firm.

You meet an old school friend, Nga, for dinner — you haven’t seen each other for
several years. Nga is surprised that you are now working as an auditor because your
childhood dream was to be a ballet dancer. Unfortunately, your knees were damaged
in a fall and you can no longer dance. The conversation turns to your work and Nga
wants to know how you do your job. Nga cannot understand why an audit is not a
guarantee the company will succeed. Nga also thinks that company managers will lie
to you in order to protect themselves, and as an auditor you would have to assume
that you cannot believe anything a company manager says to you.
Required
(a) Write a letter to Nga explaining the concept of reasonable assurance, and how
reasonable assurance is determined. Explain why an auditor cannot offer absolute
assurance.
(b) Explain in the letter to Nga the concept of ‘professional scepticism’ and how it is
not the same as assuming that managers are always trying to deceive auditors.
(a).
There is a gap between Nga’s expectations and the level of auditor performance. An audit
provides reasonable assurance, not absolute assurance. The audit enhances the reliability
and credibility of the information included in a financial report but is not a guarantee that the
financial report is free from error or fraud, or that the company will not fail. Partly, this is
because of the nature of financial reporting. It requires judgements about accounting
estimates and the choice and application of various accounting methods. There is usually
not one ‘right’ answer for a company’s profit. The auditor cannot guarantee the profit
reported by the company is ‘right’, only provide assurance about the appropriateness of the
accounting method selection and application and the accounting estimates. Another reason
the assurance is not absolute is the nature of the audit process. Auditors cannot review
every transaction and account balance, therefore they use sampling (which could mean that
representative items are not selected for testing). Some transactions and balances are
difficult to gather reliable evidence about, clients can conceal evidence, and auditors have a
limited time frame in which to complete the audit.
(b).
Professional scepticism is required of an auditor. It is an attitude that requires the auditor to
remain independent of the client and its staff. The auditor has a questioning mind and
thoroughly investigates all evidence presented by their client. This does not mean that they
regard the client as a liar, but that they need to do more than simply take the client’s word
about anything. Usually, there will be confirming evidence which supports the client’s
statements (e.g. copies of contracts, minutes of meetings, etc.). Evidence gathered from
independent third parties is generally regarded as more reliable than that gathered from the
client. Managers will not always try to deceive auditors, but auditors must take the
responsibility of gathering evidence to verifying managers’ statements. The auditor needs to
be alert to the fact that some managers will try to deceive auditors sometimes.
3.28 Risk assessment — considering going concern: operating
Celebrity Land is a theme park operated by an audit client of Best Partners. It is
located on the Gold Coast and, due to its proximity to the ocean, the rides are prone
to rust and corrosion. During the 2017 school holidays, two of the most popular rides
experienced major breakdowns. Children were trapped on the rides for several hours,
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resulting in several being taken to hospital with minor injuries. An inspection

following the incident revealed that key parts needed urgent replacement. The parts
are made in the United States and imported by Celebrity Land. The cost of the
replacement parts is $3.5 million (against profit after tax in the previous year of $300
million). The repairs are scheduled to begin in April, with completion in July 2017.
Required
Discuss whether there are any events or conditions that may cast significant doubt on
the new client’s ability to continue as a going concern.
Source: Adapted from the CA Program’s Audit & assurance exam, December 2010.
Factors that may cast doubt on going concern:
- Lack of maintenance on rides – suggests sufficient cash flow not available to pay for
maintenance, or poor management of facilities (i.e. not required inspections, not
required qualified staff to operate rides.
- Two popular rides have suffered major damage – given proximity to salty conditions
(causing rust) are other rides all fully operational? Any further failures in facilities
could close theme park completely, severely damaging revenue and cash flows.
- Minor injuries suffered by patrons – is the client legally liable for damages as a result
of court cases against it for the injuries? If major damages awarded against the
client, does the client have capacity to pay?
- Most popular rides have major breakdowns – taking them out of action for several
months until repairs are completed. Major impact on revenue because theme park
would be closed or severely restricted.
- Significant cost of replacement parts (more than 10% of profit) – requires major
capital investment, is there sufficient cash flow to service the investment?
- Repairs are scheduled to be done during the period April – July – this would be ongoing
at a balance date of June (balance date not stated in the question). Auditor
would not be able to gather evidence of the successful repairs before the balance
date. Major question about client’s ability to continue at full capacity if repairs are
delayed or not successful.
