Solutions manual

to accompany

AUDIT AND ASSURANCE

Leung, P., Coram, P., Cooper, B.J., Richardson, P. (2019). Audit and Assurance
(1st Ed), John Wiley & Sons Australia (ISBN:9780730363477)

The following questions and answers are from John Wiley & Sons
and reproduced with permission of the publisher

© John Wiley & Sons Australia, Ltd 2019

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Chapter 7: Client evaluation and planning the audit

Review questions
7.13 What are the benefits of audit planning?
Benefits include allowing the auditor to:
• Direct attention to the key areas for the audit.
• Identify and resolve potential problems efficiently.
• Identify the mix of skills required to respond to identified risks.
• Select, direct, supervise, manage, including reviewing the work performed by, the
audit team.
• Ensure the audit is performed in a controlled manner.

7.18 What are the auditor’s responsibilities in relation to fraud?

The activities that the auditor will carry out include procedures to:
• Identify and assess the risks of material misstatement due to fraud.
• Ensure the audit team is aware of the risks of fraud and their responsibilities in
response to those risks.
• Design and implement appropriate responses to the fraud risks identified.
• Respond to any fraud or suspected fraud identified during the audit.

Professional application questions

7.25 Planning the audit 
Your client is Gateshead Pty Ltd, a large family-owned company which imports and
sells computer hardware products. You are planning the 30 June 2019 audit and,
from your enquiries of management, have obtained the following information.
1. In January 2019, Gateshead applied for and was granted a new loan. The
submission made to the bank stated:
• The current ratio was 0.90
• Gross profit was up by 25% compared with that at the same time last year
• The debt-to-equity ratio was 0.40.
2. The bank agreed to the new loan but did enter into a loan covenant with
Gateshead. The covenant required that the company should not breach certain
ratios, and placed certain restrictions on dividends.
From audits you have conducted in previous years, you are suspicious about the
validity of the ratios discussed in the submission. You hear from one of Gateshead’s
accounting staff that the figures had been ‘gently massaged’ to obtain the required
ratios.

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Required
Discuss (referring to specific areas of the audit) the implications of this information
on your planning of the audit.
This information will affect the planning of the audit for the year quite significantly as
a result of the analytical procedures carried out (ASA 520). It indicates that there is a
high risk of balances within the financial statements being manipulated to ensure that
the company achieves the requirements of the bank covenant with regard to financial
ratios. In particular, the comment that figures have been ‘gently massaged’ should be
a cause for concern.
Particular risks:
Industry Computer hardware
Risk Potential risk of obsolescence in the inventory held because it
is a product that becomes obsolete very quickly.

Loan Current ratio requirements

Risk The company may attempt to overstate current assets and understate
current liabilities to comply with the loan agreement. They may do this
by not providing for doubtful debts or overvaluing inventory. Accruals
may not be completely recorded.

Loan Company has stated that the gross profit was increased by 25%.
Risk There is a risk that the cut off for sales has not been properly
effected. This should be carefully reviewed in the audit at the
year-end.

Loan Debt to equity ratio

Risk This is more difficult to manipulate, however the auditor should look
for potential misclassification.
It is important for auditors to evaluate the compliance of companies with financial
ratios. The implications of a lack of compliance may be quite severe for the company,
including potential going concern problems.

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7.26 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.

30 June 2020 30 June 2019

(draft) (actual)

Revenue 536 994 617 140

Cost of sales (322 187) (302 788)

Gross profit 214 807 314 352

Other income ̶ 7 186

Operating expenses

Administration (95 438) (92 064)

Selling and distribution (50 575) (79 933)

Finance costs (7 434) (7 623)

Profit/(loss) before tax 61 360 141 918

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Ratio calculations

Ratio Formulae 2020 2019

Gross profit margin Gross profit ÷ Net sales 40% 51%

Profit margin Profit ÷ Net sales 11% 23%

Times interest Profit before income taxes and interest 9% 20%

earned expense ÷ interest expense

Trend analysis

30 June 2019 30 June 2020 30 June 2020

Income statement items (actual) % (draft)

