Auditing Assignment: Financial Analysis For Business Scenarios
Prepare an auditing assignment addressing the following questions:
You had been recently promoted to Senior Auditor of the audit firm Jose Rizal and Associates and was asked to consider the following independent situations:
A. One of your major clients, Just Squeeze Juice Pty Ltd, has talked to you about a consulting engagement next year for you to do a complete review of the adequacy of the entity’s quality controls over the production of its fruit juices. However, the managing director has indicated that some of the Board are concerned about you taking up too much of their staff’s time asking unnecessary questions. Therefore, he has suggested that your chances of getting the engagement will be significantly improved if you keep your questions of staff to a minimum during the current audit.
B. One of your audit clients, Amethyst Pty Ltd (APL) is a large superannuation fund. The Australian Taxation Office has advised APL that it has rejected its taxation treatment of a material amount of income from investments and that it disagrees with the taxation advice APL gave to its members. The matter has been referred to the Superannuation Complaints Tribunal and APL has requested that you represent them at the Superannuation Complaints Tribunal.
For each of the independent situations above:
(a) Identify the type of potential threat to independence. Justify your answer.
(b) Explain what safeguards, if any, that could be implemented to reduce the independence threats.
(c) Assess whether audit independence can be achieved.
(d) Explain what is ‘public interest’ and how does it relate to the auditor’s code of ethics?
You are the audit senior on the audit of Resilient Furniture Manufacturers Pty Ltd (Resilient). Your firm has recently been appointed as the first auditors of the company.
You interview the managing director of the company to obtain background information on Resilient and to understand its business operations, its environment and system of internal control. You noted and documented the following:
- Resilient was founded 30 years ago and makes ‘grandfather’ clocks (freestanding, weight driven, pendulum clocks).
- The clocks are made in one factory (situated in the Alice Springs) and are distributed through boutique homeware and antique furniture stores.
- The clocks are advertised mainly in local newspapers and through pamphlet drops.
- In order to promote longer production runs and minimise finished goods stocks, Resilient’s retail distributors are offered stock on a ‘sale or return’ basis. This means that the homeware and antique furniture stores are invoiced immediately, subject to a 90-day term of payment, but are allowed to return the stock up to 30 days before payment is due. Only the marketing manager has been given the authority to make these offers.
- All of Resilient’s timber is obtained from offshore sources. Timber prices, which are denominated in US dollars, have risen substantially over the past two years and the recent drop in the value of the Australian dollar has caused them to rise even further.
- Timber purchases are secured by providing Resilient’s suppliers with letters of credit which become due when the container shipment of timber arrives in Australia.
- Labour costs are high due to the craftsmanship and quality required for the production of the grandfather clocks. Skilled labour is not easy to obtain and wage rates have recently risen.
- Resilient has found it difficult to pass on these timber and labour price increases to customers.
An analysis of costs indicates that there have been material negative purchase price variances in purchases of timber over the course of the year. You have compiled the following information from Resilient’s financials:
- the current ratio as at 30 June 2019 is 1.24
- the shareholders’ funds to total assets ratio is 30%
- gross profit margins and net profit margins for the year ended 30 June 2019 have dropped to the level where losses are being incurred.
Resilient’s bank finances the company’s timber purchases using bills of exchange drawn at 90 days from the date of payment of the shipment. It has also extended loan finance to Resilient. The bank covenant, which is due for review shortly, requires Resilient to:
- maintain a current ratio of 1.2
- maintain a shareholders’ funds to total assets ratio of at least 30%
- maintain net sales of a minimum of $100,000 per quarter
- prepare a general purpose financial report for the year ended 30 June 2019 and have it audited according to Australian Auditing Standards. Note that this is a requirement of the bank covenant as Resilient is not required to produce a general purpose financial report under the Corporations Act.
