2005 35- Case Studies PDF

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200535- Case Study 1.33 Being an auditor You have recently graduated from your university course and start work with an audit firm. You meet an old school friend, Nga, for dinner — you haven’t seen each other for several years. Nga is surprised that you are now working as an auditor because your childhood dream was to be a ballet dancer. Unfortunately, your knees were damaged in a fall and you can no longer dance. The conversation turns to your work and Nga wants to know how you do your job. Nga cannot understand why an audit is not a guarantee the company will succeed. Nga also thinks that company managers will lie to you in order to protect themselves, and as an auditor you would have to assume that you cannot believe anything a company manager says to you. Required (a) Write a letter to Nga explaining the concept of reasonable assurance, and how reasonable assurance is determined. Explain why an auditor cannot offer absolute assurance. (b) Explain in the letter to Nga the concept of ‘professional scepticism’ and how it is not the same as assuming that managers are always trying to deceive auditors. (a). There is a gap between Nga’s expectations and the level of auditor performance. An audit provides reasonable assurance, not absolute assurance. The audit enhances the reliability and credibility of the information included in a financial report but is not a guarantee that the financial report is free from error or fraud, or that the company will not fail. Partly, this is because of the nature of financial reporting. It requires judgements about accounting estimates and the choice and application of various accounting methods. There is usually not one ‘right’ answer for a company’s profit. The auditor cannot guarantee the profit reported by the company is ‘right’, only provide assurance about the appropriateness of the accounting method selection and application and the accounting estimates. Another reason the assurance is not absolute is the nature of the audit process. Auditors cannot review every transaction and account balance, therefore they use sampling (which could mean that representative items are not selected for testing). Some transactions and balances are difficult to gather reliable evidence about, clients can conceal evidence, and auditors have a limited time frame in which to complete the audit. (b). Professional scepticism is required of an auditor. It is an attitude that requires the auditor to remain independent of the client and its staff. The auditor has a questioning mind and thoroughly investigates all evidence presented by their client. This does not mean that they regard the client as a liar, but that they need to do more than simply take the client’s word about anything. Usually, there will be confirming evidence which supports the client’s statements (e.g. copies of contracts, minutes of meetings, etc.). Evidence gathered from independent third parties is generally regarded as more reliable than that gathered from the client. Managers will not always try to deceive auditors, but auditors must take the responsibility of gathering evidence to verifying managers’ statements. The auditor needs to be alert to the fact that some managers will try to deceive auditors sometimes. 3.28 Risk assessment — considering going concern: operating Celebrity Land is a theme park operated by an audit client of Best Partners. It is located on the Gold Coast and, due to its proximity to the ocean, the rides are prone to rust and corrosion. During the 2017 school holidays, two of the most popular rides experienced major breakdowns. Children were trapped on the rides for several hours,

resulting in several being taken to hospital with minor injuries. An inspection following the incident revealed that key parts needed urgent replacement. The parts are made in the United States and imported by Celebrity Land. The cost of the replacement parts is $3.5 million (against profit after tax in the previous year of $300 million). The repairs are scheduled to begin in April, with completion in July 2017. Required Discuss whether there are any events or conditions that may cast significant doubt on the new client’s ability to continue as a going concern. Source: Adapted from the CA Program’s Audit & assurance exam, December 2010. Factors that may cast doubt on going concern: - Lack of maintenance on rides – suggests sufficient cash flow not available to pay for maintenance, or poor management of facilities (i.e. not required inspections, not required qualified staff to operate rides. - Two popular rides have suffered major damage – given proximity to salty conditions (causing rust) are other rides all fully operational? Any further failures in facilities could close theme park completely, severely damaging revenue and cash flows. - Minor injuries suffered by patrons – is the client legally liable for damages as a result of court cases against it for the injuries? If major damages awarded against the client, does the client have capacity to pay? - Most popular rides have major breakdowns – taking them out of action for several months until repairs are completed. Major impact on revenue because theme park would be closed or severely restricted. - Significant cost of replacement parts (more than 10% of profit) – requires major capital investment, is there sufficient cash flow to service the investment? - Repairs are scheduled to be done during the period April – July – this would be ongoing at a balance date of June (balance date not stated in the question). Auditor would not be able to gather evidence of the successful repairs before the balance date. Major question about client’s ability to continue at full capacity if repairs are delayed or not successful. 3.32

