ch18 sm maas5

SOLUTION MANUAL

to accompany

MODERN AUDITING

&

ASSURANCE SERVICES 5th edition

Prepared by

Philomena Leung, Barry J. Cooper and Peter Richardson

© John Wiley & Sons Australia, Ltd 2011

Solution Manual to accompany Modern Auditing and Assurance Services 5e

Chapter 18 Completing the audit and other services

Review questions

18.11 Explain the auditor’s responsibility for identifying and acting on events after the end of the reporting period. Is there an ‘end point’ to the auditor’s responsibilities?

There are two main dates of importance in determining the auditor’s responsibilities. They are the dates when the audit report is signed and when the financial report is issued. In the period before the audit report is signed the auditor has a responsibility to discover and evaluate all subsequent events that may have a material effect on the financial report. In the period after the audit report has been signed but before the audit report has been issued the auditor does not have a responsibility for identifying after balance date events. However, the auditor does need to examine events that come to his or her attention. After the auditor report has been issued, the auditor has a responsibility to examine only events that come to his or her attention and that existed at the date of the audit report. So these are events that the auditor effectively ‘missed’ in the performance of the audit. After the audit report has been issued – this is the ‘end point’ to the auditors’ responsibilities because ‘new’ events have no impact on the audit report.

18.12 Can facts discovered after the issue of the financial statements have an impact on the auditor’s report? Discuss.

An auditor has no responsibility to make an on-going inquiry on the financial report after it has been issued. The key difference in the period after the financial report has been issued is that the only event that concerns the auditor is something that he or she missed before signing the audit report that has now come to light. This is in contrast to the period before the financial report has been issued when the auditor must consider whether to take action in relation to any event that he or she becomes aware of. This limitation in the period after the financial report has been issued ensures that there is an end point to the auditor’s responsibilities in relation to a company’s financial statements for a particular year.

The main issue for the auditor to consider in assessing the impact of this event is to determine whether or not, if the event were known at the date of the audit report, the auditor would have qualified the audit report. If the auditor would have qualified the audit report, he or she should consider whether the financial report needs revision. If management does not agree to the revision, the auditor should notify the persons ultimately responsible for the overall direction of the entity that action will be taken by the auditor to prevent future reliance on the audit report.

The preferred result is the preparation of a revised financial report by the client and the issuance of a revised audit report as soon as practicable. Again, prior to the issuance of a revised audit report the auditor should extend the review of subsequent events up to the date of the issuance of the revised report. The new report should

© John Wiley & Sons Australia, Ltd 2011 18.2

Chapter 18: Completing the audit

include an emphasis of matter paragraph referring to a note in the financial statements that provides an explanation for the revision of the previously issued financial report and the earlier audit report.

18.13 How would you define the two types of events that occur after the reporting period? What are the potential accounting effects of each type?

Conditions existing at the reporting date (adjusting events)Events that provide additional evidence with respect to conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing the financial report. These events may require adjustment of the financial report.

Conditions arising after the reporting date (non-adjusting events)Events that provide evidence with respect to conditions that did not exist at the date of the balance sheet but arose subsequent to that date. These events require disclosure, and in very material cases, by attaching pro-forma data to the financial report.

18.14 What procedures should the auditor perform when a question arises regarding going concern?

The auditor performs most of these procedures during the period of completion of the audit (ASA 570.16), such as:

Analysing and discussing cash flow, profit and other relevant forecasts with management.

Analysing and discussing the entity’s latest available interim financial report. Reading the terms of debentures and loan agreements and determining

whether any have been breached. Reading minutes of the meetings of shareholders, those charged with

governance and relevant committees for reference to financing difficulties. Enquiring of the entity’s legal counsel regarding the existence of litigation and

claims and the reasonableness of management’s assessments of their outcome and the estimate of their financial implications.

Confirming the existence, legality and enforceability of arrangements to provide or maintain financial support with related and third parties and assessing the financial ability of such parties to provide additional funds.

Evaluating the entity’s plans to deal with unfilled customer orders. Performing audit procedures regarding subsequent events to identify those that

either mitigate or otherwise affect the entity’s ability to continue as a going concern.

Confirming the existence, terms and adequacy of borrowing facilities. Obtaining and reviewing reports of regulatory actions. Determining the adequacy of support for any planned disposals of assets.

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18.15 Should management representation be in written form? What are the objectives of a management representation as opposed to a communication with those charged with governance?

