Question

You are an Audit Senior currently planning the 30 June 20X8 audit of Forest Limited, an Australian-owned company that produces and exports woodchips to Japan. Forest’s operations are located in Eden, on the far south coast of NSW. Timber is purchased from forests nearby, processed into woodchips and immediately stockpiled for export at the company’s shipyards at Twofold Bay. Forest contracts timber cutters to deliver set tonnages of logs to its mill throughout the year. Woodchips are transported to Japan on charter vessels, which make an average of one trip a month.

At a recent planning meeting with Forest Limited’s senior staff, you obtained the following overview of this year’s operations:

A massive conveyor belt is used to transport the woodchips from the mill to the stockpile. The manufacturer of this belt was recently taken over by an overseas competitor of Forest Limited, Chipper Limited, which processes woodchips in several South-East Asian countries. Chipper Limited has indicated that it is willing to sell equipment to its competitors, but at double the price it will sell to its other customers. It is doubtful whether any other companies in the world manufacture such specialised conveyor belts.

Based on current usage figures, it is expected that the existing conveyor belt will last until December 20X9. Sufficient spare parts are on hand to carry out routine maintenance work. However, should a replacement belt be required, it would take at least six months to have a replacement made and shipped to Australia, and a further four weeks to install and test it. It is unlikely that the company could survive a six-month interruption to normal operations. Management are currently deciding whether they should order a replacement belt from Chipper Limited despite the excessive cost, or continue to search for an alternate supplier.

Timber is purchased in 50 hectare lots from plantations and state forests. In the past, 70% of timber was sourced from plantations, however this has fallen to 50% in the current year. The corresponding increase in timber sourced from state forests has angered environmental groups. Protests have been held in several forests, which has slowed production and frustrated the contractors, who are only paid once set tonnages of timber are delivered to the mill. In addition, several shipments of woodchips have been delayed, angering the Japanese customers who are threatening to deduct 20% from amounts owing as compensation for lost production time.

Last month, a protester suffered a broken leg, allegedly because he was hit by a timber truck. The protester was blocking the main access road to one of the state forests at the time of the accident. The protester is now suing Forest Limited for damages, claiming the contractor was in fact an employee of Forest Limited at the time of the accident, and was acting on Forest Limited’s instructions. Forest Limited is fighting the case and appears to have a reasonable chance of winning; however, the adverse publicity being
generated is making the state government nervous about selling Forest Limited any more of its timber resources.

One of Forest Limited’s customers, Wood Limited, is claiming that the latest batch of woodchips it received was contaminated with a microbe. This microbe affects the physical structure of the chips, reducing the pressure the chips can withstand when compressed. This has made the chips useless for heavy duty items such as desks and bookcases. Wood Limited is refusing to pay its account, which is already five months overdue. Forest Limited has launched an investigation into the allegations, but as yet has not been able to substantiate them.

In January, Forest Limited upgraded its accounts payable system to a fully integrated package that automatically updates the general ledger when creditor entries are made. Some problems have been experienced with the creditors ledger, which is split into $US and $AUD amounts. In some cases, $US amounts have been recorded as $AUD, resulting in inaccurate creditor balances. Month-end rollovers have also proved problematic, with creditor balances being incorrectly re-set to zero at the first of every month. This has required each creditor’s history to be re-entered manually each month, a time-consuming process that is taking accounting staff away from their normal duties.

During the period, the Australian dollar has remained steady against the Yen, although it fell by about 3% against the US dollar. Debtors are invoiced in $US at the time of shipment, and paid in $US one month after the shipment is received. It takes around six weeks for the charter vessels to travel from Twofold Bay to Japan. All plantations from which Forest Limited sources timber are owned by US firms, which demand payment in $US prior to the timber being cut. A recent downturn in the Japanese economy is affecting forward orders, which have fallen by 15%.

Required:

Prepare a memorandum to the audit manager, outlining your risk assessment relating to Forest Limited. When making your risk assessment:

(a) Identify three (3) key accounts from the information provided that are subjected to an increase in audit risk. Briefly explain what factors increase the audit risk associated with the three (3) accounts identified. In your explanation, please mention the key assertion(s) at risk of material misstatement and the components of the audit risk model affected for each account identified.

(b) Identify how the audit plan will be affected and recommend specific audit procedures to address the risks associated with each account identified.