Understanding the client and its risks — risk assessment

Ivy Brown is preparing a report for the engagement partner of an existing client, Scooter Ltd, an importer of scooters and other low-powered motorcycles. Ivy has been investigating certain aspects of Scooter Ltd’s business given the change in economic conditions over the past 12 months. She has found that Scooter Ltd’s business, which experienced rapid growth over its first five years in operation, has slowed significantly during the last year. Initially, sales of scooters were boosted by good economic conditions and solid employment growth, coupled with rising petrol prices. Consumers needed transport to get to work and the high petrol prices made the relatively cheap running costs of scooters seem very attractive. In addition, the low purchase price of a small motorcycle or scooter, at between $3000 and $8000, meant that almost anyone who had a job could obtain a loan to buy one. However, Ivy has discovered that this year, the sales of small motorcycles and scooters have slowed significantly and all importers of these products, not just Scooter Ltd, are being adversely affected. Sales are down because the economic recession has caused many people to lose their jobs. Petrol prices have fallen this year, reducing the demand for more economical vehicles, and changes in banking laws have meant it is harder to get loans for vehicles which cost less than $10 000. Required

(a) Identify the issues that potentially impact on the audit of Scooter Ltd. (b) Explain how each issue affects the audit plan, by identifying the risks and the financial report accounts that require closer examination. (a) Issues: Change from good economic conditions (solid employment growth, rising petrol prices, easy access to credit for consumers) to recession (recession with lower employment growth, falling petrol prices, difficult access to credit). Changing conditions such as lower petrol prices and lower employment growth have slowed consumer demand for scooters. Consumer demand is also likely to be affected by less access to consumer credit for scooter purchases. The changed economic conditions also likely adversely impact Scooter Ltd’s access to finance (tighter finance market, slower cash flow to service debt). (b) Impact on audit plan Greater risk of fraudulent financial reporting because of pressure on Scooter Ltd management to meet performance targets (either for bonuses or to satisfy bank covenants) Likely impact on profit: Sales revenue: Consider risk of fraudulent transactions, cut-off (sales from future period back-dated to the current period), revenue recognition issues (e.g. scooters loaned to potential customers recorded as sales despite generous rights of return) Risk associated with finance company – scooter price inflated to be above $10,000 with ‘allowance’ granted later to customer. Expenses: Consider risk that expenses post-dated to next period to improve current period profit. Going concern risk – is business able to pay its debts as they fall due? What are the terms of finance between Scooter Ltd and its banks? Is Scooter Ltd locked into a lease on premises that are now too large? Risk associated with staff layoffs – poor sales could lead to staff sackings not in accordance with relevant awards, risk of successful case for unfair dismissal. 4.33

Determining audit strategy

Princess Island Vineyards is a boutique wine-maker based on Princess Island. Over the years, the business has grown firstly by supplying local retailers, and then through exports. In addition, there is a cellar door shop and café located next to the main processing plant on Princess Island, serving tourists who also visit the other specialist food and wine businesses in the region. Quality control over the wine manufacturing process and storage of casks and bottles at Princess Island Vineyards is extremely high. All members of the business are committed to high product quality because any poor practices which could result in a drop in wine quality would ruin the business very quickly. The export arm has been built up to become the largest revenue earner for the business by the younger of the two brothers who have run Princess Island Vineyards

since it was established. Jim Bannock has a natural flair for sales and marketing, but is not so good at completing the associated detailed paperwork. Some of the export deals have been poorly documented and Jim often agrees to different prices for different clients without consulting his older brother, Bob, or informing the sales department. Consequently, there are often disputes about invoices and Jim makes frequent adjustments to debtor accounts using credit notes when clients complain about their statements. Jim sometimes falls behind in responding to customer complaints because he is very busy juggling the demands of making export sales and running his other business, Café Consulting, which provides contract staff for the café business at Princess Island Vineyards. Required (a) Identify the factors that would affect the preliminary assessment of inherent risk and control risk at Princess Island Vineyards. (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: o Wine is vulnerable to storage conditions (temperature), suggesting high risk of spoilage, affecting inventory valuation. o Boutique wine operation – highly skilled processes requiring skilled staff (winemaker), reliant on few customers? o Export sales, foreign exchange transactions – complicated transactions with risk of incorrect pricing, risk assessment. o Tourism based sales at shop and café – fluctuating demand? o Competing incentives for export sales and café consulting businesses. o 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: o Effectiveness over quality control over wine production and storage, affecting saleability of product (although quality control is apparently high). o Risk of product spoilage, affecting value of inventory. o Controls over sales made by Jim, documentation, pricing, sales allowances. o 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: 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. 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 reasonably high. 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. For Debtors: A predominantly substantive approach for sales is more appropriate because the adjustments to debtor accounts do not appear to be adequately controlled. 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 company’s protocol (i.e. Jim is to too busy to respond to customer complaints) increases the control risk. 6.33 Dolphin Surf & Leisure Holidays Pty Ltd (Dolphin) is a resort company based on the Great Barrier Reef. Its operations include boating, surfing, diving and other leisure activities, a backpackers’ hostel, a family hotel and a five-star resort. Justin and Sarah Morris own the majority of the shares in the Morris Group which controls Dolphin. Justin is the chairman of the board of directors of both Dolphin and the Morris Group, and Sarah is a director of both companies as well as the CFO of Dolphin. Justin and Sarah have a fairly laid back management style. They trust their workers to work hard for the company and reward them well. The accounts staff, in particular, are very loyal to the company. Justin tells you that some accounts staff enjoy their jobs so much they have never taken any annual leave, and hardly any workers ever take sick leave. Justin and Sarah have not bothered much in the past with formal procedures and policies, but they have requested the accounts staff to start documenting the more common procedures. They do not conduct formal performance reviews; they rely on their staff to tell them when there is a problem. There are three people currently employed as accounts staff, the most senior of which is Peter Pinn. Peter heads the accounts department and reports directly to Sarah. He is in his fifties and plans to retire in two or three years. Peter prides himself on his ability to delegate most of his work to his two accounts staff, Kristen and Julie. He claims he has to do this because he is very busy developing the policy and procedures manual for the accounting department. The delegated work includes opening mail, processing payments and receipts, banking funds received, performing reconciliations, posting journals and performing the payroll function. Julie is a recent Chartered Accountant graduate. Kristen works part time — coming into the office on Mondays, Wednesdays and Fridays. Kristen is responsible for posting all journal entries into the accounting system and the payroll function. Julie does the balance of the work, but they often help each other out in busy periods. Kristen authorises Julie’s transactions and Julie returns the favour by authorising Kristen’s transactions. Together, they usually make the accounts balance.