3.32 Understanding the client and its risks — risk assessment
Ivy Brown is preparing a report for the engagement partner of an existing client,
Scooter Ltd, an importer of scooters and other low-powered motorcycles. Ivy has
been investigating certain aspects of Scooter Ltd’s business given the change in
economic conditions over the past 12 months. She has found that Scooter Ltd’s
business, which experienced rapid growth over its first five years in operation, has
slowed significantly during the last year. Initially, sales of scooters were boosted by
good economic conditions and solid employment growth, coupled with rising petrol
prices. Consumers needed transport to get to work and the high petrol prices made
the relatively cheap running costs of scooters seem very attractive. In addition, the
low purchase price of a small motorcycle or scooter, at between $3000 and $8000,
meant that almost anyone who had a job could obtain a loan to buy one.
However, Ivy has discovered that this year, the sales of small motorcycles and
scooters have slowed significantly and all importers of these products, not just
Scooter Ltd, are being adversely affected. Sales are down because the economic
recession has caused many people to lose their jobs. Petrol prices have fallen this
year, reducing the demand for more economical vehicles, and changes in banking
laws have meant it is harder to get loans for vehicles which cost less than $10 000.
Required
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(a) Identify the issues that potentially impact on the audit of Scooter Ltd.
(b) Explain how each issue affects the audit plan, by identifying the risks and the
financial report accounts that require closer examination.
(a) Issues:
Change from good economic conditions (solid employment growth, rising petrol
prices, easy access to credit for consumers) to recession (recession with lower
employment growth, falling petrol prices, difficult access to credit).
Changing conditions such as lower petrol prices and lower employment growth have
slowed consumer demand for scooters. Consumer demand is also likely to be
affected by less access to consumer credit for scooter purchases.
The changed economic conditions also likely adversely impact Scooter Ltd’s access
to finance (tighter finance market, slower cash flow to service debt).
(b) Impact on audit plan
Greater risk of fraudulent financial reporting because of pressure on Scooter Ltd
management to meet performance targets (either for bonuses or to satisfy bank
covenants)
Likely impact on profit:
Sales revenue: Consider risk of fraudulent transactions, cut-off (sales from future
period back-dated to the current period), revenue recognition issues (e.g. scooters
loaned to potential customers recorded as sales despite generous rights of return)
Risk associated with finance company – scooter price inflated to be above $10,000
with ‘allowance’ granted later to customer.
Expenses: Consider risk that expenses post-dated to next period to improve current
period profit.
Going concern risk – is business able to pay its debts as they fall due? What are the
terms of finance between Scooter Ltd and its banks? Is Scooter Ltd locked into a
lease on premises that are now too large?
Risk associated with staff layoffs – poor sales could lead to staff sackings not in
accordance with relevant awards, risk of successful case for unfair dismissal.
4.33 Determining audit strategy
Princess Island Vineyards is a boutique wine-maker based on Princess Island. Over
the years, the business has grown firstly by supplying local retailers, and then
through exports. In addition, there is a cellar door shop and café located next to the
main processing plant on Princess Island, serving tourists who also visit the other
specialist food and wine businesses in the region. Quality control over the wine
manufacturing process and storage of casks and bottles at Princess Island Vineyards
is extremely high. All members of the business are committed to high product quality
because any poor practices which could result in a drop in wine quality would ruin the
business very quickly.
The export arm has been built up to become the largest revenue earner for the
business by the younger of the two brothers who have run Princess Island Vineyards
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since it was established. Jim Bannock has a natural flair for sales and marketing, but
is not so good at completing the associated detailed paperwork. Some of the export
deals have been poorly documented and Jim often agrees to different prices for
different clients without consulting his older brother, Bob, or informing the sales
department. Consequently, there are often disputes about invoices and Jim makes
frequent adjustments to debtor accounts using credit notes when clients complain
about their statements. Jim sometimes falls behind in responding to customer
complaints because he is very busy juggling the demands of making export sales and
running his other business, Café Consulting, which provides contract staff for the
café business at Princess Island Vineyards.
Required
(a) Identify the factors that would affect the preliminary assessment of inherent risk
and control risk at Princess Island Vineyards.
(b) Explain how these factors would influence your choice between the predominantly
substantive approach and the lower assessed level of control risk approach for sales,
inventory and debtors.
(a) Factors affecting preliminary assessment of inherent risk include:
o Wine is vulnerable to storage conditions (temperature), suggesting high risk
of spoilage, affecting inventory valuation.
o Boutique wine operation – highly skilled processes requiring skilled staff
(winemaker), reliant on few customers?
o Export sales, foreign exchange transactions – complicated transactions with
risk of incorrect pricing, risk assessment.
o Tourism based sales at shop and café – fluctuating demand?
o Competing incentives for export sales and café consulting businesses.
o Heavy reliance on export sales increases vulnerability of business to this
source of revenue and making product available to meet this demand.
