AUDITING SEMESTER 1 2019: ANSWERS TO WEEKLY QUESTIONS FROM LECTURE

AND TUTORIAL OUTLINE FOR WEEK 3

QUESTION 1
1. Analytical review procedure
2. Inspection
3. Observation
4. Inquiry
5. Inspection
6. Recalculation
7. Reperformance
8. External confirmation
9. Analytical review procedure
10. External confirmation

LEARNING OBJECTIVE:
Lecture 3 Learning Objective (1): Understand the procedures applied by an auditor.

REFERENCES:
Lecture Slides: Lecture 3, slides 5-24
Textbook: pp.342-349
Handbook: ASA 500, Paragraphs A14 to A25

QUESTION 2
ANSWER TO QUESTION 1 (a- c)
(a) Whether or not the internal control that is being tested is effective.
(b) Whether or not the ending balance of an item recognised in the Statement of Financial
Position is fairly stated.
(c) Whether or not a transaction class recognised in the Statement of Profit or Loss and
Other Comprehensive is fairly stated.

ANSWER TO QUESTION 2 (d)

Item Type of Test Explanation
1 Test of control The auditor has gathered and evaluating evidence about the
effectiveness of a control over the processing of purchase
transactions (authorisation by the manager).

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 2 Test of control The auditor has gathered and evaluating evidence about the
effectiveness of a control over the processing of sales transactions
(that an accounts clerk had checked the prices against the authorised
price list).
3 Substantive test The auditor has gathered evidence about the validity of a transaction,
of a transaction i.e. whether or not a sale that was recorded in the Sales Journal
actually occurred.
4 Test of control The auditor has gathered and evaluated evidence about the
effectiveness of a control over the processing of purchases
transactions (that a sequence check had been performed)
5 Substantive test The auditor is gathering and evaluating evidence about the amount of
of an account an ending balance (cash at bank). The result will be expressed in
balance monetary terms. (In this case the difference (if any) between what the
client has recorded and the bank has recorded)
6 Substantive test The auditor has gathered and evaluated evidence, using the analytical
of an account procedure of ratio analysis to determine the speed with which
balance (analytical inventory is turned over. This indicates the value of the inventory
procedure)

NOTE:
For the substantive tests, (3), (5) and (6), the auditor is gathering and evaluating evidence
about the validity of items in the accounts.

For the tests of control, (1) (2) and (4), the auditor is gathering and evaluating evidence
concerning the effectiveness of the client’s controls. He/she is determining whether or not the
client (effectively) performed a control they claimed to have performed.

LEARNING OBJECTIVE: Lecture 3, Learning Objective (2) Understand the various types of
audit tests.
.
REFERENCES:
Textbook: p. 346
Lecture Slides: Lecture 3, slides 26-40

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QUESTION 3
ANSWER QUESTION 3 (a)
(i) Inspection
(ii) Credit manager’s initials
(iii) Occurrence.
(iv) Sampling would have been used. Sales transactions for a shoe wholesaler will be at
a high volume and be of a similar nature. Only 30 sales transactions have been
tested.

ANSWER TO QUESTION 3 (b)

(i) Sales journal
(ii) Vouching (from accounting record to source document)
(iii) Inspection
(iv) Shipping Order
(v) Occurrence
(vi) Sampling would have been used. Sales transactions for a manufacturer of doors will
be at a high volume and be of a similar nature. Only 40 sales transactions have been
tested.

ANSWER TO QUESTION 3 (c)

(i) Ledger balances (subsidiary ledgers)
(ii) From the accounting record to the external (independent) record
(iii) External confirmation
(iv) Response from the debtors
(v) Existence and Rights and Obligations*
(vi) Sampling has not been used. The method of evidence collection is specific
iddentification. (items over the specified amount of $1m.)

* We are testing whether or not the debt (gross value) exists and whether the client has the
right to the receivable. We are not testing valuation. Valuation depends on the ability of the
customer of the client to pay.

LEARNING OBJECTIVES:
Lecture 2, Learning Objective (1) Understand that, essentially, financial reports are a set of
assertions; Lecture 3, Learning Objective (1): Understand the procedures applied by an
auditor and Learning Objective (2) Understand the various types of audit tests.

REFERENCES:
Lecture Slides: Lecture 2 slides 4-26; and Lecture 3, slides 5-40
Textbook: pp. 280-284 and pp.342-349
QUESTION 4:

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ANSWER TO QUESTION 4 (i)
The audit risk model specifies the realtionship between audit risk (AR) and its compnent
parts, which are ingerent risk (IR), control risk (CR) and detection risk (DR). It is expressed
as follows: AR = IR x CRx DR.

