Week 6 Tutorial Questions sols PDF

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Week 6 Tutorial Questions (Sem 2) Solutions Chapter 7 7.12 Identify applicable ethical considerations in accepting a new audit engagement. Solution Before accepting a new client, the auditor should consider whether acceptance would create any threats to compliance with the fundamental principles (APES 110). The auditor should: 

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evaluate whether there are circumstances that would compromise his or her independence such as the existence of personal or financial relationships with the proposed client or any conflict of interest between the auditor or any existing client and the proposed client; assess competence to perform the audit, especially the availability of the necessary expertise relative to the nature of the proposed audit client’s business or scale of operations; determine the ability to use due care, especially with respect to the timing of the audit work and the availability of competent staff to complete the work to the required standard within the time available.

7.15 Discuss the steps involved in the audit planning process. Solution Planning an audit involves establishing the overall audit strategy for the engagement and developing an audit plan, in order to reduce audit risk to an acceptably low level (ASA 300). Planning starts with an understanding of the entity and its environment. Planning also involves: (1) setting materiality levels - How do auditors determine materiality? To establish a level of materiality, auditors rely on rules of thumb and professional judgment. They also consider the amount and type of misstatement. The materiality threshold is typically stated as a general percentage of a specific financial statement line item (2) assessing audit risk and its components - Audit risk is a function of the risks of material misstatement and detection risk'. Hence, audit risk is made up of two components – risks of material misstatement and detection risk. Risk of material misstatement is defined as 'the risk that the financial statements are materially misstated prior to audit. (3) obtaining an understanding of the internal control structure - Identify types of potential misstatement. Consider factors that affect the risk of material misstatement. Design tests of controls, when applicable. (4) developing a preliminary audit strategy for significant assertions- The auditor should establish an overall audit strategy that sets the scope, timing, and direction of the audit and guides the development of the audit plan

Auditors should also perform analytical procedures as part of the planning process as well as consider the risk of fraud.

7.23

Client evaluation  Dinfal Ltd is a company that manufactures a range of products for the electronics industry. You work for a medium-sized firm of accountants, Ejo, Gam & Step. It is now 29 May 2020 and you have been approached by Dennis Launch, one of the directors of Dinfal Ltd, to perform the financial report audit for the year ended 30 June 2020. From your brief conversation with Dennis you establish the following:  Dinfal Ltd was set up by Dennis and his cousin Berty Drip, who are both directors and each own 50% of the shares.  Both Dennis and Berty consider themselves to be entrepreneurs and have a range of experience in different industries.  Since creating Dinfal Ltd six years ago, the profits have increased very quickly, sales having nearly doubled each year.  Dennis mentions that they left their previous two auditors due to differences of opinion about accounting policies and accounting treatments for various transactions including research and development expenditure. Your firm has wide experience of the industry but no previous connection to the company.  You have explained to Dennis that there are certain procedures that need to be followed before you can accept appointment as auditors.  Dennis has indicated that Dinfal Ltd is seeking additional financing and would like the audit to be completed as soon as possible so that the audited financial report can be provided to the potential financiers to prevent any delay in accessing additional funds. Required Highlight the issues that your firm should consider before accepting the appointment as the auditor of Dinfal Ltd. Solution          

Does the firm have the staff with appropriate skills to carry out the audit? Determine the firm’s ability to use due care in performing the audit. Are the staff available at what is likely to be a busy time for the firm? A check will need to be performed to ensure the firm has no connections with the firm that would affect independence. The firm has clients in the same industry and should therefore ensure there are no conflicts of interest. Permission should be sought to contact the previous auditors, the audit should not be accepted if this is not received. Communicate with the outgoing auditor to establish if there are any reasons why you should not accept appointment, review the response you receive from the auditors for any issues that would prevent you accepting the audit. You should also ensure that the previous auditor has properly resigned. Obtain further details of the issues with the previous auditors, including the details of accounting policies being followed. Review prior year financial reports and obtain copies of the most recent financial information.

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7.26

Consider the integrity of management. Obtain further details of the finance being sought, who the potential financiers are and how the financial report will be presented to them as part of any funding application.

Planning the audit; analytical review Tirthe Ltd sells a range of indoor and outdoor furniture by recycling and reinterpreting old furniture and other wood, metal, glass and plastic products obtained from a variety of sources such as derelict buildings, deceased estate auctions and so on. Revenue comes from sales to the general public and businesses such as hotels and restaurants. Some small items are collected by customers but generally goods are delivered by Tirthe Ltd. The directors have reported that it has been another good year for the organisation and that they expect the coming year to be successful. The draft income statement for 2020 together with audited figures for 2019 are given

below. Required You are planning the audit of Tirthe Ltd for the year ended 30 June 2020, discuss the issues to be considered in your audit planning from the information contained in the income statements.

Ratio calculations Ratio Formulae Gross profit margin Gross profit ÷ Net sales Profit margin Profit ÷ Net sales Profit before income taxes and Times interest interest expense ÷ interest expense earned Trend analysis

2020 40% 11%

2019 51% 23%

9%

20%

Income statement items Revenue Cost of sales Gross profit Other income Operating expenses Administration Selling and distribution Finance costs Profit/(loss) before tax

30 June 2019 (actual) 617 140 (302 788) 314 352 7 186

30 June 2020 % (13) 6 (32) (100)

(92 064) (79 933) (7 623) 141 918

4 (37) (2) (57)

30 June 2020 (draft) 536 994 (322 187) 214 807 — (95 438) (50 575) (7 434) 61 360

Net profit (decrease of 57%) The change in net profit is a much a greater fall than the levels of turnover would suggest. The profit margin has dropped from 23% to 11%. The reasons for this fall needs to be investigated. A review of each item on the income statement, as discussed below, should provide those answers. Sales revenue (decrease of 13%) There needs to be some investigation to the director’s assertion that it has been another good year given that the draft income statement shows a fall in revenue. Specific attention may be devoted to sales testing for completeness (for possible understatement of sales) and cut-off for receivables to ensure sales have been recorded in the correct period. Cost of sales (increase of 6%) Cost of sales have increased when sales revenue has fallen. This may indicate occurrence problems for purchases (overstatement) or cut-off problems relating to payables and inventory. It may also indicate completeness problems for inventory quantities (understatement). Gross profit (decrease of 32%) Gross profit margin has fallen from 51% to 40% this may indicate difficult trading conditions which contradict the director’s assertion about it being a good year. Investigations into the causes of the change are required, it maybe that there has been an adjustment to pricing policy leading to reduced profit percentages. Other income (none this year) There is no other income this year, this may refer to interest income, or other investment income. In which case this would indicate the downturn in trade has reduced cash balances or other investment balances. A review should be conducted to establish the ability of the company to meet liabilities as they fall due to assess the possible going concern risk - it should be noted that it usually takes more than one year of reduced performance to create going concern problems.

Administration (increase of 4%) Admin costs are likely to be fairly fixed (or stepped) and therefore it might be expected that admin costs do not change much unless there is a significant change in volume of trade. Selling and distribution (decrease of 37%) There has been a decrease in sales which may suggests fewer deliveries, it may also be the case that reducing the spend on marketing may have led to the fall in sales. There is a possibility that some costs have been incorrectly allocated to cost of sales - given the increase in cost of sales referred to above. Interest payable (decrease of 2%) A small decrease in the amount paid would not indicate any significant risk. Levels of cash balances, loans and overdraft levels would indicate the extent to which this expense appears realistic....