Factors affecting preliminary assessment of control risk include:
o Effectiveness over quality control over wine production and storage, affecting
saleability of product (although quality control is apparently high).
o Risk of product spoilage, affecting value of inventory.
o Controls over sales made by Jim, documentation, pricing, sales allowances.
o Lack of communication between Jim and brother Bob and other staff –
affecting efficiency and effectiveness of management.
(b) Lower assessed level of control risk approach is appropriate when control risk is
assessed as low while predominantly substantive approach is appropriate when
control risk is assessed as high, and it is more efficient not to rely on controls.
For Sales:
The poor communication between Jim and other management and staff, plus his
competing incentives and the lack of control over his actions means that control risk
in these areas would be considered high. The validity of sales transactions, including
the amounts and terms of the sale, is at risk. There is also a risk that sales made to
customers are not entered correctly in the accounts.
Control risk for sales and debtors is high, meaning that the predominantly substantive
approach would be adopted in these areas.
For Inventory:
Control over production appears to be good, and inventory quality seems to be high.
However, the inherent risk of inventory spoilage is reasonably high. This suggests
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that a lower assessed level of control risk could be adopted for inventory. Testing the
controls over inventory, and obtaining satisfactory results, would mean that less
substantive testing would be required.
For Debtors:
A predominantly substantive approach for sales is more appropriate because the
adjustments to debtor accounts do not appear to be adequately controlled. Rather
than developing and implementing a policy and procedures on credit notes, Jim
frequently issues credit notes to clients who complain about their statement without
investigating it. Also the lack of resources to follow company’s protocol (i.e. Jim is to
too busy to respond to customer complaints) increases the control risk.
6.33
Dolphin Surf & Leisure Holidays Pty Ltd (Dolphin) is a resort company based on the
Great Barrier Reef. Its operations include boating, surfing, diving and other leisure
activities, a backpackers’ hostel, a family hotel and a five-star resort. Justin and Sarah
Morris own the majority of the shares in the Morris Group which controls Dolphin.
Justin is the chairman of the board of directors of both Dolphin and the Morris Group,
and Sarah is a director of both companies as well as the CFO of Dolphin.
Justin and Sarah have a fairly laid back management style. They trust their workers to
work hard for the company and reward them well. The accounts staff, in particular, are
very loyal to the company. Justin tells you that some accounts staff enjoy their jobs
so much they have never taken any annual leave, and hardly any workers ever take
sick leave. Justin and Sarah have not bothered much in the past with formal
procedures and policies, but they have requested the accounts staff to start
documenting the more common procedures. They do not conduct formal performance
reviews; they rely on their staff to tell them when there is a problem.
There are three people currently employed as accounts staff, the most senior of which
is Peter Pinn. Peter heads the accounts department and reports directly to Sarah. He
is in his fifties and plans to retire in two or three years. Peter prides himself on his
ability to delegate most of his work to his two accounts staff, Kristen and Julie. He
claims he has to do this because he is very busy developing the policy and
procedures manual for the accounting department. The delegated work includes
opening mail, processing payments and receipts, banking funds received, performing
reconciliations, posting journals and performing the payroll function. Julie is a recent
Chartered Accountant graduate. Kristen works part time — coming into the office on
Mondays, Wednesdays and Fridays. Kristen is responsible for posting all journal
entries into the accounting system and the payroll function. Julie does the balance of
the work, but they often help each other out in busy periods. Kristen authorises
Julie’s transactions and Julie returns the favour by authorising Kristen’s transactions.
Together, they usually make the accounts balance.
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6.33 Internal control components

(a) Explain how the internal control components are usually adjusted to meet
the needs of small entities. What advantages and disadvantages does this
bring?
(b) Assess the internal controls at Dolphin. What changes would you
recommend?
(a) Small entities have limitations in their ability to implement a comprehensive control
system. There are fewer employees in small entities, which means that segregation of
incompatible duties is harder to organise. In addition, small entities usually do not have
formal documentation of their control systems, making assessment of their design
effectiveness more difficult. However, managers of smaller entities (who are usually also the
owners) are able to have a greater personal involvement in all aspects of the business and
are therefore able to monitor activities directly. With direct monitoring, many departures from
control systems could be detected. The effectiveness of this direct monitoring is dependent
on managers’ knowledge and interest in controls, which could be low. Managers may also
be tempted to override systems because they do not distinguish between their interests and
the interests of the entity.
