after an investigation of the accounting records, it was discovered that $200 000 was
missing. Subsequently, the board met and decided Black and Black was almost entirely
to blame. As a result, Ms Chong said the board had decided to dismiss Black and Black
as auditors, effective immediately. Black and Black would receive written confirmation
in the next week and legal action would probably follow.

Required
(a) Explain whether E-Wine has taken the pr oper action to r emove their auditor .

No. The proper process to remove an auditor is as follows:
(a) Special notice under s.329(1A) must be given at least two months before a general
 meeting
(b) A copy of the special notice needs to be sent to the auditor and a copy must also be
lodged with ASIC. (s.329(2))
(c) The auditor has a right to respond and a right to be heard at the meeting. (s.329(3))
(d) The company may appoint another auditor at the general meeting with at least a three-
quarter majority. (s.327(10)(a))

In this case, the main problem is that the company has not properly followed the due process.
The auditor should be given the opportunity to justify why the $200 000 fraud was missed
during the audit at the general meeting and the ASIC should be made aware of what is going
on.

(b) Explain why r estr ictions ar e placed on r emoving auditor s.

Restrictions are placed on the removal of auditors so auditors can feel free to act independently

without potential recrimination from the company through dismissal. This is because

independence is a fundamental attribute of the audit function.

6.27 Audit committees

You work for a mid-sized audit firm, Green & Co. One of your clients, Wedford Ltd,
recently established an audit committee in compliance with the Australian Securities
Exchange listing requirements. The committee is made up of Francis Carton, Jo
Pashtoon and Charles Digson.
Francis is an executive of the company and has worked his way up from a factory
worker through to management. Francis is the chairperson of the audit committee.
Jo is not a member of management and is therefore a non-executive director, but she
does serve on a number of other boards. Jo’s background is in accounting and before
she became a director she was the CFO of a large corporation for many years.
Charles is the chairperson of the board of directors and is an executive of the company.
Charles’ background is in manufacturing and he has been with Wedford Ltd for 5
years.
The committee has drafted a charter which details its rights and responsibilities. This
will include the committee’s interactions with the newly formed internal audit
department. The Board would like to discuss with you the relationship between your
firm as external auditors, the internal audit team and the audit committee.

Required
Pr epar e a r epor t for the Boar d, cover ing the following matter s:
1. Outline the objectives of an audit committee.

improving the credibility and objectivity of the accountability process (including financial
reporting);
assisting the board of directors to discharge its responsibility to exercise due care,
diligence and skill;
improving the effectiveness of the internal and external audit functions and the
 communication between the board of directors and the external and internal auditors;
facilitating the maintenance of the independence of the external auditor;
strengthening the role and influence of non-executive directors.

(b) Discuss the inter action between the audit committee and both the inter nal and
exter nal audit functions.

The main role is an alternative to management as point of communication for the internal and
external auditors. This allows for a greater degree of independence in reporting and helps
ensure a stronger level of corporate governance for the company.

(c) Identify the strengths and weaknesses of Wedford Ltd’s audit committee.

Strengths:
Chairperson of the audit committee is not the same as chairperson of the board
One member (Jo) with financial expertise
Formal charter specifying the rights and responsibilities (but still only a draft)

Weaknesses:
(a) Only one non-executive member (should be a majority)

(d) Recommend ter ms of r efer ence for the committee.

It might include:
(a) Review monthly financial reports.
(b) Review reports from internal auditors.
(c) Liaise with internal auditors and assist in directing the internal audit work program.
(d) Liaise with external auditors at the planning, performance and completion of the external
audit.
(e) Review the external auditor’s management letter before it goes to management.
(f) Be involved in any discussions between auditors and management on contentious
accounting issues or treatments in the financialreports.
(g) Be available for the communication of problems experienced by internal and external
auditors.


Chapter 8
8.11 List the steps per for med by an auditor befor e accepting a new audit appointment.

