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TUTORI AL6 DESIGNING SUBSTANTIVE PROCEDURES;COMPLETION OFTHEAUDI T; AUDIT REPORTS

CHAPTER 7–THEAUDITOR’ SREPORT. Review questions 7.13 What are the different types of modified audit opinion? Explain each type. A modified auditor’s report is issued when the auditor concludes that, based on the audit evidence obtained, the financial report as a whole is not free from material misstatement, or, the auditor is unable to obtain sufficient appropriate audit evidence to conclude that the financial report as a whole is free from material misstatement. Material misstatements may be the result of a number of factors, including an inappropriate selection or application of accounting policies that are required by the applicable financial reporting framework, or inadequate disclosures of matters that are required or disagreement with management relating to the financial statements ot conflict between applicable financial reporting frameworks. Guidance is given in ISA(NZ) 705 Modifications to the Opinion in the Independent Auditor’s Report. When an audit report is other than unqualified, it is either qualified, a disclaimer or an adverse opinion, as described in ISA(NZ) 705. Type of audit opinions:  Qualified opinion is expressed when the auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are material, but not pervasive, to the financial report; or the auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, but the possible effects on the financial report of undetected misstatements, if any, could be material but not pervasive. 

Adverse opinion is expressed when the auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are both material and pervasive to the financial report.

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Disclaimer of opinion is expressed when the auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, and the auditor concludes that the possible effects on the financial report of undetected misstatements, if any, could be both material or pervasive. In extreme cases, the auditor may conclude that, even after having obtained sufficient appropriate audit evidence, it is not possible to form an opinion on the financial report due to the potential interaction of multiple uncertainties and their possible cumulative effect on the financial report.

7.14 Under what circumstances may the auditor decide to include an ‘emphasis of matter’ section in the audit report? An auditor may add an ‘emphasis of matter’ section to an audit report while still expressing an unqualified opinion on the financial report. The purpose of this is to draw the attention of users of the audit report to relevant information that are regarded as relevant to a proper understanding of the basis of the opinion. Examples of circumstances when an explanatory paragraph is appropriate include (ISA(NZ)-706, para A1):  An uncertainty relating to the future outcome of exceptional litigation or regulatory action.  Early application (where permitted) of a new accounting standard (for example, a new New Zealand Equivalent to an International Financial Reporting Standard) that has a pervasive effect on the financial statements in advance of its effective date.  A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position. An emphasis of matter paragraph should be suitably headed and care should be taken when drafting it to ensure it will not be mistaken for a qualification of the audit report.

Professional Application Questions 7.21 (Effect of circumstances on audit opinion) Assume you are an auditor and you are facing the following separate circumstances, the effects of all the items below are material: 1. 2.

The provision for stock is inadequate. A retailer values inventory at sales price less an allowance for sales margin.

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A manufacturing company is currently negotiating with the bank an extension of a loan facility that is due for repayment shortly after the AGM; without this refinancing the business will not be able to continue operations. A significant proportion of a retailer’s sales are on a cash basis and inadequate records have been maintained; there are no audit tests that can be done to satisfy yourself that the cash sales are accurate. Management have excluded from the financial report the necessary disclosures in relation to a contingent liability. The company that runs a dairy farm has prepared the financial report on a going concern basis; shortly after the year end the company’s contract with a major supermarket was cancelled. Without this customer you expect the business to cease trading

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within six months and it is unlikely that the company will be able to secure any new contracts in that time. The directors of a construction company refuse to give you access to reports produced by an independent quantity surveyor in relation to the value of work done on some of their construction projects. A wholesaler has a policy of including all of its buildings in the balance sheet at cost less depreciation. You establish that one of the warehouses included in the balance sheet at a value of $20m has an actual market value of $23m.

Required Indicate the effect of the above circumstances on your auditor’s report if management were to refuse to make any changes you feel necessary in order that the financial report gives a true and fair view. 1.

2. 3.

4. 5. 6.

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This is a disagreement with management. The audit report would be qualified if the issue is material but not extreme, or an adverse opinion in extreme cases. This is an acceptable method of valuing inventory at cost and therefore an unmodified opinion can be given. If the matter of loan negotiations is not adequately disclosed, then this constitutes a disagreement with management, and the report would be qualified or an adverse opinion, depending on the circumstances. If the matter of the loan negotiations is adequately disclosed, a “Material Uncertainty Related to Going Concern” section is added. This is a scope limitation. The audit report would be qualified or a disclaimer, depending on the circumstances. This is a disagreement with management and a qualified opinion is necessary, refer to 1 above. It appears that it is highly likely that the business will not continue to trade and therefore the financial report should not be prepared on a going concern basis; some alternative such as a break-up basis would be appropriate. This gives rise to an adverse audit opinion. This is a scope limitation. Refer answer 4 above. The policy is to include buildings at cost less depreciation and therefore the accounts do not need to be changed to include the market value of the property. An unmodified opinion is appropriate.

