Tutorial 9 & 10 - ACC304 PDF

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9 Business risk and assertionsYou are a senior auditor working on the audit of HealthyGlow for the year ended 30 June 2015. You are in the planning stage of the audit. It is April 2015 and you discover that HealthyGlow has recently acquired two new, full-body scanning machines, representing the very...

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9.25 Business risk and assertions You are a senior auditor working on the audit of HealthyGlow for the year ended 30 June 2015. You are in the planning stage of the audit. It is April 2015 and you discover that HealthyGlow has recently acquired two new, full-body scanning machines, representing the very latest in technology, at a cost of more than $10 million each. The machine enables a full 360 degree scan of the body with the ability to identify tumours, cysts and other abnormal internal growths which currently have a 50% probability of being detected with other scanning devices on the market. Recent studies have shown there may be potential long-term side effects to patients who are scanned by the new technologically advanced machine. However, given the machine has only just arrived on the market, the results will not be known for many more years. This uncertainty and the potential high risk associated with the machine have caused bad press for both the scanning machine and HealthyGlow. HealthyGlow charges patients a premium price for the scanning machine due to its advanced technological abilities. As a result of high demand, the hospital has decided to reserve the use of the machine for pre-paid patients only. All scans must be paid for in full by patients at the time of booking. Payments are immediately recognised as revenue by the hospital. Demand for the scanners has been extremely high and HealthyGlow now has bookings for four months in advance. You note that even though it is only April 2015, the hospital has bookings for July and August 2015. The Medical Association of NSW is currently reviewing the use of the scanning machines and may ban their use within Australia until the issue is resolved. The decision is expected to be communicated on 1 August 2015. Management have indicated there is an 80% chance the scanners will be given the go ahead. Required a. Assess the main business risks for HealthyGlow. b. Identify two key account balances likely to be affected by the above information. c. For each account balance identified in (b), identify and explain the key assertion most at risk

Solution a) Business risks are threats that the organisation faces in attempting to achieve its goals. In this case there are a couple of main business risks to HealthyGlow, both are in relation to the purchase of the new full-body scanning machines. 

Studies that have shown the potential side-effects of the new machines is a concern, which is a risk in the longer term. In the short term, the bad publicity is a risk although it appears to have had little effect on the level of bookings.



The potential ban of the use of the machines by the Medical Association of NSW is a much more significant short term business risk – even though management only assesses this likelihood at 20% (the auditor would want more evidence on this). HealthyGlow have significant capital investment in these machines and also significant revenue that is contingent on the continued operation of the machines.

b) 1. The scanners (property, plant and equipment) 2. Revenue and unearned revenue

c) 1. Valuation. The scanners may become worthless if they cannot be used due to the possible decision by the Medical Association of NSW. There may be an overseas market for them but this presumably would result in a significant discounting of value. 2. Accuracy and cut-off for revenue. There is a risk that HealthyGlow has been incorrectly recording revenue before the service is provided. The auditor will need to ensure that only those services provided before the end of June have been included in revenue and payments received for bookings after the end of June should be included as ‘Unearned revenue’.

Completeness for unearned revenue. There is a risk that revenue that has not been earned has not been accounted for properly.

9.27 Audit risk, components of audit risk Elliot Ltd operates a road maintenance company. Consider the following information: (i)

Your firm has just been appointed auditor of Elliot at its annual general meeting. During your planning of the audit, you notice that Elliot is unlisted public company and its directors do not consider it to be a reporting entity. Elliot has prepared special purpose financial reports for the past 5 years. It has significant bank debts and is required to lodge audited accounts with its bankers within 90 days of year-end

(ii)

Elliot recently won substantial contract to perform road maintenance work for the Queensland government for the next 3 years, As a result of winning the contract, to meet the increased demands and satisfy the specialized nature of the work for the government, Elliot purchased additional machinery. The machinery has an expected life of 10 years.

(iii)

Elliot is also involved in the manufacture of backyard water tanks. A revolutionary process developed a couple of years ago has enabled Elliot to build a tank far superior to any of its competitors, at half the price. It has therefore dominated the market over the past few years. However, you recently read a weekend newspaper in which you saw an article previewing Elliot’s main competitor’s new tank. it is made of a new material Lycrafon, and it will be superior to Elliot’s tanks and cost 25%.

Required (a) Discuss why each of these situations represents a risk.

(b) Identify the main account or group of accounts affected by this risks and how the specific aspects of the audit plan would be affected by these risks.

10.24 Materiality You have just completed audit testing on the 30 June 2015 accounts of JJJ Ltd, a manufacturing firm. Extracts from the draft financial statements are given below.

The audit manager has asked you to review the following summary of audit differences working paper to determine whether there are any material errors in the financial report.

Required a. Discuss the differences in the purpose, method of calculation and relative use of judgement of: i. materiality as used at the planning stage of the audit

ii. materiality as used at the final review stage of the audit. b. Outline the materiality guidelines as described in AASB 1031. c. Under what circumstances might an error be judged to be material as a result of its nature rather than its amount? Give examples. d. Are any of the errors in items 1–4 material? In each case explain how you reached your conclusion Solution

(a) Purpose

Method calculation

Planning the level of testing on each account balance and transaction class.