ANSWER TO QUESTION 4 (ii)

Audit risk: The risk that the auditor provides an inappropriate opinion when the financial
statements are materialy misstated.

Inherent risk: The risk of material misstatement in the financial report before taking into
account the entity’s internal controls. It is due to the nature of the entoty and its environment.
Inherent risk arises due to decsions made by the client.

Control risk: The risk of material misstatement in the finacial repost due to failure of the
entiy’s internal controls. Control risk arises due to decsions made by the client.

Detection risk: The risk that the auditor’s procedures will fail to detect a material
misstatement when one exists. Detection risk arises because of decisions made by the
auditor.

ANSWER TO QUESTION 4 (iii)

Inherent risk: (1)unusual pressure on management, such as paying bonuses on accounting
profit as opposed to underlying economic perfromance; (2) complexity of transactions, such
as foreign exchange transaltions.

Control risk: (1) lack of commitment tocompetence, such that staff make errors because thay
are not properly trained; (2) access to journals is not controlled because passwords are not
required to logon.

Detection risk: (1) poor planning, such as failure to properly understand the nature of the
client and its environment; (2) poor evaluation of results, such as assigning inexperienced
staff to evaluate results of tests.

ANSWER TO QUESTION 4 (iv)

The auditor uses the audit risk model at the planning stage of an audit to provide a
framework for risk assessment. At the planning stage, the auditor uses the planning form of
the audit risk model, which is stated as: DR = _AR_
IR x CR

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This shows that detection risk is inversley proportional to inherent risk and control risk. When
using the audit risk model in this way, the auditor establishes a level of audit risk that, based
on judgement, is appropriate for the engagement. The auditor then evaluates the client’s
inherent risk and control risk, and sets detection risk in response to those evaluations. The
higher the inherent and/ or control risks, the lower will be detection risk. That is, the auditor
will want a lower level of risk that his/ her procedures will fail, the higher the posssibility there
is of material misstatement due to the nature of the client and its environement, and its
internal controls failing. The lower the detection risk that the auditor sets, the more work
he/she mjust do.

ANSWER TO QUESTION 5
Situation Component of
audit risk
(a) Technological innovations within the industry have caused a major Inherent risk
product to become obsolete
(b) Cash is more susceptible to theft than an inventory of cement Inherent risk
(c) Segregation of duties is inadequate Control risk
(d) Cash disbursements have occurred without proper approval Control risk
(e) A necessary substantive audit procedure is omitted Detection risk
(f) Bank accounts are not reconciled monthly, resulting in a client failing Control risk
to discover employee fraud on a timely basis
(h) Confirmation of receivables by an auditor fails to detect a material Detection risk
misstatement
(i) Notes receivable are susceptible to material misstatement, assuming Inherent risk
there are no related internal controls
(j) A client, Lemon Ltd, has insufficient working capital to continue its Inherent risk
operations

LEARNING OBJECTIVE:
Lecture 3: Learning Objectives (3) Define the Audit Risk Model and (4) Apply the Audit Risk
Model when planning an audit.

REFERENCES:
Lecture Slides: Lecture 3, slides 43-69
Textbook: pp. 307-310
Handbook: ASA 200 Paragraphs 17 and A32 to A44

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ANSWER TO QUESTION 6:
The auditor’s consideration of materiality and audit risk are really inseparable. Materiality
relates to how precise auditing procedures need to be, and audit risk relates to the
degree of certainty achieved by the procedures. There is an inverse relationship between
audit risk and materiality. This means that the auditor sets a lower materiality threshold
where there is a higher audit risk. The auditor allows for this by increasing the extent of
audit procedures, selecting a more effective audit procedure and/or performing audit
procedures closer to the balance date.

The audit should be planned so that audit risk is kept at an acceptably low level. The
audit risk the auditor seeks to restrict is the risk of a material misstatement remaining
undetected after applying audit procedures. This requires the auditor to plan the nature,
timing and extent of audit procedures by taking into account the level of materiality.

Planning materiality determines the items that will receive more attention in terms of
conclusiveness of evidence required or extent of items examined. If a low materiality threshold\
is set, more evidence would be gathered than if a higher materiality threshold were set.

LEARNING OBJECTIVE:
Lecture 3: Learning Objectives (5) Understand the concept of materiality as it is applied in an
audit.

REFERENCES:
Lecture Slides: Lecture 3, slides 71-84
Textbook: 325-329