Session 4 solutions

Self study questions

5.11

Explain why the quality of audit evidence is determined by the choice of audit
procedure and the assertion at risk of material misstatement.

Evidence is higher quality when it is more relevant and/or more reliable. Evidence is obtained
by performing audit procedures. Auditors choose procedures which will give them reasonable
assurance about management assertions at the transaction, account balance, or disclosure
level. If auditors choose procedures to gather evidence about the occurrence assertion (for
example, occurrence of sales), the evidence is relevant to the occurrence assertion but will not
be relevant to the completeness assertion. This is because the evidence shows whether
recorded sales occurred, but not whether all sales that occurred are in the records. Therefore,
the evidence is likely to be of high quality for the occurrence assertion, but low quality for the
completeness assertion.
5.12

What is the difference between a legal confirmation and a legal representation

letter? What other external parties could an auditor send a confirmation to?
What other parties provide representation letters to an auditor?

An external confirmation may be sent to a clients lawyer if the lawyer holds documents on
behalf of the client that are of relevance to the audit. Such documents could be titles,
contracts etc. The auditor will ask the lawyer to confirm that the title is held in the clients
name.
A legal representation letter could be provided by a lawyer to the auditor on the auditors
request to confirm the lawyers opinion about a matter, such as the likely outcome of a court
case.
A legal representation letter is different to a confirmation because the confirmation letter asks
about matters of fact, but the representation letter asks about matters of legal opinion.
The auditor could send a confirmation letter to any third party, to ask them to respond to the
auditor on the matter(s) included in the letter. For example, the auditor could ask the clients
bank to confirm the amount of cash held in the bank, details of any loans and interest rates
charge.
An auditor will ask the clients management to provide a representation letter to confirm their
discussions or other matters relevant to the audit. The contents would normally include an
undertaking that laws and regulations have been complied with, a statement that there have
been no material frauds or errors that would impact the financial report, and that internal
controls are effective.

5.13

Explain how gathering physical evidence by inspecting a clients tangible assets

assists the audit of the completeness and existence assertions.

When an auditor inspects a clients tangible assets they can see that the assets physically
exist, and that they appear to be in good working order.
In order to gather evidence about the completeness assertion for the assets, the auditor would
trace the details of the assets, gathered from the physical inspection, to the clients accounting
records. For example, if the auditor inspects 10 motor vehicles and makes a note of their
registration details and physical characteristics, the auditor would then inspect the asset
register to determine if all the motor vehicles were present in the register with the appropriate
registration information and details about colour, make etc. The focus for this test is that all
the physical assets are in the accounting records.
In order to provide evidence about the existence assertion for the assets, the auditor would
start with the asset register and then inspect the physical assets to determine if they existed as
described. The focus for this test is that the assets in the accounting records physically exist.
5.14

Discuss the impact of electronic processing of transactions on the audit.

Electronic processing of transactions leaves no paper trail when the documents are initiated
and stored electronically. To access the details of these transactions, an auditor must access
their clients computer system, where details are kept.
For example, the contact between the client and its supplier to create a purchase order could
be done electronically, such as through an email. The client emails the supplier with purchase
order details, and the supplier confirms the placement of the order via return email. The
return email confirms the order and also provides detailed information about the estimated
delivery date and the amount to be invoiced upon delivery of the goods. When the goods are
received, the receiving department advises the accounts department which then initiates an
electronic transfer of funds from the bank account to the suppliers bank account.
The client can provide the information about electronically processed transactions to the
auditor via email. The auditor then searches for corroborating evidence to verify the details of
the files. The extent to which the auditor can rely on electronic evidence from the clients
computer system depends on the strength of the clients internal control system.

5.15

Why does an auditor have to consider the persuasiveness of corroborating

evidence? Explain.

