Question

Today is 15 April 2020.

You are an audit manager of QUTPG Partners and are planning the audit of RST Co for the year ending 30 June 2020. The company is a manufacturer of digital devices and your have already had a planning meeting, with the finance director. Forecast revenue is $137.2m and profit before tax is $8.4m. The following notes from the planning meeting have been given to you.

Planning Meeting Notes

• RST Co holds inventory in four warehouses in Brisbane, Sydney, Melbourne, and Canberra respectively. RST Co plans to conduct a full inventory stocktake at the warehouses on 1, 2, 3 and 4 July. Any necessary adjustments will be made to reflect post year-end movements of inventory. RST Co has an internal audit function and an internal audit team will attend the inventory counts. Inventories are measured at the lower of cost and net realisable value. Cost includes the purchase price of raw materials, labour and other production costs, and other general overheads including head office administrative costs.
• During the year, RST Co paid $2.2m to purchase a patent which allows the company the exclusive right for five years to customise their portable audio player to gain a competitive advantage in the market. The $2.2m has been expensed in the current year statement of profit or loss. To finance this purchase, RST Co raised $2.4m through new share issuance.
• It was discovered that, in January 2020, a significant fraud had been colluded by four employees in the sales ledger department by stealing funds from wholesale customer receipts. They allocated later customer receipts against the older receivables to cover the stolen funds. RST Co had reported to the police and subsequently dismissed the four employees.
• As a result of the vacancies in the sales ledger department, RST Co has outsourced its sales ledger processing to U Services, an external service organisation since 1March 2020. U Services handles all elements of the sales ledger cycle, including sales invoicing, chasing receivables balances, and sending monthly reports of sales and receivable amounts to RST Co.
• In December 2019, the financial accountant of RST Co was dismissed. He had been employed by the company for ten years, and he has threatened to sue the company for unfair dismissal. Until his replacement commences work in March, the financial accountant’s responsibilities have been allocated to other staff in the finance department. However, in January and February 2020, no reconciliations of supplier statement have been performed, and no reconciliations of purchase ledger control account have been performed.
• In January 2019, a receivable balance of $1.8m was written off by RST Co when a customer had declared bankruptcy. In February 2020, the liquidators of the customer company publicly announced that it was likely that most of its creditors would receive a pay-out of 30% of the balance owed. As a result, RST Co has included a current asset of $540,000 in the balance sheet and other income in the statement of profit or loss.

• Required:

  (a) Describe QUTPG Partners’ responsibilities in relation to the prevention and detection of fraud and error.

  (b) Describe EIGHT audit risks, and explain the auditor’s response to each risk in planning the audit of RST Co.

Answer 1

1) Fraud is an intentional act by one or more indivisuals among management , those charged with governance , employees or third parties involving use of deception to obtain an unjust or illegal advantage.
Auditor is conncerned with the frauds causing material mis statements in the financial statements.

Auditor is expected to provide opinion on true and fair view of financial statements.
He cannot frame such opinion if he is not able to confirm/dispel the possibility of existence of fraud and error in financial statements.
Thus Incidental or secondary objective of auditor is detection of mis statements in financial statements.

Following are the Auditor’s responsibilities here:

1. Obtain reasonable assurance that the financial statements are free from material misstatements
2. Maintain professional skepticism throughout the audit
3. Should know that Risk of non-detection of management fraud is greater than of employee fraud
4. Must be aware Risk of non-detection of fraudulent material misstatement is higher than the misstatement due to error.   

Management has the Primary responsibility for the prevention and detection of fraud and not the auditor. Management should take all necessary steps for fraud prevention and deterrence through implementing policies and controls. However if theres is doubtful situation that some material mis statements may exist , auditor should extend his procedures to confirm of dispel the doubt.
Auditor may not be able to reveal all the mis statements due to inherent limitations of audit. He shall maintain professional skepticism throughout the audit.. He should be alert to the conditions indicating possible mis statements. If auditor works in accordance with basic principles governing an audit, he cannot be held liable for non detection of material mis statememt in financial statements of client.

However if he notices material mis statement resulting from fraud , he should comunicate the same at appropriate level of management.
If mis statements are found, he should ensure their appropriate disclosure either in financial statements by the management or in the audit report.

b) Audit risk is defined as ‘the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk’. Hence, audit risk is made up of two components – risks of material misstatement and detection risk.

Risk of material misstatement is defined as ‘the risk that the financial statements are materially misstated prior to audit. This consists of two components... inherent risk ... control risk.’

Inherent risk is ‘the susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.’

Control risk is ‘the risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.’

Detection risk is defined as ‘the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.’

Other examples of audit risks include:

• treatment of capital and revenue expenditure – the risk here could relate to existence of property plant and equipment if revenue expenditure has been capitalised rather than charged as an expense in the income statement
• valuation of inventory – when, for example, there are considerable levels of aged inventory
• completeness of liabilities – this could arise if provisions have been incorrectly treated as contingent liabilities
• completeness of revenue – this could be relevant where the entity being audited has significant cash sales.

Responses to audit risks

Having identified the audit risk candidates are often required to identify the relevant response to these risks.Auditor’s responses should focus on how the team will obtain evidence to reduce the risks identified to an acceptable level. Their objective is confirming whether the financial statement assertions have been adhered to, and whether the financial statements are true and fair.

Based upon assessed risk of inherent and control risks the auditor should

(a) plan for overall response and

(b) plan and perform audit procedures in relation to specific assertions.

1. The auditor should determine overall responses to address risks of material misstatement at the financial statement level. “The phrase over all responses” mean that the auditor should:

– maintain professional skepticism in gathering and evaluating audit evidence
– delegate the work to more experienced and skilled staff
– consult with experts
– modify nature, timing and extent of audit procedures as overall response.

2.Specific response to material misstatement involves designing and performing appropriate tests of controls and substantive procedures.

Matters to be considered in designing further audit procedures include impact and likelihood of risk of material misstatement
The auditor may rely:
– Only on tests of controls
– Only on substantive procedures
– Combination of both.