Required – Q2 Part 1: For parts (a), (b) and (c) of this question, please disregard all going concern considerations. Based on the background information above and your use of preliminary analytical procedures, answer the following questions:
a) Identify and explain two (2) asset accounts at risk of material misstatement
b) Describe one (1) issue regarding the prior year’s figures and explain why
c) Describe three (3) factors that may bring into question the going concern assumption for Resilient. Disregarding the evaluation of management’s assessment of the going concern assumption, briefly describe the effect of the facts on your audit planning
Now, after examining Resilient’s detailed trial balance, you notice that one of the expenses of the sales and marketing department is ‘sales bonuses’. You question this expense and the company’s accountant informs you that a monthly bonus of 10% of salary is paid to all sales and marketing staff if sales for the month exceed the budgeted target. The marketing manager is entitled to a 20% bonus if the targets are achieved. This incentive was implemented during the previous financial year and was in place for the last six months of the year. You note that the bonus has been paid every month since the incentive was implemented (except for the previous month, when sales were much lower than expected). This seems a little unusual because Resilient had only achieved its budgeted sales targets in two out of the six months prior to the start of the scheme. You investigate results for the last six months of the year and find that:
- sales were above the monthly budget figure when bonuses were paid
- there was no significant change in gross margins
- returns of stock sold on the ‘sale or return’ basis were well below those in the first six months except in the final month of the year
- debtors’ levels (measured in days outstanding) were above their budgeted levels but returned to a more normal level at year end.
On further enquiry, the accountant advises that the marketing manager is authorised to do the following with regard to the stock sold on a ‘sale or return’ basis:
- offer customers a ‘sale or return’ deal as long as the deal is within the company’s pricing structures and the terms of the scheme
- initiate and approve the invoicing of customers when a sale is made (i.e. if the stock is not returned within 60 days)
- initiate and approve the issue of credit notes for these customers when returns are made within 60 days or when pricing or quality issues arise.
Required – Q2 Part 2:
Based on the background information above, answer the following questions:
a) Explain one (1) internal control issue at Resilient
b) Identify and explain two (2) fraud risk factors at Resilient
c) Identify two (2) assertions (as defined by ASA 315) at risk as a result of the fraud risk factors identified in (b) above. Justify your answer with reference to the background scenario
d) Describe two (2) audit procedures that would address potential misstatements arising from fraudulent financial reporting. Ensure that your procedures are specific to the scenario and the fraud risk factors identified in (b) above. You may wish to refer to Appendix of ASA 240
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.
- 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.
- 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):
a. Define materiality.
b. Outline the qualitative and quantitative guidelines of materiality.
c. How the constructs of “materiality” influence the auditors’ professional judgment on misstatements?
3. Post withdrawal of AASB 1031, would this withdrawal of AASB1031 Materiality Standards:
a. harmonise/bring uniformity to auditors’ assessment of materiality misstatements or would this bring disparity to auditors’ assessment of misstatements? Why so?
b. 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.
(Support your answers with the relevant Australian Accounting Standards and Australian Auditing Standards as well as authorised/published Peer-reviewed Academic Journals and Articles.)
AUDITING ASSIGNMENT PART 1
The Managing Director of the company has suggested keeping the questions to the staff to a minimum to obtain the audit assignment. It is a possibility that the management is trying to cover or hide a few errors and is hence requesting the auditor to restrict the audit procedures.
The possibility of a few errors getting missed is increased as the auditors’ duties are restricted by the Managing Director. An audit is an overall assessment by making detailed verification and inquiry in all the possible areas.
The auditor carries out the analytical and substantive procedures to ensure that the financial statements reflect a true and fair view. There should be no compromise in this either by the auditor or by the management. If there is any limitation on the scope of the audit, then this fact needs to be mentioned in the audit report.
The auditor has to be firm in carrying out the audit procedures without being influenced by the words of the managing director. If his independence is at stake, then he should refuse the audit assignment. To obtain the audit assignment, the auditor should not cut down the audit procedures (Baldwin 2010).