(b) There is little separation between the board and the senior management – Sarah is both
CFO and director of both Dolphin and the Morris Group. The control environment would be
stronger if the CFO and the director positions were split.
Management philosophy and operating style are ‘laid back’, suggesting that formal control
structures are not in place. Although some documentation is now being done, it is being
done at a low level rather than being designed by senior management. There is a risk that
the documentation will be incomplete, without the necessary review procedures.
Peter Pinn does not appear to be very active in reviewing the performance of the more junior
staff, and there is a lack of clear information on whether Sarah is adequately supervising
Peter. The lines of accountability should be stronger and because of the small size of the
accounts department, should include periodic reviews of transactions authorised and
processed at lower levels.
There appears to be a lack of adequate segregation of duties, both Kristen and Julie are
involved in opening mail, processing transactions, banking, bank reconciliations, and payroll.
These duties should be segregated so that staff handling cash are also not able to record
transactions. Bank reconciliations and reviews of journal postings should be done by Sarah
or Peter, and they should also be authorising transactions. There appears to be no separate
HR function and there is a danger that payroll is not valid.
Overall, the internal controls appear to have deficiencies. The documentation should be
completed by Sarah and she should take more responsibility for overseeing the operations
of the accounts department. Peter does not appear to be performing the necessary
authorisation and supervision roles.
Questions 7.36 and 7.37 are based on the following case.
Chan & Partners Chartered Accountants is a successful mid-tier accounting firm with
a large range of clients across Australia. During the 2017 year, Chan & Partners
gained a new client, Medical Services Holdings Group (MSHG), which owns 100 per
cent of the following entities:
 Shady Oaks Hospital, a private hospital group
 Gardens Nursing Home Pty Ltd, a private nursing home
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 Total Cancer Specialists Limited (TCSL), a private oncology clinic that

specialises in the treatment of cancer.
Year-end for all MSHG entities is 30 June.
During the 2017 financial year, Shady Oaks released its own range of medical
supplies such as bandages and first aid kits, which are sold via direct marketing by a
sales team employed by the hospital. The sales team are remunerated via a base
salary and a bonus component which is based upon the dollar value of sales they
generate. You recognise that their main motivation is to maximise their bonuses. You
select a sample of payments received by the hospital post year-end and trace back to
the general ledger and customer account balance.
In addition, you are reviewing the results of a number of tests in relation to accounts
payable at Gardens Nursing Home, as follows.
7.36 Substantive testing and assertions2 8
(a) Identify the key account balance at risk because of the sales team
remuneration at Shady Oaks. Also identify and explain the key assertion at
risk.
(b) Identify the key account balance and key assertion being tested with the
substantive procedure. Given the bonus structure in place for the sales
team, justify your answer.
(a) The sales team are remunerated in two ways; a base salary plus a bonus based on the
dollar values of sales. The bonus payment increases if the sales person increases recorded
sales. An inappropriate way of increasing sales is to record sales during the year for
samples given to customers. When the sample is returned following the year-end the sale is
reversed or adjusted with a sales return or allowance. Another way of increasing sales is to
falsify sales by recording a sale to a fictitious customer. The account balance is eventually
written off for non-payment of the account. The sales and accounts receivable account
balances are at risk because of these practices. The assertions at risk are occurrence and
existence for the sales transaction and accounts receivable balance. In addition, the
valuation and allocation assertion for accounts receivable is at risk because the balance
does not represent the amount that is reasonably expected to be received from customers.
(b) The substantive test described in the question is to take a sample of payments received
by the hospital (i.e. cash receipts) and trace back to the general ledger and customer
account balance. Performing this test will provide evidence about the existence/occurrence
assertion for the accounts receivable and sales balances, and the valuation and allocation
assertion for accounts receivable. If the client receives cash for the credit of an accounts
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receivable this is reliable evidence that the recorded sale did occur and that the balance of
accounts receivable was fairly stated at the year-end.
The reference to the bonus structure is to reinforce the risk to the occurrence assertion for
sales and the valuation and allocation assertion for accounts receivable.
7.37 Substantive testing versus control testing 1 8
For each of the test results for Gardens Nursing Home:
(a) Identify whether this is a test of controls or a substantive test of detail.
(b) Determine the key assertion addressed by the test procedure.
(c) Explain why the conclusion reached is appropriate or inappropriate.
(d) Outline the key additional procedure that you believe needs to