Corroborating evidence is evidence that supports the clients records in terms of accuracy.
Corroborating evidence can be internally generated by the client, such as copies of
documents, externally generated evidence held by the client, such as bank statements and
supplier invoices, or externally generated evidence sent directly to the auditor, such as
lawyers representation letters or debtors confirmations.
The auditor must consider the persuasiveness of corroborating evidence to help them judge
how much weight to place on each piece of evidence. The auditor needs to gather sufficient
appropriate evidence about the assertions and the financial reports as a whole. If the evidence
is very persuasive the auditor would need to gather less of it. If the evidence is not very
persuasive the auditor might judge that there is not sufficient appropriate evidence to support
their audit opinion, and try to gather more persuasive evidence.
The most persuasive evidence, generally, is the externally generated evidence sent directly to
the auditor, and the least persuasive evidence is, generally, the internally generated evidence.
5.16

If an auditor does not have sufficient knowledge and skill in an area, the auditor
can ask for the assistance of an expert. This creates a problem how does an
auditor know if the experts work is correct if the auditor is not also an expert?
Explain.

The auditor can use an expert to provide sufficient, appropriate evidence when the auditor
does not have the requisite skills and knowledge to assess the validity of an account or a
transaction. The expert could be from within or external to, the audit firm.
The auditor must decide if an expert is required and the scope of the work to be done by the
expert. The auditor must assess the capacity of the expert to do the job and the experts level
of objectivity. The auditor must assess the experts completed work and draw a conclusion.
Ultimate responsibility rests with the auditor.
The auditor does not usually have the same level of expertise as the expert, but is able to
assess the capacity and the objectivity of the expert based on their qualifications, experience,
and association with the client.
The auditor is able to make a judgement about the validity and usefulness of the experts
report based on their reading of the report and the consistency of the experts conclusions
with other evidence gathered during the audit.
The expert should write the report in such a way that an auditor can understand the technical
content of the report. This means that the expert should details each stage of the process used
in arriving at the overall opinion or conclusion in the report. The auditor should be able to
understand the process and how the expert reached the conclusion.
The expert should explain the data sources or estimation models used or calculations
conducted. The auditor would be able to check the data and re-perform the calculations. The
auditor will assess the consistency of any assumptions made with those in prior years and
with other known information. The auditor also assesses the consistency of the experts report
and conclusions with other information they have gathered about the client, and with other
corroborating information gathered by the audit team.

5.18

What are the evidence gathering procedures an auditor might use? At which
stages of the audit are these procedures appropriate? How do the procedures
relate to the types of evidence an auditor can rely upon?

The main evidence gathering procedures are:

Inspecting viewing documents or tangible assets
Observation - watching
Enquiry - asking
Recalculation checking mathematical accuracy
Re-performance redoing client process
Analytical procedures studying plausible relationships among data
These evidence gathering procedures can be done at different stages of the audit. For
example, analytical procedures are used in the client evaluation process, gaining an
understanding of a clients system of controls in planning, as evidence gathering procedures
such as testing controls, and in reviewing the audit evidence in the final stages.
Documents and assets can be inspected during the audit, and can be used to provide evidence
of controls as well as substantive testing, such as existence of inventory.
Client staff can be observed performing their duties during the period or at specific times
such as stocktaking.
Enquiry is appropriate at all stages; management can be asked about their reasons for actions
taken during the year and external parties, such as solicitors, can be asked about progress of
court cases.
Recalculation can be used to check any client records, such as pricing on invoices and subtotals for receivables ledger.
Re-performance can be used to check any client process, e.g. a bank reconciliation.
In general, re-performance and recalculation provide more reliable evidence than observing
or enquiring. Client staff may perform their duties more diligently when they are being
observed than at other times, so observation provides evidence only for the time that the staff
are being observed. Verbal evidence obtained by asking client management about the reasons
for their actions is not very reliable until it is corroborated by other evidence. Re-performance
allows an auditor to gain a deeper understanding of how a task is performed by client staff
and to confirm that the items in question are being dealt with appropriately. Recalculation
allows an auditor to confirm mathematical accuracy, but does not in itself confirm the data
being used in the recalculation.
Analytical procedures are limited as evidence by the validity of the underlying data (which
could be unaudited client data). Inspecting provides useful reliable evidence to the extent that
the auditor understands what they are inspecting (e.g. an auditor may not understand the
usefulness and appropriateness of specialised computer hardware), and in some cases needs
to be confirmed by other data (e.g. inspecting a vehicle provides evidence that a particular
vehicle exists, and in what condition, but documentary evidence is needed to confirm that the
particular vehicle is owned by the client).