APL has ignored the tax treatment of a material item of income from investment due to which the matter has been referred to the Superannuation Complaints Tribunal. The auditor has been requested to represent the company at the Tribunal level. The threat here is that the auditor is being asked to support a cause which is the mistake of APL.
The ignoring of the tax treatment of an item of income is a loss of revenue for the government and hence the auditor must report such an event of fraud. As this is a material item, it has to be adequately reported in the audit report and statements issued by the auditor.
The auditor has to represent the client in the case against the Tribunal in which the auditor is required to justify the actions of the client. As this is in disagreement with the advice given by the Australian Taxation Office, the auditor has to safeguard his interest by either declining the representation on behalf of the company or by making the company aware of its mistakes and settling the case in favor of the department.
The independence of the auditor is at stake if they agree to represent APL in a case that is in clear violence of the tax of a material item of income. The auditor becomes liable for professional negligence as the taxation laws have to be complied in full by every business. If there are frauds, then the auditor should qualify the audit reports and take the side of the taxation department (Baldwin 2010).
‘Public interest’ and its relation to auditor code of ethics
The purpose of the introduction of the concept of public interest is that the part of the public should assume priority over the personal, business, or sectional interests. The quality of work should be such that it enhances the usefulness for the users of the financial statements. An auditor is expected to have honesty and integrity in the representation of their services. Professional development, professionalism, competence, and honesty are the few core values that a member of the ACS is expected to conform with (Cernusca & Balaciu 2015). In cases of conflict, the concept of public interest assumes prominence over the other vales mentioned in the code of ethics. These values are expected to be followed by all the members irrespective of the fact whether they are in individual practice or employment. The Code of Ethics has been drafted to encourage professional behaviour. The spirit of the Code of ethics is to resolve any ambiguous issues. Professional conduct should safeguard the interests of the immediate stakeholders as there should be no conflict with the duties and loyalty owed to the public and stakeholders (Setiany et al 2017). Professional standards must be maintained at all levels and in all situations as auditors are watchdogs and have to safeguard the interests of the stakeholders (EY 2015). The members have to undertake such actions that maintain the integrity and image of the profession.
a). Two asset accounts which are at risk of material misstatement are:
Sale or Return Debtors- The firm Resilient offers its retail distributors with specific schemes to promote its products and minimise the stocks of its finished products. The system is that the retail distributors purchase products from the firm on Sale or Return basis. This means that they are given the work and invoiced immediately. But, if the product does not get sold out, the retailers shall return the goods to the firm. This will create a misleading figure of sales or return debtors as this figure might change any moment when the retailers will reverse the unsold products (Parker 2019). The marketing manager is authorised to offer such schemes, and for increasing his commissions, he may issue such offers which may lead to an increase in the overall sale but increase sale or return debtors too. This figure may rise or fall drastically as there is no certainty of sale of such products. Hence, there are chances of material misrepresentation in these figures.
Inventory- The inventory figures shall also be tentative as it is not sure whether the stock sold under the ‘Sale or Return’ offer will be sold or returned to the firm. The certainty shall be known only after 60 days of sale completion by the firm to retailers as the maximum period allowed for return by the retailers is 30 days before payment due date which is maximum 90 days. Hence, there are greater chances of material misrepresentation in inventory figures.
b). One issue with prior-year figures was that instead of an increase in sales, the net profit of the firm had shown a decline. This was mainly due to rise in price variances of material and labour. At the time of entering into the purchase contract, prices are fixed and at the time of actual delivery of goods if the price changes, then it creates variances (Gay & Simnett 2018). The inverse variance was made in case of purchase and labour prices in the prior year.