Written representations are an important source of audit evidence. If management modifies or does not provide the requested written representations, it may alert the auditor to the possibility that one or more significant issues may exist. Further, a request for written, rather than oral, representations in many cases may prompt management to consider such matters more rigorously, thereby enhancing the quality of the representations. (ASA580)

The objectives of a management representation letter are to: Confirm with management and those in charge with governance that they have

fulfilled their responsibility for the preparation of the financial report and for the completeness of the information provided to the auditor.

Support other audit evidence relevant to the financial report or specific assertions in the financial report.

A representation letter may complement other auditing procedures or it may be the primary source of audit evidence, which cannot be corroborated through other auditing procedures. It is not, however, a substitute for other auditing procedures.

On the other hand, the objectives of the auditor in communicating matters with those charged with governance are:

To communicate clearly with those charged with governance the responsibilities of the auditor in relation to the financial report audit, and an overview of the planned scope and timing of the audit;

To obtain from those charged with governance information relevant to the audit;

To provide those charged with governance with timely observations arising from the audit that are significant a relevant to their responsibility to oversee the financial reporting process; and

To promote effective two-way communication between the auditor and those charged with governance. (ASA260)

18.16 Explain the purpose of the performance of analytical procedures at the end of the audit.

The objective of using analytical review in the overall review is to corroborate conclusions formed during the audit on individual elements of financial information and to assist in arriving at the overall conclusion that the financial information as a whole is consistent with the knowledge of the entity’s business. Analytical review procedures applied at the end of the audit are also a useful method in gaining assurance that the company will remain a going concern for the relevant period.

18.17 Describe the various steps required in completing the audit.



a) Undertaking a review of subsequent eventsThe auditor is responsible for designing specific procedures to identify subsequent events that may have an impact on the financial statements before the auditor’s report is signed, as discussed in ASA 560 Subsequent Events (ISA560).In identifying subsequent events, the auditor needs to consider two separate issues. First, the auditor must assess whether it is an event on which he or she has a responsibility to act (ASA560; ISA560). Second, if the auditor does have a responsibility to take action, he or she must consider the appropriate reporting treatment for the subsequent event (AASB110 Events after the Reporting Period; IAS10)

b) Considering the appropriateness of the going concern assumptionWhen the use of the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business. The auditor must consider whether applying this basis is appropriate in the valuation and allocation of items appearing in the financial statements and in the support of the directors’ assertion as to solvency in the directors’ declaration. ASA570 (ISA570) requires the auditor to assess the risk of going concern problems at the planning stage and again during the final review. Where a going concern problem is identified, the auditor will need to discuss with management its plans for alleviating the problem, such as raising additional finance, disposing of surplus assets or selling loss-making business operations. The auditor will need to obtain written representation concerning such plans and should consider their feasibility by analyzing their effect on cash flow or other relevant forecasts.

c) Reviewing for contingent liabilitiesIrrespective of whether conditional liabilities should be recognised as liabilities or otherwise describe in the notes, they are of relevance to the auditor because they are unlikely to be recorded in the accounting records until the occurrence of the uncertain future event. Therefore, there is a risk that they will not be completely and properly disclosed. These obligations include potential liabilities from income tax disputes, product warranties, guarantees of obligations of others, and litigation and claims.

d) Written representationsASA580 Written Representations (ISA 580) requires the auditor to obtain written representations from management and, where appropriate, those charged with governance in an audit of financial report. The auditor shall request written representations about management’s responsibilities regarding the following matters:

The preparation of the financial report in accordance with the applicable financial reporting framework, including where relevant their fair presentation, as set out in the audit engagement

All relevant information and access as agreed in the terms of the audit engagement has been provided to the auditor

All transactions have been recorded and are reflected in the financial report.A representation letter may complement other auditing procedures or it may be the primary source of audit evidence, which cannot be corroborated through other auditing procedures. It is not, however, a substitute for other auditing procedures as it is judged to have relatively low reliability.e) Performing analytical procedures

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The auditor designs and performs analytical procedures near the end of the audit to arrive at an overall conclusion as to whether the financial report is consistent with the auditor’s understanding of the entity. In carrying out an overall review, the auditor reads the financial statements and accompanying notes.