Assess the firm’s competence to carry out the audit work.
Obtain permission from the client to contact the outgoing auditor, refuse the
engagement if permission is not received.
Communicate with the outgoing auditor to assess if there are any reasons why they
should not accept appointment.
Outgoing auditor will seek permission from client to respond and reply.
Incoming auditor reviews response from outgoing auditor for any issues that might
affect acceptance of the audit.
Consider if any conflicts of interest arise by accepting the client.
Determine the firm’s ability to use due care in performing the audit.
Consider the integrity of management.
Prepare a preliminary assessment of risk of accepting the client.

8.15 Discuss the steps involved in the audit planning pr ocess.

Planning an audit involves establishing the overall audit strategy for the engagement and
developing an audit plan, in order to reduce audit risk to an acceptably low level (ASA 300).
Planning starts with an understanding of the entity and its environment. Planning also
involves (1) setting materiality levels, (2) assessing audit risk and its components, (3) obtaining
an understanding of the internal control structure and then (4) developing a preliminary audit
strategy for significant assertions. Auditors should also perform analytical procedures as part
of the planning process as well as consider the risk of fraud.

8.18 What ar e the auditor ’s r esponsibilities in r elation to fr aud?

The activities that the auditor will carry out include procedures to:
Identify and assess the risks of material misstatement due to fraud.
Ensure the audit team is aware of the risks of fraud and their responsibilities in
response to those risks.
Design and implement appropriate responses to the fraud risks identified.
Respond to any fraud or suspected fraud identified during the audit.
8.21 Risk of fr aud

Following are a number of factors recognised by the auditor as having an effect

on the risk of fraud.
1. The company is vulnerable to interest rate fluctuations.
2. Management has significant financial interests in the entity.
3. Employees express dissatisfaction with the company and its treatment of
staff.
4. Many asset values are based on significant estimates that involve subjective
judgements.
5. Management does not place a high priority on ethical standards.
6. Inadequate systems of authorisation and approval of purchase
transactions.
 7. Management shows an excessive interest in increasing the entity’s share
price.
8. There is a high turnover of internal audit and information technology staff.
9. Employees ignore internal controls and do not focus on reducing risks of
misappropriations of assets.
10. The entity’s industry is highly competitive.
11. Employees anticipate future redundancies.
12. Management attempts to justify marginal or inappropriate accounting on
the basis of materiality on a recurring basis.

Required
For each of the for egoing r isk factor s, use the following codes to identify the r isk
component that is most dir ectly r elated to (a) fr audulent financial r epor ting or
misappr opr iation of assets and (b) incentives/pr essur es, oppor tunity or
attitude/r ationalisation.
FFR = fraudulent financial reporting I/P = incentives/pressures
MA = misappropriation of assets O = opportunity
A/R = attitude/rationalisation

(a) (b)
1 FFR I/P

2 FFR I/P

3 MA A/R

4 FFR O

5 FFR A/R

6 MA O

7 FFR A/R

8 FFR O

9 MA A/R

10 FFR I/P

11 MA I/P
 (a) (b)
12 FFR A/R

8.27 Fr aud r isk

Cleanway Ltd is a public company that competes in the highly competitive market for
manufactured household products. The company is dominated by Rob Bigbucks, the
chairman and chief executive officer, who has guided the company since it was a private
company and has extensive influence on all aspects of company operations. Rob is known
to have a short temper and in the past has threatened individuals in the accounting
department with no pay rise if they failed to help him achieve company goals.
Furthermore, the company has extended its influence over customers and has dictated
terms of sale to ensure that customers are able to obtain desired quantities of their most
popular products. Bonuses based on sales are a significant component of the
compensation package for individual product sales managers. Sales managers who do not
meet sales targets three quarters in a row are often replaced. The company has performed
well up until a recent recession, but now the company is having difficulty moving
inventory in most product lines as retailers have difficulty selling in a down economy.

(a) Identify the fr aud r isks factor s that ar e pr esent in the case above.
(b) Identify the accounts and asser tions that ar e most likely to be misstated based on
the fr aud r isk factor s noted in this case.

(a) Fraud risk factors are identified in ASA 240:

● High degree of competition in the market
● Domination of the Rob Bigbucks
● Threatened employees with no payrises
● Significant portion of sales managers salaries are paid in bonuses
● Sales managers who do not meet targets three quarters in a row are replaced
● The industry is in a recession and it is starting to affect the company

(b) The financial statement assertions are identified in ASA 500. The most significant threat
is to the occurrence assertion for sales. There is very significant pressure on the sales
managers and there is a high risk that they will take any opportunity to overstate sales,
particularly given that there is a recession.

