Background theory

Background theoryAccording to ASA 315 :gaining anunderstanding of the client is necessary to assess the risk that the financial report contains a material misstatement due to: The nature of the clients business The industry in which the client operates The level of competition within that industry The clients customers and suppliers The regulatory environment in which the client operatesSelection and application of accounting policiesThe entitys objectives and strategies and related business risk(ASA 315 para.11)

With the access to prior financial report, the auditor can use the information to perform an analytical procedures thus gaining the understand of the entitys ratios, trends thus assisting in assessing risk of material misstatement (ASA 315, Para. A14,15). In addition, accessing to the entitys financial reports can also provide information regarding the selection and application of accounting policies such as revenue recognition, accounting for fair value, source of finance, ownership structure, nature of employment contract, provision for warrantiesMeasure and review of entitys financial performance thus helping auditor consider whether the pressures to achieve the target goal may result in management action that increase the risk of fraud. -Related risks that the company is facing that could result in risks of material misstatement.

Anticipated result for the current year could assist the auditor in understanding the clients expectations regarding growth (decline).The auditor can also examine whether the actual change reflected in the account (new bank loan used to purchase equipment or expansion). The report can be used to understand the difference between peaks and off-peaks period and how it affects profit of the company The reports also identify some issues regarding provision for annual leave or other leaves associated with senior staffs retirement related provision.

By accessing to industry comparisons, auditor can compare the firm to other firms in the industry especially whether the firm is following the current major trends in the industry as economic condition changes.The auditor also can obtain information about the occupancy rate, visitors numbers, staff numbers and compare them to financial data.The regulatory environment and level of competition in tourism industry

According to ASA 240, auditor has the responsibility to assess risk of material misstatement due to fraud .

During the audit, the auditor is responsible for :-Maintaining professional scepticism -Considering the potential for management override of controls Recognising that audit procedures may not effective in detecting fraud (ASA 240. Para 8).

Misstatement in financial report can arise from fraud or error. Fraud is misstatement that are done intentionally (ASA 240. Para 2).

The accounts that are at risk includingRevenue in PLAccount receivable in BLCash from operations in Cash flow statementThis fraud is a misappropriation of asset fraud -Unauthorised discount to customers. The collusion resulted in reduced fees for patients thus revenue is understated for various medical and other services as well as room charges. As a result of this, account receivable on the balance sheets and cash in cash flow statement are also affected cause they would be understated.

Effect of the fraud on the entityGarden Nursing Home appears less profitable than it is.As a result, this could impact on staffing decisions, equipment purchase, loan covenants .Due to poor internal control, The ramifications on control environmentConditions lead to fraudOther controls are inadequateManagement and supervision

Effect of the fraud on auditorExternal auditor will focus on how the fraud affect the financial statements where are the likely misstatement (revenue, account receivable, cash) and how poor internal control systems affected the quality of the accountsInternal auditors will focus on wider implication of internal system breakdown - How are management objective achieved if controls are week.-Implications on future business plan or operations.

Background theoryMaterial guides audit planning, testing and assessment of information in the financial reportTwo characteristics:Qualitative materiality: information that impacts a users decision-making process for a reason other than its size. such as a fraud, non-compliance with lawsQuantitative materiality: information exceeds an auditors preliminary materiality assessmentAuditor has to uses professional judgement in setting materiality based on inherent risk and control risk ( opposite direction).

Discovering evidence that the client is having ongoing cash flow issues is relevant to the audit because the audit can assess which accounts could possibly be at risk for material misstatement. Eg: Debt may fall due earlier then it must be classified as current debt instead of non current.In addition, suppliers request cash on deliver meaning if not enough cash the client may suffer loss of safe thus leading to negative effect on the clients financial positions and greater risk on undetected errors.

Moreover, the auditor is required to assess the going concern assumption of the client thus more evidences would be needed to assess the validation of the assumption since there are more risks indicators including : Long term fall dueSuppliers problemProblem obtaining raw materials etc (ASA 570)

As a result, materiality level at a quantitative perspective needs to be set at a lower level since it is expected that there are more misstatement in the accounts.

Background theoryAudit strategy: set scope, time and direction of the audit based of preliminary assessment of the IR and CR.-Low CR/IR = auditor will to rely on internal control to detect material misstatement and must conduct control test to find out if the internal control are operative (control testing)-High CR/IR = auditor will to rely on substantive testing (checking accounts, transactions and balances) to detect material misstatement.

The initial strategy of the auditor is to rely on the internal control to detect material misstatement because the assessment of control risk is low. The strategy is conducted by testing the effectiveness of the internal control to see if it is operating correctly associated with some substantive test to back up.

However, during the subsequent test of internal controls, the auditor has found that there are deviations in the operation of the internal control thus the preliminary assessment of control risk needs to be adjusted to a higher level Therefore the initial strategy for low control risk is no longer appropriate.

As a result, the auditor needs to Set a higher level of control risk thus the detection risk is heading toward lowReports the deviations to the governance Therefore, auditor needs to conduct more amount of substantive testing along with the internal control.

Background theory-Inherent risk is the possibility that material misstatement could occur in an assertion either individually or when aggregated with other misstatements, assuming there are no related controls (ASA 200, para 13(n))-Control risk is the risk could occur in an assertion, either individually or aggregated with other misstatements and not be prevented, detected, corrected by entity s internal control (ASA 200, para 13 (n)) -The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial report and assertion levels (ASA 315 . Para 5).

Inherent riskCheese is perishable risk of spoilage- affecting inventory valuation- affecting inventoryBoutique cheese operation- required high skilled staff- affecting sales, debtors, inventoryExport sale, foreign exchange transaction- complex transaction and exposed to incorrect pricing affecting salesTourism sales based at caf and shop- fluctuating demand affecting salesHeavy reliance on exporting sales exposes the business to this source of revenue- affecting sales

Control riskEffectiveness over quality control of cheese operation affecting saleability of product ( although this is a low risk)- affecting inventoryRisk of product spoilage -> inventory valuationControl of document, pricing, sale allowances made by Jim affecting sales, debtorsLack of communication between Jim and his brother and other staff affecting sales, debtors.Adjustment to debtors is inadequate -> affecting debtors

The poor communication between Jim and other management and staff is poor thus the control over sales and debtors are at high risks.The validity of sale transactions including terms and amount is at risk.There is also a risk that sale amount is not entered correctlyAdjustment made to debtors is not correctly controlledTherefore, it is likely that substantive control would be eligible for debtors and sales.

Control over product quality appears to be good and inventory quality seems to be high.However, the inherent risk of spoilage is greatThus it is suggested that control test could be adopted to inventory but substantive test is still required as back up. However, if under control test , deviations are detected then it will require more substantive test for inventory.

Background theory -Inherent risk is the possibility that material misstatement could occur in an assertion either individually or when aggregated with other misstatements, assuming there are no related controls (ASA 200, para 13(n)) -The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial report and assertion levels (ASA 315 . Para 5).

Source of inherent riskNature of clients businessNature of data processing systemComplexity, lack of integrity, sloppy management practice.Clients motivationResults of previous auditRelated party transactionsNon-routine transactionHigh judgementSusceptibility to theft.

Industry levelThe competitive market tendering to win government contracts- involve complexity, high judgement. Defense industry- sensitive to product information, customer information, highly regulated.Susceptibility to theft

Entity levelHigh reliance on one product, export customers creates risk to revenue stream.Pricing of sophisticated product designed to meet customers requirement- high judgementSophisticated product designed and costing information thus risks of standard costing, inventory movement. Risk of foreign exchange dealings