18.18 What should the auditor do when aggregate uncorrected misstatements are material?

If the aggregate uncorrected misstatements are material, the auditor needs to consider reducing audit risk by extending audit procedures or requesting management to adjust the financial report. In planning the audit, the auditor has specified an acceptable level of audit risk. As the aggregate level of uncorrected misstatement increases, the risk that the financial report may be materially misstated will also increase. When the auditor concludes that audit risk is at an acceptable level, he or she can proceed to formulate the opinion supported by the findings. However, if the auditor believes audit risk is not acceptable, he or she should either perform additional substantive procedures or convince management to make the adjustments necessary to reduce the risk of material misstatement to an acceptable level. If management does not make the adjustments as required by the auditors, the auditor may decide to issue a qualified audit report.

18.19 Discuss the audit partner’s responsibilities in evaluating the findings of the audit.

The audit partner is ultimately responsible for the audit opinion so therefore he or she has considerable involvement in the final stages of an audit. The partner’s main involvement is in the final review of working papers and formulating the audit opinion. The review by the partner has similar objectives to the review performed by the manager. The extent of the partner review will depend on the partner, the type of engagement, and the partner’s confidence in the audit manager. Generally the partner will review not all working papers. The partner will tend to focus on sections of the audit that he or she perceives to be high risk. This assessment may come from the partner’s knowledge of the client or from the final analytical review performed on the client.

In completing the audit, the separate findings of each of the sections need to be summarised and evaluated so as to express an opinion on the financial report as a whole. The ultimate responsibility for these steps rests with the partner in charge of the engagement. In some cases, the audit manager makes the initial determinations, which are then carefully reviewed by the partner.

Before reaching a final decision on the audit opinion, a meeting should be held with management. At this meeting, the partner reports the findings orally and attempts to provide a rationale for proposed adjustments and/or additional disclosures that have not been resolved. Management, in turn, may attempt to defend its position. In practice, agreement is generally reached on the changes to be made and the partner can proceed to issue an unqualified opinion



18.20 Do you think the auditors should be more careful in arriving at the audit opinion of a financial report audit in times of economic crisis? Why?

Yes. In the times of economic crisis many companies will try to manipulate the accounting numbers in the financial statement as to look better, to achieve a certain debt covenant ratios, etc. The company might have some going concern issues that are not represented in the notes of the financial statements or not communicated by management to the auditors. This will obviously increase the risk of material misstatement which will in turn lead to higher audit risk. Auditors should consider many factors before arriving to the audit opinion; if the auditors issued a wrong audit opinion, they might be sued for negligent conduct. Therefore, auditors should exercise due care and diligence as well as professional skepticism in auditing a client’s financial reports.

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Professional application questions

18.21 Subsequent events

Required

(a) In your memo explain the auditor’s responsibilities for identifying subsequent events in the following periods:

30th June 2011 to 31st August 2011 1st September 2011 to 15th September 2011 18th September 2011 to 30th September 2011 1st October 2011 onwards

Memo

To: Managing Director – Topporene Ltd

30 June 2011 to 31 August 2011Events occurring up to the date of the audit report

The auditor is required to perform procedures to identify and evaluate all events that might require adjustment or disclosure in the financial report up until the date the audit report is signed. This responsibility is discharged by the auditor in the following two ways: (1) by being alert for subsequent events in performing year-end substantive procedures (such as cut-off tests and the search for unrecorded liabilities); and (2) by performing the auditing procedures specified in ASA 560.10 (ISA 560.07) at or near the completion of the examination (discussed below in (b). If the audit procedures identify events that could affect the financial report, the auditor should carry out further procedures to assess whether such events are appropriately reflected in the financial statements. At this point the auditor needs to consider the appropriate accounting treatment of the event as discussed in page 773.

1 September 2011 to 15 September 2011Post-Audit responsibilities for subsequent events

After the audit report has been signed the auditor has no responsibility to perform procedures to detect subsequent events or to make any inquiry regarding the financial report. This is one of the reasons why the date on the audit report is important; the audit report should be signed on the same day as the directors’ report where possible. However, if the auditor becomes aware of a fact after the audit report has been signed, it may be appropriate to take some type of action. The action the auditor should take depends on whether the fact is discovered after the date of the audit report but before the issuance of financial statements or after the financial report has been issued.



16 September 2011 to 30 September 2011Events occurring after the date of the audit report but before the financial report is issued

The auditor has no responsibility to make an inquiry or to perform auditing procedures during this time to discover any material after-balance-date events. However, during this period, management is responsible for informing the auditor of any events that may affect the financial report. The events may relate to conditions existing at reporting date or conditions existing after reporting date. The need to amend the financial report should be considered and discussed with management.

