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ACCT3322 SEMESTER 2, 2019

Answers to the Tutorial Questions Chapters 2 (client acceptance), 3 and 4 Question 2.25 Starc and Partners Chartered Accounting firm has built up its audit work over the last five years. It has obtained new clients each year and many of its existing clients have grown in size. It has clients in many industries, but none of its clients are in the mining industry. At this month’s planning meeting, the audit partners will consider whether they will tender for audit work for a potential new client that has several divisions including oil and gas, gold mining and steel fabrication. Required Explain whether Starc and Partners should tender for the audit work for the potential new client. Solution

There is nothing in the question to suggest that Starc and Partners' independence would be compromised for the client. The issue is one of competence. The potential new client has an oil and gas division and a gold mining division. Both of these divisions are in industries that are mining or mining related. The question states that the audit firm does not have any existing clients in the mining industry. This suggests that the firm does not have the relevant expertise to audit clients that are in the mining industry. The partners need to consider whether, even though they have no existing clients in the mining industry, they would have sufficient expertise to take a client in mining. Some existing personnel could have the relevant expertise from previous work (with another audit firm). Perhaps, that is why the firm is considering the tender. It could be possible to hire new personnel before the audit work commences (note: a competent person evaluates the acceptance decision. Hiring someone later may not resolve the issue on hand). Question 3.32 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. 1

ACCT3322 SEMESTER 2, 2019

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. Solution: a) Issues: Risks from the external environment: • 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 economical scooters. This trend is expected to continue. • Stringent banking laws (difficult access to consumer credit for scooter purchases) are likely to continue lowering consumer demand in the future. Entity-specific risks: • Observed reduced turnover – past growth trend has slowed significantly • The company’s access to future loans and funding might also be adversely impacted due to tougher banking laws b) Risk of material misstatement The above risks from the external environment and entity-specific conditions are likely to increase the risks of misstatements at both the financial reporting level and at the assertion level. Financial reporting level: • Fraudulent financial reporting because of pressure on Scooter Ltd management to meet performance targets (either for bonuses or to satisfy bank covenants). • Going concern risk – will the company be able to pay its debts as they fall due? o What are the terms of finance between Scooter Ltd and its banks? o 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.

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ACCT3322 SEMESTER 2, 2019

Account level: • Overstated sales o Audit plan - Consider risk of fraudulent sales transactions, revenue recognition issues (e.g. scooters loaned to potential customers recorded as sales despite generous rights of return) and this risk of cut-off (future sales recognised as current year’s sales) • Collusion with finance companies o Audit plan - Scooter prices inflated to be above $10,000 with ‘allowance’ granted later to customer. • Understatement of expenses o Audit plan - Consider risk that expenses are post-dated to next period to improve current period profit. Also, consider risk of expenses scheduled/necessary for the current year postponed to the next year, resulting in increased risk of machinery shutdowns and major repairs. Question 3.39 Chan and Partners Chartered Accountants is a successful mid-tier accounting firm with a large range of clients across Australia. During the 2017 year Chan and 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 • Total Cancer Specialists Limited, a private oncology clinic that specialises in the treatment of cancer. Year-end for all MSHG entities is 30 June. The audit partner for the audit of MSHG, Tania Fellowes, has discovered that two months before the end of the financial year, one of the senior nursing officers at Gardens Nursing Home was dismissed. Her employment was terminated after it was discovered she had worked in collusion with a number of patients to reduce their fees. The nurse would then take secret payments from the patients. The nursing officer had access to the patient database. While she was only supposed to update room-located changes for patients, she was able to reduce the patient period of stay and the value of other services provided. The fraud was detected by a fellow employee who overheard the nurse discussing the ‘scam’ with a patient. The employee reported the matter to the Gardens Nursing Home’s general manager. Source: Adapted from the CA Program’s Audit & assurance exam, December 2008.

Required (a) Which accounts (balance sheet and income statement) are potentially affected by the fraud? (b) Describe how Gardens Nursing Home’s business could be affected as a result of the fraud event.

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ACCT3322 SEMESTER 2, 2019

Effect on Balance Sheet accounts: • Accounts Receivable – o This account is understated because nursing officer has not been billing the patients or reducing the billing amount in exchange of secret payments (fraudulent financial reporting) o It is even possible that patients were invoiced or billed correctly but upon receipt of cash payments, the nursing officer did not adjust the billing amount; resulting in accounts receivables being overstated. As these payments are unlikely to pay the full invoice amount, a provision of bad debts might be required (fraudulent financial reporting). o Some patients may falsely claim that they made cash payments to the nursing office and that the officer failed to record the receipt. Therefore, any unpaid invoice amount will have to be accounted for as a bad debt expense • Cash – o This account is understated for the same reasons (fraudulent financial reporting) o Cash has been misappropriated (misappropriation of assets) • Inventory of equipment/medical supplies/medicines – o This account could be overstated because some equipment/medical supplies/medicines might have been used or consumed but upon receipt of secret payments, not actually recorded (misappropriation of assets). Effect on Income Statement accounts: • • •

Revenue from medical services - this account is understated. Revenue from room charges - this account is understated. Bad debt expense - this account is understated.

Effect on Garden Nursing Home’s business: •

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•

Revenue has been understated and cash receipts misappropriated. This will result in Gardens Nursing Home appearing less profitable than it actually is and may also result in cash flow issues. The ripple effect of decreased profit could be on staffing decisions (i.e. decreasing number of staff, increasing work load on retained staff), use of capital equipment, loan covenants (potential breach) and other managerial decisions. Management will have to review the company’s controls. o What conditions led to this fraud? o Are controls inadequate in other areas as well? o What is the prevailing attitude within the business to fraud? Are personnel upset by the fraud? Rationalisation of fraudulent behaviour may increase the risk of undetected frauds or their occurrence in the future. o How effective is Gardens Nursing Home’s management and supervision?

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ACCT3322 SEMESTER 2, 2019

Questions 4.11 and 4.12 What is audit risk? What are the components of audit risk? Which components of audit risk can an auditor control? Explain. Solution ASA 200 states that audit risk means the risk that the auditor expresses an inappropriate audit opinion when the financial report is materially misstated. Audit risk is a function of the risks of material misstatement and detection risk. The risk of material misstatement means the risk that the financial report is materially misstated prior to audit. This consists of two components, described as follows at the assertion level: (a) Inherent risk means 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. (b) Control risk means 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 (AUASB Glossary). Detection risk means 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 aggregate with other misstatements (AUASB Glossary). The auditor cannot control inherent and control risk, and thus the risk that there are material misstatements in the client’s financial report. The auditor is required to assess the risk of material misstatement and plan the audit accordingly. The auditor controls detection risk by performing different audit procedures and varies both the nature and amount of audit work done. Question 4.32 Li Chen has calculated profitability ratios using data extracted from his client’s pre-audit trial balance. He also has the values for the same ratios for the preceding two years (using audited figures). The data for the gross profit and profit margins are as follows:

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ACCT3322 SEMESTER 2, 2019

Li is a little confused because the profit margin shows declining profitability but the gross profit margin has improved in the current year and is higher in 2018 than in the previous two years. Required (a) Make a list of possible explanations for the pattern observed in the gross profit and profit margins. Solution Possible explanations for the increasing Gross profit margin (a) and the declining profit margin are: • Cost of goods sold being misclassified as operating expenses (reducing cost of goods sold, increasing gross profit, increasing other expenses) • Understated purchase costs • Overstated closing inventory • Overstated sales • Increased other costs (e.g. interest costs, salaries etc., which have impacted adversely on overall profit but not on gross margin)

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