c). The three major factors that creates doubt over the going concern of the firm are:
i. Drastic Net Losses in the year 2019: The Company’s going concern is affected mainly due to losses in the current year. The company is not able to cover its expenses majorly due to increase in price differences. Till the previous year, the company was earning handsome profits. However, the gains had shown a declining trend in the last two years but with a sudden loss incurred in 2019. This creates suspicion over the going concern in coming years.
ii. Inability to maintain cost efficiency: Even though the gross sales have declined, the administrative and other operating expenses have risen. This means that the company is unable to cut down its costs effectively. If the values are not managed efficiently, this will affect the going concern.
iii. Sudden increasing cost variances: there has been a sharp increase in cost variances which included the purchase price and labour cost. This variance was a significant reason behind the incurring of losses. If such conflicts are not taken care of, this would also affect the going concern concept..
a. One of the Internal Control issue at Resilient is the issue of Sales bonus to the sales department. It seems that the sales department tries to inflate sales to achieve its bonus targets. However, the same is not done in line with company policies and its welfare. The company’s net debtors have increased, which is an extra burden on its financial capacity. Also, sales become ineffective if the goods are returned. The marketing manager is authorised to sale products on a return basis within 60 days of invoice. This is a major internal control weakness in the company. The Sales department receives a bonus on sales achievement and not on sales fewer returns basis.
b. The two obvious fraud factors that are evident in the company are to inflate sales figures every month to achieve a sales bonus. Secondly, the Unnecessary and undue powers granted to Marketing manager to sale goods on a return basis, which can quickly be done by an under table arrangement with any of company debtors. The sales team is in continuous touch with the company debtors. The debtors are not required to pay anything in 60 days from the date of sales. Even if they return goods within 60 days of sales, the marketing manager can secure its bonus. This is a total loss to the company.
c. The two assertions at risk are that the statement or the sales figures claimed by the Marketing manager is incorrect because he has the right to cancel the invoice in case of a return within 60 days of invoice and hence the sales figure cannot be trusted. Another assertion is the debtors’ amount which is doubtful as it can both reduce and turn into bad debts if the credit period is not served on time.
d. The auditor should adopt following audit procedures to find out potential fraud and misstatements referred to in (b) above. Firstly, the sales bonuses should only be issued by competent authority once the return period is over. Also, the auditor should check the budgeted sales figures given by the marketing team and check whether or not they are under-budgeted, which is easily achievable (Oussii & Boulila 2018). Secondly, the auditors should check the credit periods allotted to major debtors and whether the payments are honoured are made as per the credit period allowed to them. In case of any default, the credit period of defaulting debtors should be mentioned in the auditors’ report...
Initially, the auditing standard for materiality was made in September 1995 namely ‘AAS-5 Materiality’. The applicability of the measure was from June 1996. The introduction of this standard aimed to define the criteria and quantum of those items in the financial statement that could affect the opinion of auditor and other users of financial statements to a substantial extent. Before the withdrawal of AASB- 1031, there were different amendments done to the standard by the AASB board during the years 1995 to 2015, which are mentioned as under
Year/Years or Time period
Changes in AASB-1031 Materiality Standard
Impact on financial reporting
Year 2004 to Year 2005
In this period, IFRS was adopted in the year 2005 which enhanced materiality scope.
With the introduction of IFRS, the study of materiality was to be done keeping in mind IFRS (Oussii & Boulila 2018). Before that, there were very limited restrictions with regard to preparation and presentation of financial statements. This got a wide scope with the introduction of IFRS.
In the year 2010, the IASB issued some major revisions in the conceptual framework. These revisions were related to up gradation of theories that were used to assess the financial data with respect to materiality clauses.
The revisions or up gradation helped in laying more emphasis on usefulness of important information in financial statements and how that important data can be extracted and utilised by using the materiality standards.
There was not much change in the accounting standard, but the notification was passed to continue the AASB-1031 for guidance related to materiality.
The continuance of materiality standard along with other standards impacted in removing duplicate opinions regarding material aspects in financial data.