6.33

Internal control components (a) Explain how the internal control components are usually adjusted to meet the needs of small entities. What advantages and disadvantages does this bring? (b) Assess the internal controls at Dolphin. What changes would you recommend?

(a) Small entities have limitations in their ability to implement a comprehensive control system. There are fewer employees in small entities, which means that segregation of incompatible duties is harder to organise. In addition, small entities usually do not have formal documentation of their control systems, making assessment of their design effectiveness more difficult. However, managers of smaller entities (who are usually also the owners) are able to have a greater personal involvement in all aspects of the business and are therefore able to monitor activities directly. With direct monitoring, many departures from control systems could be detected. The effectiveness of this direct monitoring is dependent on managers’ knowledge and interest in controls, which could be low. Managers may also be tempted to override systems because they do not distinguish between their interests and the interests of the entity. (b) There is little separation between the board and the senior management – Sarah is both CFO and director of both Dolphin and the Morris Group. The control environment would be stronger if the CFO and the director positions were split. Management philosophy and operating style are ‘laid back’, suggesting that formal control structures are not in place. Although some documentation is now being done, it is being done at a low level rather than being designed by senior management. There is a risk that the documentation will be incomplete, without the necessary review procedures. Peter Pinn does not appear to be very active in reviewing the performance of the more junior staff, and there is a lack of clear information on whether Sarah is adequately supervising Peter. The lines of accountability should be stronger and because of the small size of the accounts department, should include periodic reviews of transactions authorised and processed at lower levels. There appears to be a lack of adequate segregation of duties, both Kristen and Julie are involved in opening mail, processing transactions, banking, bank reconciliations, and payroll. These duties should be segregated so that staff handling cash are also not able to record transactions. Bank reconciliations and reviews of journal postings should be done by Sarah or Peter, and they should also be authorising transactions. There appears to be no separate HR function and there is a danger that payroll is not valid. Overall, the internal controls appear to have deficiencies. The documentation should be completed by Sarah and she should take more responsibility for overseeing the operations of the accounts department. Peter does not appear to be performing the necessary authorisation and supervision roles. Questions 7.36 and 7.37 are based on the following case. Chan & Partners Chartered Accountants is a successful mid-tier accounting firm with a large range of clients across Australia. During the 2017 year, Chan & Partners gained a new client, Medical Services Holdings Group (MSHG), which owns 100 per cent of the following entities:  Shady Oaks Hospital, a private hospital group  Gardens Nursing Home Pty Ltd, a private nursing home

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Total Cancer Specialists Limited (TCSL), a private oncology clinic that specialises in the treatment of cancer.

Year-end for all MSHG entities is 30 June. During the 2017 financial year, Shady Oaks released its own range of medical supplies such as bandages and first aid kits, which are sold via direct marketing by a sales team employed by the hospital. The sales team are remunerated via a base salary and a bonus component which is based upon the dollar value of sales they generate. You recognise that their main motivation is to maximise their bonuses. You select a sample of payments received by the hospital...