If the financial report is amended, the auditor must carry out any necessary auditing procedures, including extending the review of after-balance-date events, and reissue the audit report at the date of approval of the amended financial report. If management do not amend the financial report where the auditor believes it should be amended, and the audit report has not been released to the entity, the auditor should issue a qualified report in accordance with ASA 705 (ISA 705). If the financial report has been released to the entity and management refuses to make the required amendments the auditor should take action to prevent reliance on the audit report. This can be done, for example, by exercising the auditor’s right to be heard at the general meeting at which the audited financial report is presented to members.

1 October 2011 onwardsFacts discovered after the financial report has been issued

An auditor has no responsibility to make an on-going inquiry on the financial report after it has been issued. This responsibility is essentially the same as during September where action by the auditor is only required if he or she becomes aware of an event. The key difference in this period is that the only event that concerns the auditor is something that he or she missed before signing the audit report that has now come to light. This is in contrast to September when the auditor must consider whether to take action in relation to any event that he or she becomes aware of. This limitation from 1 October ensures that there is an end point to the auditor’s responsibilities in relation to a company’s financial statements for a particular year. The main issue for the auditor to consider in assessing the impact of this event is to determine whether or not, if the event was known at the date of the audit report, the auditor would have qualified the report.

If the auditor would have qualified the audit report, he or she should consider whether the financial statements need revision. If management does not agree to the revision, the auditor should notify the persons ultimately responsible for the overall direction of the entity that action will be taken by the auditor to prevent future reliance on the audit report. The preferred result is the preparation of a revised financial report by the client and the issue of a revised audit report as soon as practicable. Again, before a revised auditor’s report is issued, the auditor should extend the review of subsequent events up to the date of the issuance of the revised report. The new report should include an emphasis of matter paragraph referring to a note in the financial statements that

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provides an explanation for the revision of the previously issued financial report and the earlier audit report. The new report should be dated not earlier than the date on which the revised financial statements are approved. If the issue of the following period’s financial statements is imminent, then the revised financial statements may not be issued. However, in these circumstances, appropriate disclosures are required in the following period’s statements.

(b) Discuss the procedures that are involved in identifying subsequent events.

ASA 560.10 (ISA 560.07) suggests some of the following: Reviewing procedures that management has established to ensure that

subsequent events are identified; Enquiring of management and where appropriate, those charged with

governance, as to whether any subsequent events have occurred which might affect the financial report;

Reading minutes of the meetings of shareholders, those charged with governance, audit and executive committees held after the end of the reporting period, and enquiring about matters discussed at meetings for which minutes are not yet available;

Reading the entity’s latest available interim financial report and, as considered necessary and appropriate, budgets, cash flow forecasts and other related management reports;

Enquiring (or adding to previous oral or written inquiries) of the entity’s lawyers;

Enquiring of management as to whether any subsequent events have occurred which might affect the financial statements. Examples of specific inquiries that might be made of management include: the current status of items that were accounted for on the basis of tentative, preliminary or inconclusive data; whether new commitments, borrowings or guarantees have been entered into; or whether sales of assets have occurred or are planned.




RequiredFor each of the five events/transactions, indicate to the audit partner the sorts of procedures that should have brought the matters to her attention and the form of disclosure that should have been required in the financial statements (if any).

Item No.

Audit Procedures Required Disclosure or Entry and Reasons

Goods in transit would be detected in the course of the auditor’s review of the year-end cut-off of purchases. The auditor would examine receiving reports and purchase invoices to make certain that the liability to suppliers had been recorded for all goods included in inventory, and that all goods for which the entity was liable at year end were recorded in inventory.

The receipt of the goods provides additional evidence with respect to conditions that existed at the date of the balance sheet and hence the financial report should be adjusted to take into account such additional information.

2. Settlements of litigation would be revealed by requesting from the entity’s solicitors a description and evaluation of any litigation, claims and contingent liabilities of which he or she had knowledge that existed at the date of the balance sheet being reported on. A review of cash disbursements for the period between the balance sheet date and completion of the audit may also reveal evidence of the settlement.

Settlements of litigation would require an adjustment of the financial report since the events that gave rise to the litigation had taken place prior to the balance sheet date.

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3. The purchase would normally be revealed in general conversation with management and would further be detected by reading the minutes of directors’ meetings. In addition, because the amount paid is likely to be unusually large in relation to other cash disbursements, a review of cash disbursements for the period between the balance sheet date and the completion of the audit is likely to reveal such an extraordinary transaction. Moreover, because a purchase of a business normally requires a formal purchase agreement, the letter from the entity’s solicitor may have revealed the purchase.