Answer 1

RISK ASSESSMENT AND ENGAGEMENT SELECTION MEMO

The purpose of this form is to document the review team’s understanding of the reviewed firm’s structure, its accounting and auditing practice, and its system of quality control. Based on the risk factors noted, the team captain will select engagements to be reviewed to reduce peer review risk to an acceptable level.

Peer review risk consists of two parts:

1. The risk (consisting of inherent risk and control risk) that an engagement will not be performed and/or reported on in conformity with applicable professional standards in all materials respects, that the reviewed firm’s system of quality control will not prevent such failure, or both.
2. The risk (detection risk) that the review team will fail to detect and report on design and/or compliance deficiencies or significant deficiencies in the reviewed firm’s system of quality control.

INHERENT RISK FACTORS

1. Circumstances arising within the firm:-
2. Circumstances outside the firm:-
3. Variances that may occur during the year:-

CONTROL RISK FACTORS

1. The size of the firm’s major engagement(s), relative to the firm’s practice as a whole
2. Any initial engagements and their impact on the firm’s practice as a whole
3. The industries in which the firm’s client base operate, especially any industry concentrations
4. The risk level of the engagements performed

PEER REVIEW RISK, DETECTION RISK, AND ENGAGEMENT SELECTION

The higher the combined inherent and control risk, the higher the peer review risk. The review team assessed the combined inherent and control risk as [low, moderate, high] SELECT ONE, therefore, peer review risk is assessed as [low, moderate, high] SELECT ONE. A higher peer review risk indicates the scope of the peer review MUST BE INCREASED to keep detection risk acceptably low.

Please note that even when the combined assessed levels are low, the peer review team must review some engagements to obtain reasonable assurance that the reviewed firm is complying with its quality control policies and procedures and applicable professional standards. For the review team to obtain such assurance, a reasonable cross section of the reviewed firm’s accounting and auditing engagements must be reviewed or inspected, with greater emphasis on those portions of the practice with higher combined assessed levels of inherent and control risk.

With peer review risk assessed as [low, moderate, high] SELECT ONE, the following engagements were selected for review in order to reduce detection risk to an acceptably low level. Based on the above inherent and control risk assessment, these engagements represent a reasonable cross section of the reviewed firm’s accounting and auditing engagements, with greater emphasis on those portions of the practice with higher combined assessed levels of inherent and control risk.

RISK FACTORS AFFECTING THE AUDIT RISK

Engagement Risk

1. Risk auditors incur by being associated with a particular client
2. Risk is high whenever there is increased likelihood that
   1. Auditor is associated with a failed client
   2. Financial statements contain material misstatement that the auditor fails to find
3. These conditions increase the likelihood that the auditor will be sued

Client Acceptance or Retention Decision

1. Perhaps the most important audit decision
2. A number of factors affect this decision, but most important involve
   1. Quality of the client's corporate governance
   2. Client's financial health

Corporate Governance & Client Acceptance

1. The key factors an auditor will analyze include
2. Management integrity
3. Independence and competence of the audit committee and board
4. Quality of ERM and controls
5. Regulatory and reporting requirements
6. Participation of key stakeholders
7. Existence of related party transactions

Financial Health of the Organization

There are a number of reasons why the auditor needs to evaluate a potential client's financial health:

1. The auditor will most likely be sued if a client declares bankruptcy
   1. Investors and creditors who have lost money will look for recovery
   2. Attorneys will claim the financial statements were misstated and the auditors should have known they were misstated
2. The auditor also needs to understand the financial health in order to:
   1. Assess management's motivation to misstate the financial statements
   2. Identify areas that are likely to be misstated
   3. Identify account balances that appear unusual

Factors Affecting Engagement Risk

The auditor should evaluate the company's economic prospects to help ensure that

1. Important areas will be investigated
2. The company will likely stay in business

High-risk companies are generally characterized by

1. Inadequate capital
2. Lack of long-run strategic and operational plans
3. Low cost entry into the market
4. Dependence on limited product offerings
5. Dependence on technology subject to obsolescence
6. Instability of future cash flows
7. History of questionable accounting practices
8. Previous inquiries by the SEC or other regulatory agencies

Financial Reporting Risk

Financial reporting risk is influenced by

1. The company's financial health
2. The quality of the company's internal controls
3. The complexity of the company's transactions and financial reporting
4. Management's motivation to misstate the financial statements

These factors are interrelated

The auditor will gather information on these issues through reviews of previous audits, or by talking with the predecessor auditor