7.24 (Going concern issues, audit opinion) Temper Telecommunication Ltd is a listed public company that manufactures communication equipment. Last year the company engaged itself in a contract involving the engineering and infrastructures for a highly complex broadband network in Adelaide. The company has a 30 June yearend, and the statutory accounts are due to be signed one week after the board of directors meeting on 5 August 2014. During the course of the audit, you become aware that the due to the complex negotiations with the Australian Government on broadband networks, and the likely change in government policies, the company was advised that the plan for the broadband network engineering project may be suspended until further notice. Temper Telecommunications had bought sophisticated equipment which was to be paid off through the life of the project over 3 years. It also commenced the architectural planning, employing two highly paid experts in broadband architecture. Temper Telecommunications is now experiencing growing cash flow difficulties (the project was meant to be able to save its business). It has recently applied for a significant increase to a borrowing facility that is already fully drawn. Management is adamant that the company will continue to be viable. If necessary, it claims it can resort to cutbacks in its other future capital expenditure program, seek additional off-balance-sheet financing and/or reschedule existing debt arrangements.

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Required (a)

Explain the concept of going concern. Discuss the reporting options open to an auditor when going-concern issues arise.

The going-concern concept means that it is assumed that the entity will realise its assets and extinguish its liabilities in the normal course of business. The auditors’ reporting options are:  Going concern basis considered appropriate Auditor should issue an unmodified audit report.  Going concern basis considered appropriate but a material uncertainty exists If the uncertainty is adequately disclosed in the financial statements, the audit report should be unmodified and include a “Material Uncertainty Related to Going Concern” section (a special form of ‘emphasis of matter’ paragraph) in accordance with ISA(NZ) 570. (Note that if there are multiple material uncertainties that are significant to the financial statements as a whole, the auditor may in “extremely rare cases” express a disclaimer of opinion instead of an ‘emphasis of matter’ paragraph). If the financial statements do not adequately disclose the uncertainty, a qualified or adverse opinion should be expressed as appropriate in accordance with ISA(NZ) 570.  Going-concern basis considered inappropriate If the auditor is satisfied that it is highly improbable that the entity will continue as a going concern for the relevant period, an adverse opinion should be expressed in accordance with ISA(NZ) 570. (b)

Discuss the potential audit report options in relation to Temper Telecommunications Ltd.

There are a number of matters that indicate potential going-concern reporting issues for Temper Telecommunications Ltd (TT). These include:  Due to the complex negotiations with the Australian Government on broadband networks, and the likely change in government policies, TT was advised that the plan for broadband network engineering project may be suspended until further notice.  TT has been experiencing cash flow difficulties and the project was meant to be able to save its business.  TT’s borrowing facility is already fully drawn. The auditor would need to perform a number of procedures to evaluate the appropriateness of the going-concern basis, including gaining evidence concerning the potential mitigating factors (cutting back capex, rescheduling debt, etc). In this case all of the above should be disclosed in a note to the accounts. If the auditor is satisfied with the disclosure, he or she may issue an unqualified audit report with a “Material Uncertainty Related to Going Concern” paragraph. However, if the auditor is unsatisfied as to the ability of the entity to continue as a going concern (which is difficult to tell from the information given in this case), he or she should issue an adverse audit opinion.

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CHAPTER 1 2–DESIGNING SUBSTANTIVEPROCEDURES Review Questions 12.11 Which components of the audit risk model can be controlled by the auditor? Discuss the interrelationships. In terms of which components can be controlled by the auditor, the only part would be detection risk (ISA(NZ) 200). This is varied based on the assessment of inherent risk and control risk. Inherent risk is given for a particular client, the auditor assesses it but cannot change it. Similarly, control risk is given for a particular client, however if control risk is medium or low the auditor may choose to rely on the controls and will therefore have to perform some compliance testing. Audit risk is specified for the auditor, but is probably constant for the majority of the clients of the audit firm. For a given level of audit risk, detection risk is inversely related to the assessed levels of inherent risk and control risk for each financial report assertion. The level of detection risk influences the auditor’s assessment of the nature, timing and extent of the procedures needed to gain sufficient appropriate audit evidence. 12.12 Identify and explain the three steps in assessing the risk of material misstatement. Step 1 Evaluate the type of potential misstatements that may occur The auditor needs to recognise risk factors and then link those risk factors to assertions that are likely to be misstated. Some risks may have a pervasive effect on the financial statements and may influence multiple account balances and assertions while other risk factors will be assertion specific. Step 2 Evaluate the magnitude of potential misstatements Some potential misstatements are more significant than others so the auditor needs to consider their magnitude. For example, the existence of inventory is more significant for a manufacturer than for a hotel. Auditors will need to allocate more audit attention to the assertions that can have a potential material effect, individually or in aggregate, on the financial statements. Step 3 Evaluate the likelihood of material misstatement The auditor must also determine how likely a possible material misstatement is. Once the auditor has identified the various risks that might affect the financial statements they should then assess the adequacy of the system of internal controls. The greater the effectiveness of internal controls, the less the likelihood of material misstatement.