In the year 2013, it was proposed to withdraw AASB-1031 as it was unable to match its guidance with IFRS guidelines. As there was need for guidance on materiality, amendments were made to AASB 108 so that AASB 1031 could be superseded.
Impact was that the necessary changes were made to AASB 108 regarding materiality to remove unnecessary guidance present in AASB 1031 (Gay & Simnett 2018).
a. Materiality can be defined as a concept which applies to the financial statements and information of an entity. It emphasises on those items of financial statements which are likely to have a greater and significant effect on decision making by the stakeholders and auditors. The concept explains the importance of judging the financial information based on their usage in decision making of all stakeholders (AUASB 2019). Also, materiality is crucial as it defines the scope of misstatement in financial statements which affect the work of auditors. For example, the percentage change in administrative expenses should generally be proportionate to the revenue earned. Still, where the proportion is unusually high, it creates doubt over duplicacy of entries or presence of dummy entries. This is material as it would reduce the net profits of the company to great extents. From the viewpoint of auditors, the materiality concept is essential as in large organisations, and it is not possible to verify every single transaction (AUASB 2019). In such cases, materiality thresholds are set by the auditors and transactions below such threshold are confirmed on a sampling basis only.
b. Qualitative guidelines relating to materiality include those factors that are associated with reputation and creditworthiness of a business. It not defined in exact monetary terms. Such factors are considered material if these are expected to create any misstatements in the financial data which could not be reported or detected (Gay & Simnett 2018). The materiality level of qualitative factors is essential as these factors could lead to a contingent liability of the company in future, which shall affect its goodwill and reputation (National Audit Group 2020). For example- if a company usually breaches the guidelines of the government, it is likely to enter into substantial government liabilities.
Quantitative guidelines as the name suggests can be quantified in monetary terms, unlike the qualitative factors. These are comparatively easier to detect and have significant impacts on financial statements if they remain undetected. Materiality threshold is very much needed to be set for qualitative factors as these have a direct impact on the decision making of the stakeholders (ACCA 2018).
c. The materiality concept plays a vital role in judgements of auditors. For setting up materiality thresholds, the auditors need to have an in-depth understanding of the client’s business. This understanding involves regular operations of business, financial and non-financial data of the client, availability of required information, etc. If such factors are not provided to the auditors, it is not possible to set the materiality levels, which can lead to misstatements and affect auditor’s opinions (ASIC 2020). The setting of materiality level should be done, so that maximum transaction and information are covered under such groups as material misstatements are likely to occur within these limits (Geoffrey et al, 2016). For example, in the audit of a multinational company with innumerable transactions, the audit team can't verify and inspect every single transaction. Hence, it is required to set materiality levels in such kind of organisations.
a). The withdrawal of AASB 1031- Materiality is a well planned and discussed the move by the Authority. There has to be a straightforward thought process before the discontinuance of any standard (AASB 1031, 2020). The primary reason was to avoid duplicate advisory issued by different criteria. The Board also aimed at finding out common issues which were addressed by other means like AASB 108 and amended it accordingly to put more emphasis on it. To avoid confusion and bring more uniformity, the decision to scrap AASB 1031 was taken unanimously by the board members (Grayston 2019). The matter was widely discussed in the meetings among the board members.
b). The removal of AASB 1031 Materiality came in force for annual reporting starting from 1st July 2015. This move was in line with the recommendation of IFRS to provide more transparency and avoid duplicate addressed issues (AASB 1031, 2020). This will also help the auditors to refer to a limited set of audit standards and its advisories. Moreover, the auditors can now save their time and efforts on finding out the common issues discussed in more than one auditing standards, so this is a good move. The financial statements issued will now be more accurate and precise as it does not have to pass the test of materiality matters more than once. The users of financial statements will also be served financial statements with less confusion and overlapping cases on Materiality (Kim 2013). This is in line with the best auditing practises adopted throughout the countries following IFRS guidelines.
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