5.19

What is the difference between recalculation and re-performance? Explain using

examples.

Recalculation involves checking additions and computations.

Re-performance means following a process used by a client.
For example, reconciling the bank account in the clients ledger with the bank account
balance as per the bank records through preparing a bank reconciliation statement is a client
process. The auditor could re-perform the bank reconciliation by confirming the opening
balance, tracing unpresented cheques and deposits in transit, and identifying fees, charges and
other items that are on the bank statement, and ensuring that the bank ledger balance can be
reconciled to the bank statement balance. Recalculation in this context would involve only
checking the accuracy of the sub-totals and totals, such as the total of unpresented cheques.
This means that re-performance is a more involved procedure than recalculation and produces
more reliable and comprehensive evidence.
5.20

Explain the difference between occurrence and existence assertions. How do

both differ from completeness?

The occurrence assertion relates to transactions. For example, when management present a
profit and loss statement they are asserting that the revenue shown in the statement occurred;
the sales took place. The existence assertion relates to balance sheet items. For example,
when management present a balance sheet they are asserting that the inventory shown on the
balance sheet exists; the inventory is physically in the warehouse or otherwise under the
clients control. The occurrence and existence assertions are different because one relates to
transactions occurring during the period and the other to balances of accounts at the end of
the period. The assertions are similar because they both relate to managements claim that an
item shown in the accounting records is a true reflection of an item or transaction in the real
world. They are also both opposite to completeness. When management present the
financial statements they are also asserting that the accounting records are complete; there are
no items or transactions in the real world that have been omitted from the accounting records.
5.21 Explain why a search for physical items in the clients premises would be part of
the test of the completeness assertion for fixed assets.
The auditor will search the clients premises for physical items because the auditor is
interested in whether all the physical items at the premises are properly reflected in the
clients accounts. For example, the auditor will walk through the office and note how many
pieces of furniture and equipment are physically present, then go to the accounting records to
check if that number of items are recorded as assets in the appropriate accounts. This type of
test is part of the test of completeness because the auditor is interested in whether the
accounting records are complete (are a full listing of each item physically present).

5.22 Why would an auditor be less likely to use payable confirmations than receivables
confirmations?
An auditor can ask a third party to confirm in writing the balance of an account recorded in
the clients records. The auditor could use a confirmation as evidence of a clients account
payable or account receivable.
A confirmation request is generated by the auditor using the list of accounts in the clients
records. That is, the auditor selects the items from the clients records, and then sends the
written request for confirmation to that third party. The assertion most at risk for debtors is
existence; that is, does the account shown in the clients records as an amount owing to it by a
third party really exist? The assertion most at risk for creditors is completeness; that is, are
the accounts shown in the clients records as amounts owing to a third party a complete
record of amounts owing by the client to others? Sending confirmation requests to any, or
even all, of the creditors shown on the list presented by the client to the auditor will not
address the completeness assertion (the auditor needs to discover if there are any payables
NOT on the list). However, sending confirmation requests to debtors from the clients list is
useful to the auditor because they want to discover if any of the debtors on the list do not
exist. Therefore, confirmations are more likely to be used for receivables than payables
because they will provide evidence about the assertion most at risk for receivables, but will
not do so for payables.

Workshop questions

4.23 Audit risk and inventory

Required
What are the inherent risks for Cheap-as- Chips inventory? Discuss the assertions
being made by management about the inventory.

