Question

You are an Audit Senior currently planning the 30 June 20X9 audits of Comp Limited (Comp), Health Limited (Health) and News Limited (News). At recently scheduled planning meetings with Comp, Health and News, you obtain the following overview of this year’s operations for each of the three client companies:

Comp is a manufacturer of computer hardware. The old costing system that was developed in- house, could no longer keep up with the complex and detailed manufacturing costing process that provides tender/bid submission costings and the company’s comprehensive reporting requirements. As a result, Comp purchased and installed a popular off the shelf (not customized) costing system to support the highly sophisticated and cost sensitive nature of its product designs. Since this system had been utilised by many other firms in the industry, Comp has not thoroughly tested the adequacy of the features and controls inherent within the system. At the same time, the staffs are not feeling confident with the new system due to lack of training and supervision. Staff are also concerned that data might be lost when converting to the new system.

Health operates chemist shops in Perth. A large proportion of the sales transactions are conducted in cash. Health claims on having strong control policies and procedures in place to monitor the employees handling cash transactions and safeguarding the cash. However, the proper implementation of those policies had been questioned by the previous auditor. As Health is planning to expand to Mandurah and Busselton, it is applying for a bank loan to obtain additional funding for the expansion. Before approving the loan, the bank requires Health to provide them with an audited financial statement. The unaudited figures of current year suggest Health’s revenue to have increased significantly by 25 percent from last year while the gross profit appears to have increased marginally by 5 percent.

News has been in the paper manufacturing business for the last 17 years. It manufactures and distributes paper throughout the Australian continent. During the last five years, News opened four new factories in three different locations, financed mainly from bank loans. Due to rapid growth in the company, the financial director John Brown is keen to set up an internal audit department. Currently the project appears to have stalled, as some of the senior executives do not foresee the benefit of setting up such a department and are unwilling to commit any additional fund or resources on this plan. The senior executives argue that they are competent enough to monitor the internal controls of News.

Required:

Prepare a memorandum to the audit manager, outlining your risk assessments relating to Comp, Health and News. When making your risk assessments:

(a) Identify and discuss the risks that may arise from each of the above companies. In your explanation, please mention the components of the audit risk model affected.

(b) Identify how the audit plan will be affected and recommend specific audit procedures to address these risks.

Answer 1

a) The audit risk model determines the total amount of risk associated with an audit, and describes how this risk can be managed. The calculation is:

Audit risk = Control risk x Detection risk x Inherent risk

These elements of the audit risk model are:

• Control risk. This risk is caused by the failure of existing controls or the absence of controls, leading to incorrect financial statements.

• Detection risk. This risk is caused by the failure of the auditor to discover a material misstatement in the financial statements.

• Inherent risk. This risk is caused by an error or omission arising from factors other than control failures. This risk is most common when accounting transactions are quite complex, there is a high degree of judgment involved in accounting for transactions, or the training level of the accounting staff is low.

b) The auditor should design and perform further audit procedures whose nature, timing, and extent are responsive to the assessed risks of material misstatement at the relevant assertion level. The purpose is to provide a clear linkage between the nature, timing, and extent of the auditor's further audit procedures and the risk assessments. In designing further audit procedures, the auditor should consider such matters as:

• The significance of the risk

• The likelihood that a material misstatement will occur

• The characteristics of the class of transactions, account balance, or disclosure involved

• The nature of the specific controls used by the entity, in particular, whether they are manual or automated

• Whether the auditor expects to obtain audit evidence to determine if the entity's controls are effective in preventing or detecting material misstatements The nature of the audit procedures is of most importance in responding to the assessed risk.

The auditor's assessment of the identified risks at the relevant assertion level provides a basis for considering the appropriate audit approach for designing and performing further audit procedures. In some cases, the auditor may determine that performing only substantive procedures is appropriate for specific relevant assertions and risks. In those circumstances, the auditor may exclude the effect of controls from the relevant risk assessment. This may be because the auditor's risk assessment procedures have not identified any effective controls relevant to the assertion or because testing the operating effectiveness of controls would be inefficient. However, the auditor needs to be satisfied that performing only substantive procedures for the relevant assertions would be effective in reducing detection risk to an acceptably low level. The auditor often will determine that a combined audit approach using both tests of the operating effectiveness of controls and substantive procedures is an effective audit approach.