As a percentage of a relevant base such as profit or net assets.

Low since the specific misstatements are not yet known and only quantitative misstatements need be considered.

Materiality as Determining used at the final whether the stage of the audit financial report is materially misstated.

As a percentage of a relevant base such as profit or net assets.

High since the actual misstatements are now known and qualitative factors must be considered as well as the size of the misstatement.

Materiality as used at the planning stage of the audit

of Relative use of judgement

(b) ● AASB 1031 states that the usefulness of financial reports is impaired both by the exclusion of material information and the inclusion of immaterial information.

  

Information is material if it potentially affects decisions by users as to the allocation of scarce resources or the discharge of accountability by management. Materiality refers to the nature as well as the amount of an item. The amount of an item is relative to appropriate base amounts in the balance sheet, profit and loss account or cash flow statement. As a guide, items greater than 10% of an appropriate base amount are presumed to be material while items less than 5% are presumed not to be material.

(c) ● The nature of an item affects materiality where it has a particular effect on users’ decisions or where the amount is not readily determinable.  

For example, directors’ remuneration, transactions with related parties, proximity to breach of a covenant are examples of where the nature of an item has a particular effect on users. Restrictions on an entity’s powers, changes to operating segments affecting risk characteristics and changes in legislation affecting the entity’s operations are examples of material items with no immediate quantifiable effect.

(d) 1. Material as it is greater than 10% of the relevant base being operating profit after tax. 2. Not material as it is less than 5% of the relevant base being operating profit before tax. 3. Not material being more than 10% of a relevant base being operating profit before tax. 4. Material being greater than 5% of the relevant base of operating profit before tax and being an amount capable of precise determination not subject to judgement or estimation.

10.29 Materiality You are nearing completion of the 31 December 2015 audit of ABC Wholesalers Ltd. The figures below have been extracted from the final draft financial report.

During your review of the audit files, you note the following items recorded on the summary of audit differences. 1. ABC Wholesalers has been involved in a long-running dispute with the taxation authorities in relation to the amount of sales tax payable on certain lines of merchandise. The case was resolved this year in favour of the taxation authorities. The court ruled that ABC Wholesalers, as well as paying the outstanding taxes, must pay a non-tax-deductible fine of $420 000. 2. Sales cut-off at one of ABC Wholesaler's stores was incorrect, resulting in a large sale of inventory made early in January 2015 being recorded in the 31 December 2014 year-end. The cost price of the inventory sold was $250 000. ABC Wholesalers marks up inventory by 40%. 3. Purchases cut-off at the same store was also incorrect, resulting in a large purchase of inventory made in late December not being recorded until January 2015. The invoice price of the inventory purchased was $5 950 000. You also note that the planning materiality level was set by the audit manager at $200 000.

Required a. Consider items 1–3 independently. State whether the amounts involved would be considered material for the purpose of issuing an auditor's report. Give reasons. b. Explain the relevance, if any, of the planning materiality level to your decisions in (a). Solution (a) 1. The amount of the fine is material as being more than 10% of the relevant base of profit after tax on which, being non-tax deductible, it would have a direct effect. The nature of the event is also unique and absolutely determined such that its correction in the financial report would be necessary even if much smaller. 2. Assuming the goods were also included in closing inventory, the cut-off error results in an overstatement of operating profit before tax of the selling price of the stock which is $350 000. This error is more than 5% of operating profit before tax making it appropriate to consider the possibility of a material misstatement. The amount is not subject to uncertainty or estimation. Assuming the recording of the sale was in clear violation of the company’s policy on revenue recognition, which has been consistently applied then there is a strong argument for regarding the misstatement as material. On the other hand, the company’s profitability in the current year is low representing a return of little over 1% on capital employed. There comes a point where every trivial error becomes material if judged against an exceptionally low profit figure. Since this amount is less than 10% of this year’s profits it might be appropriate to determine whether it is greater than 5% of average profits in recent years. Although independent of the materiality decision, there are other implications of the error. Assuming inherent and control risk assessments over cut-off were consistent for the company, the incidence of a material error at one store suggests a higher risk assessment for that store requiring a need for more extensive substantive testing than has already been performed. 3. Assuming the stock was physically on hand at the year end and included in closing inventory, the failure to record the purchase results in an error in operating profit before tax of $5 950 000. This is clearly material in that it turns a profit into a loss. (b) Planning materiality is based on preliminary drafts or even on projected profits and other relevant bases. It is used as an aid in determining the level of substantive procedures, together with risk assessments, to minimise the likelihood of failing to detect material misstatements. When errors are discovered, their evaluation as to

materiality is based on more recent draft financial reports, on the particular circumstances of the errors and on the cumulative effect of all uncorrected errors. The only relevance of testing materiality is the possibility, in light of corrected financial report numbers, it may be found to have been too high resulting in a need to undertake further testing....