The following are the explanations of inherent risks for Cheap-as-Chips inventory given the
circumstances of Cheap-as-Chips:
1. Material portion of inventory on hand in the current asset account- Cheap-as-Chips
inventory represents a material portion of current assets, and is likely to be a significant item
in the balance sheet. The importance of inventory to the financial position of the client
increases the inherent risks because a material misstatement in the inventory account will
cause a material misstatement. Therefore, audit risk (the risk of an incorrect opinion) is
associated with the risk of misstatement in inventory.
2. Constant and seasonal change of nature of inventory- The regularly changing nature of the
inventory stocked by the client increases inherent risk because items are likely to become
obsolete rapidly. Staff will be unfamiliar with the new items and there is a risk that items will
be misidentified, stored or recorded incorrectly, different purchasing requirements are likely
for new items (e.g. batch sizes, possibility of special discounts associated with promotions).
3. Having overseas suppliers- Dealing with overseas suppliers creates risks associated with
foreign exchange and possibly communication problems due to language barrier. .
4. Substantial deposit required by the supplier upon placement of order- The required deposit
from the supplier will impact on the cash flow of the company.
Some management assertions can be at risk given that there is an increase in inherent risk in
the inventory account. Below are explanations as to why the following management
assertions can be at risk:
1. Valuation and allocation- there is a risk that not all inventories and/or adjustments to
inventories are appropriately recorded in the balance sheet.
2. Existence- there is a risk that not all inventories that were recorded actually existed.
Management has an incentive to overstate inventory to reflect a better profit.
3. Completeness- there is a risk that not all inventory on hand that should have been recorded
have been recorded
4. Rights & Obligation- the company controls and has rights to the inventories and for
liabilities, they are an obligation of the company

4.24 Control risk

Required
Describe how the balance sheet and income statement may be at risk of material
misstatement if the controls regarding the proper allocation of revenue are not
functioning properly.
The journal entry which transfers amounts from the deferred revenue account to the revenue
account is:
Debit Deferred Revenue
Credit Revenue
This transaction reduces the liability and increases the revenue accounts. As such, it has a
direct effect on both the liquidity and profitability of the client. The transaction improves the
clients liquidity by decreasing current liabilities, so that the ratio of current assets to current
liabilities increases. The clients profitability increases because revenue increases.
Controls over transfer of revenue from deferred revenue should be able to prevent or detect
misstatements in revenue account and deferred revenue account (liability) due to incorrect
transfers. For example, processing a transaction twice would overstate revenue and liquidity.
Failure to make a transaction would understate revenue and liquidity.
4.26 Audit strategy
Required
Discuss the type of strategy planned by the audit partner. Why is it no longer
appropriate after the initial testing of controls?

The initial audit plan is to obtain evidence of the revenue recognition by relying on internal
controls and the use of analytical procedures. This type of audit approach decided by the
audit partner was based from his initial assessment of control risk which was low. When
control risk is low, the audit partner will test the operating effectiveness of internal controls
(i.e. companys policies and procedures on revenue recognition).
As per ASA330 Para 17c, if deviations from controls upon which the auditor planned to rely
on are detected, the auditor will make specific enquiries and will determine whether the
potential risks of misstatement need to be addressed using substantive procedures. In this
particular case, during subsequent testing of internal controls, significant deviations from
controls occurred where revenue was incorrectly recognised immediately upon customer
payment in advance. Therefore, the controls on revenue recognition are not operating
effectively, hence, the controls will have to be reassessed as ineffective and less reliable. In
response to the reassessed level of control risk, the audit partner changes the audit approach
to a predominantly substantive approach.
The initial planned audit approach of test of controls is not any more appropriate because the
predominantly substantive approach will be more efficient and effective in obtaining
sufficient appropriate audit evidence.

4.31

Determining audit strategy

Required
(a) Identify the factors that would affect the preliminary assessment of inherent
risk and control risk at Queen Island Dairy.
(b) Explain how these factors would influence your choice between the
predominantly substantive approach and the lower assessed level of control
risk approach for sales, inventory and debtors.
(a)
Factors affecting preliminary assessment of inherent risk include:
Cheese is perishable, suggesting high risk of spoilage, affecting inventory
valuation
Boutique cheese operation highly skilled processes requiring skilled staff,
reliant on few customers?
Export sales, foreign exchange transactions complicated transactions with
risk of incorrect pricing, risk assessment
Tourism based sales at shop and caf fluctuating demand?
Competing incentives for export sales and caf consulting businesses
Heavy reliance on export sales increases vulnerability of business to this
source of revenue, and making product available to meet this demand
Factors affecting preliminary assessment of control risk include:
Effectiveness over quality control over cheese operations, affecting saleability
of product (although quality control is apparently high)
Risk of product spoilage, affecting value of inventory
Controls over sales made by Jim, documentation, pricing, sales allowances
Lack of communication between Jim and brother Bob and other staff
affecting efficiency and effectiveness of management