Revenue 617 140 (13) 536 994

Cost of sales (302 788) 6 (322 187)

Gross profit 314 352 (32) 214 807

Other income 7 186 (100) —

Operating expenses

Administration (92 064) 4 (95 438)

Selling and distribution (79 933) (37) (50 575)

Finance costs (7 623) (2) (7 434)

Profit/(loss) before tax 141 918 (57) 61 360

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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 possible understatement. Specific attention may also be
necessary 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 potential
problems associated with overstatement of purchases relating to payables and inventory.
These purchases may also not have been recorded in the correct time period. It may also
indicate potential understatement problems for inventory quantities.
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 their spending 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.

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7.28 Planning 

Needles and Glue Ltd is an online retailer of a broad range of art and craft products.
You are an audit senior at the firm Naylor Swit & Co and are planning the financial
report audit for the year ended 30 June 2019. Needles and Glue is a new client to
your firm and this is the first year-end since you were appointed. The following
information was obtained from a meeting with the CEO, Barbara Wool.
The company has managed to ride a wave of renewed interest by younger
people in arts and crafts and the revenue for 2019 is approximately $3.2 million. This
continues a trend that has seen revenue increase by between 20% and 30%
consistently for the six years since the company was started by Barbara and her
tennis partner Sandra Cloth who is the COO. Profits in 2019 are $0.2 million and have
not increased significantly in four years despite the increased turnover. In 2020,
there are plans to broaden the range of products sold to include bedding, curtains
and household furnishings.
Rapid expansion has put pressure on the company’s systems, not least of
which is the online sales order system. Needles and Glue do not have their own in-
house IT function, relying on Barbara’s sister Tabatha who is responsible for
accounting, IT, HR, payroll and general office management.
You are aware that, in previous years, errors had been detected at the audit
stage, partly due to IT system errors and partly due to Tabatha’s inexperience as an
accountant. Barbara and Tabatha are confident that any errors in the financial
report will be immaterial and not worth investigating given how busy they are with
the growing business.
As part of the growth of the business, the company is looking to raise
additional bank borrowings to fund more warehouse space and invest in
improvements to the IT systems. Barbara has indicated that she needs the audit
report signed before 18 September which is when she will be meeting the bank to
discuss the details of the loan.
Required
Identify the issues that give rise to risks for the financial report audit you are about
to commence.

Risks to be addressed in the planning of the audit:

First year of audit
This is the first year that the firm has audited the financial report and given the risks
outlined below the audit team will need to be vigilant to ensure audit risk can be
minimised. This may involve including more senior and experienced staff on the audit
team.

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Going concern risk and over-trading

Rapidly increasing revenue without a similar increase in profits might indicate the risk
of overtrading. Overtrading creates a risk of running out of cash in spite of the
increasing revenue. The need for additional bank loan funding might also suggest that
the cash reserves of the business are under pressure.
Continued expansion and investment in the new warehouse and IT is likely to put
more pressure on cash reserves. Borrowings will require interest payments putting
more pressure on profits. With low profit levels, there may be only limited ability to
borrow, there is therefore a risk that inadequate funds will be available for expansion.
With cash flow difficulties, suppliers may be paid late and some may stop supplying if
agreed terms are breached.
The audit risk is that going concern risks are not disclosed or that the financial report
should be prepared on a breakup basis.
Selling a new range of products
The new products being sold are different to the existing product lines. They may be
sold to a similar customer group but there is a risk that obsolete stock will remain in
the balance sheet. The audit risk is that stock is over-valued in the balance sheet where
they should be written down to net realisable value.
IT control systems
There appears to be poor internal controls which leads to a risk of undetected errors
in the financial report. There is a business risk that problems arise in meeting orders
from customers leading to lost revenue.
Bank financing
It is likely that the audited financial report will form part of the decision making
process for the bank in deciding whether to lend the company money. There is a risk
that the bank might look to sue the auditor if the bank suffers a loss from the non-
repayment of the loan that might arise if the financial report contained errors that the
auditor did not detect.

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