However, there is also a broader threat of financial reporting fraud on other balances.
This is because of the threatening behaviour of Rob Bigbucks over the accounting
department to ensure that they help him achieve “company goals”. Given the recession,
company goals will be harder to achieve increasing the pressure on the accounting
department.

8.31 Planning the audit

Moss Green Ltd is a wine grower and producer of medium- to high-quality wines located
in Western Australia’s Margaret River region. The company has recently listed on the
Australian Securities Exchange. After listing, it changed auditors from Tickit Associates
to your firm, Watson and Partners. You are an audit supervisor in Watson and Partners
and you are planning the audit for 31 December 2015.
The managing director of Moss Green Ltd is Tom Green. He is the founder of the
winery and has a very ‘hands on’ management style. He is a trained winemaker and has
always focused more on the wine making and marketing side of the business than the
financial side, which he leaves to Wendy Chong, the financial director, in whom he has
great faith. He pays her a good base salary and provides an attractive bonus scheme based
on growth in net profitability.
The company has been very successful in selling its medium-quality wine to the United
Kingdom. This is mainly due to a very large contract with one of the leading supermarket
chains there, Safeburys. Part of the success has been due to the low value of the Australian
dollar compared with the British pound. However, the company manages its foreign
exchange risk through hedging, which is controlled by Wendy. Tom has also been very
happy with Wendy’s performance in this area as she has made some healthy profits on
her hedging contracts.
The wine production manager is Alfred Horndale. From discussions with Alfred, you
become aware that the company has significant stock from the 2013 vintage in the
Margaret River warehouse and in London (because it was rejected by Safeburys —
payment for this stock is currently in dispute).
As is the standard practice, you contacted Tickit Associates before you accepted the
engagement at the beginning of the year to see whether there were any matters you should
have been aware of before accepting the engagement. They told you that they had only
two main concerns. First, they had problems getting Tom Green to have any interest in
the financial side of the business, and it was their view that he was not financially literate.
Second, there had been a number of disputes over accounting policy with Wendy Chong,
particularly over getting her to implement AASB 141 Agriculture and AASB 137
Provisions, Contingent Liabilities and Contingent Assets.

Required
Pr epar e a memo to the audit par tner outlining potential pr oblem ar eas and their impact
on the audit plan.

Listed below are some points that could be included in a memo:
(e) The company has recently listed on the stock exchange. This increases the number of
possible users of the annual report and also significantly increases the extent of
reporting requirements.
(f) The change of auditors should be carefully followed up. Some information has been
provided from the prior auditors that would be useful in conducting the audit as
discussed as follows:
(g) Tom Green does not seem to have much knowledge of or interest in the financial
side of the business. This will have implications in the assessment of the control
environment.
(h) The discussion with the prior auditor also found that there had been disputes
with Wendy Chong over accounting policies. This should be noted and the
auditor should be prepared to argue over accounting policies that he or she
believes to be appropriate. It should also cause the auditor to take care in relying
on representations from Wendy.
 (i) The bonus paid to Wendy Chong based on growth in net profitability is a concern. This
is because it gives incentives for Wendy to take aggressive accounting choices to
achieve the bonus.
(j) There is a very large contract with a UK supermarket chain. Whilst this is a good thing
for the company, the percentage of the company’s sales that relate to this chain
should be reviewed to assess the implications for the business if problems occur with
this contract.
(k) Another risk is that part of the company’s success in exporting is due the low value of
the A$. The auditor should do some sensitivity analyses on the impact of variations in
this exchange rate and the possible impact it might have on the operations of the
company.
(l) The company hedges to reduce its foreign exchange risk (which is good). However,
there would be a concern from the comment that healthy profits have been made on
hedging contracts. These contracts should not be used to try and ‘make money’ but
to cover foreign currency obligations. This is something that should be considered in
assessing control risk.
(m) The stock held overseas should be carefully reviewed to assess its valuation.