(b)
Lower assessed level of control risk approach is appropriate when control risk is
assessed as low while predominantly substantive approach is appropriate when
control risk is assessed as high, and it is more efficient not to rely on controls.
For Sales and Debtors
The poor communication between Jim and other management and staff, plus his
competing incentives and the lack of control over his actions means that control
risk in these areas would be considered high. The validity of sales transactions,
including the amounts and terms of the sale, is at risk. There is also a risk that
sales made to customers are not entered correctly in the accounts.
Rather than developing and implementing a policy and procedures on credit notes,
Jim frequently issues credit notes to clients who complain about their statement
without investigating it. Also the lack of resources to follow companys protocol
(i.e. Jim is to too busy to respond to customer complaints) increases the control
risk
Control risk for sales and debtors is high, meaning that the predominantly
substantive approach would be adopted in these areas.
For Inventory
Control over production appears to be good, and inventory quality seems to be
high. However, the inherent risk of inventory spoilage is great. This suggests that
a lower assessed level of control risk could be adopted for inventory. Testing the
controls over inventory, and obtaining satisfactory results, would mean that less
substantive testing would be required.
.

4.33

Risk assessment and materiality

Required
(a) What factors in the background information would you consider when
determining preliminary materiality for the 2014 audit of Featherbed?
(b) Explain the effect of the factors identified in (a) above on your assessed audit
risk and your initial assessment of the preliminary materiality.
(a) Preliminary materiality assessment, or planning materiality (PM), is based on
the auditors assessment of the client and its users information needs. It will also
give consideration to the following:

If detection risk (DR) is determined by the inherent risk (IR) and control risk (CR)
assessments
If IR and CR are higher, DR is lower with corresponding lower materiality
Lower DR and lower planning materiality means that the auditor will
need higher quality and greater quantity of evidence.
The factors that would impact on the risk of material misstatement, and thus DR
and PM are
Several revenue streams leisure activities plus different classes of
accommodation hostel, hotel, resort creating a variety of inherent risks over
sustainability of revenue streams (e.g. customers of each part of company
could be affected by different factors). No information given about relative
reliance on each revenue stream; could be different levels of materiality.
Husband and wife own majority of shares of parent company of client.
Husband is chairman of both, wife is director of both companies and clients
CFO creating conflicting incentives and confused lines of reporting and
authority is there effective control? Suggests higher risk and lower PM for
transactions between companies.
Client has not been audited before risk associated with opening balances;
cannot rely on previous audit results lower PM for opening balances and
assessment of prior period accounting principles and application
New private equity investor group has 20% of client creating additional
demand (together with request from bank for audit) for financial reports.
Increases audit risk, suggesting lower PM
Use of part-time and casual workers, as well as permanent staff suggesting
variation in work force, problems in payroll and HR suggests greater risk,
lower PM for payroll. Also consider effectiveness of controls requiring
segregation of staff if workforce is fluctuating.
Laid-back management style suggests greater control risk from tone at the
top issues. Lower PM.
Lack of regular annual leave control risk from ineffective supervision and
segregation of duties, no opportunity to use another staff member in key roles,
lower PM.
Peter Pinn close to retirement, consider incentives for fraud and effectiveness
of supervision of accounts staff, seems inadequate segregation of duties (i.e.
they help each other during busy times). Greater CR, lower PM. However,
one staff member is a graduate, suggesting accounting expertise.

4.33(b)Overall, there appear to be a number of problems with the business,

particularly in its governance and staffing. These issues create questions about
specific control risks which would be assessed in greater detail. Greater control
risks suggest lower detection risk and lower planning materiality would be
appropriate.
These risks are most relevant to:
Board of director decisions - because of husband/wife control of both companies and
recent acquisition of significant percentage of the company by a new private equity
investor, possibility of related party transactions
Control in accounts department staff shortages, inappropriate delegation, inadequate
segregation of duties, closeness to retirement and lack of annual leave by head of
department, lack-back attitude of CFO
Staffing issues use of part-time and casual staff, variation in staffing according to
seasons, questions about adequate training and supervision of casual staff