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12.16 Explain why there is an increased audit risk from conducting procedures before the end of the reporting period and identify two ways in which this increased risk is controlled. There is an increased risk associated with performing substantive procedures before the end of the reporting period as there is an increased risk that material misstatements existing in the account at the end of the reporting period will not be detected. This risk becomes greater as the time period remaining between the date of the interim report and the end of the reporting period is lengthened. The potential increased risk audit risk can be controlled if: • The internal control structure during the remaining period is effective. • There are no conditions or circumstances that may predispose management to misstate the financial statements in the remaining period. • The year-end balances of the accounts examined at the interim date are reasonably predictable as to the amount, relative significance and composition. • The entity’s accounting system will provide information concerning significant unusual transactions and significant fluctuations that may occur in the remaining period. Discussion point What types of substantive tests are commonly performed prior to year-end, and why? 12.17

Why may an auditor decide to perform tests of details on income statement accounts rather than relying on analytical review?

When the evidence obtained from analytical procedures and from tests of details of related balance sheet accounts does not reduce detection risk to an acceptably low level, direct tests of details of assertions pertaining to profit and loss statement accounts are necessary (ISA(NZ) 330). This may be the case when: • inherent risk is high; • control risk is high; • analytical procedures reveal unusual relationships and unexpected fluctuations; and • the account requires analysis. Accounts requiring separate analysis include: • legal expenses and professional fees; • maintenance and repairs; • travel and entertainment; and directors’ remuneration 12.19

What steps may the auditor perform in evaluating the reasonableness of accounting estimates?

Due to the use of judgement and therefore the subjective nature of these balances, accounting estimates are often the ones where the most disputes occur between the auditor and management. ASA 540 suggests that one or a combination of the

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following approaches should be adopted in the audit of accounting estimates to obtain sufficient appropriate audit evidence. (a) Review and test the processes used by management to develop the estimate. This would include a review of the data and assumptions used by management in preparing the estimate, testing the calculations performed, and comparison of the accuracy of estimates made by management in prior periods. (b) The use of an independent estimate for comparison. The auditor may make his or her own independent estimate of the balance and compare it with managements. (c) Review subsequent events. A review of subsequent events after the end of the accounting period may provide evidence as to the accuracy of the estimate made by management.

Professional Application Questions 12.21 (Substantive procedures) Listed below are fifteen substantive procedures: 1. Select a sample of non-current assets and sight them. 2. Review the income statement for unusual differences in the balances recorded for this year and last year. 3. Select a sample of invoices and ensure that they have been properly recorded in the sales ledger. 4. Review the company-prepared bank reconciliation. 5 Trace the last inventory received before the year-end to the inventory listing. 6. Review the adequacy of the company’s allowance for doubtful debts. 7. Obtain the company’s depreciation rates from the financial statements and check they have been applied correctly. 8. Perform an accounts receivable circularisation. 9. Review a sample of repairs and maintenance expenditure for the year to ensure that it does not include any items that are capital in nature. 10. Ensure that interest paid on the bank loan is correct by multiplying the interest rate by the outstanding principal for each month of the year. 11. Send a letter to the bank to confirm a loan taken out by the company during the year. 12. Attend the year-end stocktake and perform test counts on a sample of stock items. 13. Ensure that all contingent liabilities have been included in the notes to the accounts. 14. Review all invoices received for one month after the year-end to ensure that they do not relate to the current year. 15. Calculate the accounts receivable turnover and compare with previous year’s turnover.

Required (a) For each test, indicate what type of substantive procedure to which it relates (analytical review, tests of details of balances or tests of details of transactions) (b) Give one assertion to which each test relates?

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(a) Type of substantive procedure (b) Assertion(s) Tests of details of balances Existence Analytical review Completeness, accuracy, cut-off, and classification Tests of details of transactions Completeness and classification Tests of details of balances Valuation and allocation,

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Tests of details of transactions Tests of details of balances Analytical review Tests of details of balances Tests of details of transactions Analytical review Tests of details of balances Tests of details of balances Tests of details of balances Tests of details of transactions Analytical review

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measurement Cut-off, also completeness Valuation...