ANSWERS TO WEEKLY QUESTIONS FROM LECTURE AND TUTORIAL OUTLINE FOR

LECTURE 5. WEEK OF APRIL 1st 2019

ANSWER TO QUESTION 1
A B C
Situation Nature of the Level of the
inherent risk Inherent risk
Your client has been named at a recent Royal Integrity of Financial report
Commission for its unscrupulous practices. management
In the previous audit. You found that the client Accounts likely to Assertion
had failed to record all sales for the period. require adjustment
Your client is a jeweller with a chain of ten Assets susceptible Assertion
suburban jewellery stores to loss or
misappropriation
Management is paid modest salaries but can Unusual pressure Financial report
earn substantial bonuses that are calculated on on management
accounting profit.
During the year, the credit controller retired and Management Financial report
was replaced by a person who had excellent experience,
accounting qualifications and experience but knowledge and
little experience of the industry in which your changes during the
client operates period.
The client capitalised a number of leases. Complexity of Assertion
underlying
transactions
The client applied the percentage of completion Judgement Assertion
method for determining revenue. involved in
determining
account balances
The client’s main source of revenue is from the Nature of the Financial report
retail sale of mobile telephones client’s business
Your client operates in an industry in which Factors affecting Financial report
demand from customers is sensitive to changes the industry in
in official interest rates. which the entity
operates

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 Your client made special arrangements to Transactions not Assertion
process a large sale to a new customer with the subject to ordinary
aim of attracting the customer’s business for the processing
longer term.
Just before balance date the client entered into Occurrence of Assertion
a series of sale and leaseback arrangements to unusual or
free-up working capital. complex
transaction,
particularly at or
near year-end

ANSWER TO QUESTION 2
Integrity of management
If management lacks integrity, they are more likely to produce materially misleading financial
reports.
EXAMPLES:
(1) Engaging in earnings management, where accounting policy choices are made not
because they are appropriate, but because they produce a desired (reported) result.
(2) Frustrating the auditor’s attempts to obtain evidence in a timely manner.

LEVEL OF RISK: Financial report level because management has the power/ability to
influence all transactions and accounts.

Management experience and knowledge

If management experience and knowledge is limited they are more likely to make sub optimum
judgements, choices and estimations which can lead to misstatements in the financial reports.

EXAMPLES:
(1) Poor understanding of market and economic conditions, and poor ability to estimate
cash flows when determining an impairment.
(2) Poor planning and risk assessment that can lead to problems with valuing non-current
assets.

LEVEL OF RISK: Financial report level because management judgement and experience has
the potential to influence all transactions and accounts.

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Complexity of underlying transactions
Transactions characterised by difficult calculations or a complex accounting standard are
more prone to error than simple repetitive transactions.

EXAMPLES
Lease capitalisation
Long term construction contracts

LEVEL OF RISK: Assertion level

Judgment involved in determining account balances

The greater the degree of judgment involved in determining account balances, the greater the
chance of an error.

EXAMPLES
Accounting estimates, such as provision for doubtful debts, obsolescence and warranty, are
more likely to be misstated than routine factual data.

LEVEL OF RISK: Assertion level

ANSWER TO QUESTION 3
(a) The going concern assumption means that the entity is viewed as continuing in
business for the foreseeable future without any intention or necessity to liquidate or
otherwise cease its operations.

(b) When the going concern assumption is appropriate, assets and liabilities are
recorded on the basis that the assets will be realised and the liabilities discharged in
the normal course of business. This means either cost or fair value. However, an
imminent business failure will have an effect on the appropriateness of the
presentation of the financial report. If the company is not a going concern, the
financial report should be prepared on a liquidation basis, which is likely to be vastly
different to the going concern basis. Further, going concern problems may motivate
management misrepresentation. Therefore, ASA 570.10 requires that when planning
and performing audit procedures and evaluating the results, the auditor must
consider the appropriateness of the going concern assumption that underlies the
financial report.

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ANSWER TO QUESTION 4
Financial indicators of going concern problems and relevant mitigating factors include:
Indicator of Going Concern
poor liquidity ratios
high debt equity ratio
difficulty in complying with the terms of
covenants
fixed-term borrowings nearing maturity
without realistic prospects of renewal or
repayment
reliance on short-term borrowings to
finance long-term assets
negative operating cash flows
dividend arrears or discontinuance
inability to pay creditors on time
denial of trade credit by suppliers.
Mitigating Factor
Disposal of surplus assets
Factoring
Sale and leaseback of assets
Disposal of surplus assets
Factoring
Sale and leaseback of assets
Additional contribution by owners
Debt restructuring
Disposal of surplus assets
Debt restructuring
Disposal of operations that produce the
negative cash flows
Disposal of surplus assets
Reduction in non-essential expenditure
Reduction I dividend payments
Reduction in dividend payment
Extension of due dates
Availability of unused lines of credit

ANSWER TO QUESTION 5
The Fraud Triangle posits that for fraud to occur, three conditions are necessary: (1)
circumstances that lead to a person feeling pressured such that they feel the need to commit
the fraud; (2) he opportunity to commit the fraud; and (3) the ability of the fraudster to
rationalise their fraudulent behaviour.

ANSWER TO QUESTION 6
Many users of financial reports believe that the detection of fraud is a primary audit objective
and that the auditor has a responsibility to detect all fraud. However, the auditing profession
sees the auditor’s responsibility for the detection of fraud as a secondary objective to

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providing an opinion on the truth and fairness of the financial report. However, ASA 240 (ISA
240) acknowledges that the auditor must exercise skill and care when planning and
conducting the audit, so as to have a reasonable expectation of detecting material
misstatements arising as a result of fraud, and must adopt an attitude of professional
scepticism. The interpretation of the auditor’s duties by the courts will be within the context of
reasonable care and skill.