Question

You are an Audit Senior currently planning the 30 June 20X8 audit of Steel Limited, an Australian-owned company that produces and exports steel to India. At a recent planning meeting with Steel Limited’s senior staff, you obtained the following overview of this year’s operations:

Tight checks by Australian custom officials to halt the smuggling of scrap steel have delayed several shipments of steel. These delays have angered Indian customers who are threatening to deduct 20% from the amounts owing as compensation for lost production time.

One of Steel Limited’s customers, Construction Limited, is claiming that the latest batch of steel it received was found to have very high levels of cheap additives such as boron. Such additives used to reinforce concrete can affect the metal’s strength when it is welded. Boron can make welds more likely to crack, weakening structures. Construction Limited is refusing to pay its account, which is allegedly five months overdue. Steel Limited has claimed to have launched an investigation into the allegations, but as yet not been able to substantiate them.

70% of the suppliers from which Steel Limited sources it’s iron ore stock are owned by US firms, which demand payment in $US prior to the iron ore being supplied. In January, Steel 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 Indian Rupee, although it fell by about 3% against the US dollar. Debtors are invoiced in $US at the time of shipment, and payment is received in $US one month after the shipment is delivered. It takes around six weeks for the charter vessels to travel from Steel Limited’s shipyard at Ausfold Bay to India. A recent downturn in the Indian economy is affecting forward orders, which have fallen by 15%.

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

(a) Identify three (3) key account balances 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

Memorandum to the Audit manager outlining the Risk Assessment:

Risk assessment should be undertaken before performing the audit to assess the risk of material misstatements (the risk that financial statement assertions may be incorrect) on;

1. Overall financial statement level and
2. In respect of specific account balances and transactions.

While making the risk assessment, the three account balances that are subjected to increased level of audit risk are;

1. Individual creditors (suppliers) account balances: (The risk of misstatement in this balance is high, as incorrect postings among the creditors ledgers would lead to misstatements)

Key assertion that would be affected:

1. Payable amounts outstanding against each supplier account.
2. There is no unrecorded creditors account balance and
3. All the transactions with the suppliers are completely recorded at correct amounts.
4. The amounts recorded as payable against each of them are infact the correct amount of payable.

1. Creditors balances control account: (The risk of misstatement in this balance is high, as incorrect postings in usd vice-versa aud amounts could lead to incorrect payable amounts)

Key assertion that would be affected:

1. Accounts payable balance that is shown under current liabilities would get affected.
2. Opening and closing balances.
3. Assertion that the balances recorded are complete and accurate

1. Purchases ledger ((The risk of misstatement in this balance is high due to wrong postings of the foreign currency & creditor entry, there is a possibility that the purchases balance could be wrong)

Key assertion that would be affected:

1. The amount shown under purchases head

1. Exchange gain/loss account balance (last but not the least, arriving of the amounts of exchange gain/loss due to currency fluctuations can go wrong due to wrong posting of currency amounts and thus increasing the risk of misstatement in this balance.)

Key assertion that would be affected are;

Exchange gain/loss calculations are correctly calculated and net exchange gain or loss is correctly reported in the Income statement.

Risk of Mis statements affecting the Audit Plan:

The auditor’s opinion on the financial statements could go wrong due to the risk of mis statements present in the financial statements. If the audit plan is not suitably modified to cover the potential risk of mis statements, the audit procedures would become ineffective leading to high audit risk.

Hence, the auditor should modify the audit plan to address the assessed risk of material misstatements at the financial statement level.

Specific audit procedures to perform to address the audit risk are;

1. Extend the substantive audit procedures on the specific account balances such as creditors balances, carry over of the balances, recording of payment transactions etc., to assess the degree of misstatements in such balances.
2. Perform analytical procedures on the account balances over various months to check if the variation in the amounts over the period is not abnormal.
3. Independently calculating the exchange gain/loss calculations to identify the operation of tests of control over the calculations and identification of exact misstatements.
4. Performing alternate substantive procedures like obtaining the balance confirmation from the vendors directly.
5. Review vendor account reconciliation of balances and determine how effectively the reconciliation process is being carried out and the frequency, timing of the process.

Thus, the auditor should adopt combination of Tests of Control and Substantive procedures to identify the extent of misstatement in the account balances and thus the overall financial statement level.If the level of misstatement is to such an extent that the financial statement assertions are grossly incorrect, the auditor should consider qualifying the audit report or issue an adverse opinion.