The purchase of a new business is not an event that provides evidence with respect to conditions existing at the balance sheet date; hence it does not require adjustment in the financial report. Disclosure in the notes to the financial report is normally adequate.

4. Inventory losses attributable to a flood would be brought to the auditor’s attention through inquiries and discussion with management. Moreover, the auditor would know the location of the entity’s plants and warehouses and, on hearing about any major floods occurring in such localities, would be likely to inquire if the entity had suffered any loss.

Losses attributable to flood subsequent to the balance sheet date do not constitute conditions existing at balance sheet date. Adjustment in the financial report is not required. However, because the losses are material, they should be revealed in the notes to the financial report. It is assumed that the loss is not sufficient to threaten the entity’s future existence.

5. The sale of debentures or other securities would involve the issue of a prospectus with which the auditor would have probably been involved. In addition the sale would be revealed by reading the minutes of board of directors meetings and by examining cash receipts books in the subsequent events period for unusually large receipts.

Sales of debentures or other securities do not provide information with respect to conditions that existed at balance sheet date. However, such sales may be of sufficient importance to require note disclosure.



18.23 Subsequent events/post-audit discovery of facts

Required

(a) Indicate your responsibilities for each of the above events.(b) Indicate the type of disclosure (if any) you would recommend in relation to each of the six events.

1. (a) The auditor has a responsibility for identifying and evaluating events up until the date of the audit report.(b) This is a subsequent event that should be disclosed by way of a note to the financial report. It is an event that occurred before the end of the financial year, however it is disclosed by way of a note because the amount of the lawsuit is uncertain at the date of signing the audit report.

2. (a) The auditor has a responsibility for identifying and evaluating events up until the date of the audit report.(b) This is a subsequent event affecting the value of a debtor's balance at year-end that will require adjustment to the provision for doubtful debts (unless it has already been included).

3. (a) This is a subsequent event occurring after the date of the audit report but before issuance of the financial report. The auditor has no responsibility to look for these events but must consider them if he or she becomes aware of them.(b) This is a subsequent event that does not relate to conditions that existed at balance sheet date. The auditor should consider and discuss with management the need to amend the financial report by including the lawsuit in a note. If the financial report is amended, the auditor must carry out necessary auditing procedures, including extending the review of after balance date events, and reissue the audit report at the date of approval of the amended financial report.

4.(a) The auditor was made aware of this event after the financial report has been issued. In this case the event occurred after the audit report was signed so the auditor has no responsibility in relation to the event.(b) No disclosure required.

5. (a) This is an event occurring after the financial report has been issued. It existed at the date the audit report was signed. The auditor has no responsibility to look for these events but must consider them if he or she becomes aware of them. The auditor should discuss with management the possibility of recalling and revising the financial report, as the debtor is very material.(b) This is a subsequent event affecting the value of a debtor’s balance at year-end that will require adjustment to the provision for doubtful debts.

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6.(a) The auditor was made aware of this event after the financial report has been issued. In this case the event occurred after the audit report was signed so the auditor has no responsibility in relation to the event.(b) No disclosure required.

18.24 Contingencies/lawyer’s representation letter

Required

(a) Explain the purpose of a lawyer’s representation letter.

The auditor should examine supporting documentation in the entity’s files pertaining to all such matters that have come to his or her attention. However, the auditor does not have sufficient legal skills to make sufficient judgements on all of these matters. A solicitor’s representation letter to the entity’s outside solicitor(s) is the auditor’s primary means of obtaining corroborating information about management’s assertions concerning the status of litigation, claims and unrecorded or contingent liabilities.

(b) Explain what you would do in the above situation.

A solicitor’s refusal to respond to a letter of audit inquiry is a limitation on the scope of the audit. The auditor needs to determine whether alternative audit procedures can provide sufficient appropriate audit evidence. This may entail further inquiries of management, reviewing documentation in management’s possession concerning legal matters or examining accounts rendered by third party solicitors. If these procedures are unsatisfactory, depending on the materiality of the item, the auditor should express qualified or disclaimer of opinion on the financial report (ASA 705; ISA 705).

In this situation, the potential legal cases could be very significant. The fact that there is more than one case against the company and that they relate to serious health side effects indicates that there would need to be some disclosure.

18.25 Communicating matters to management

Required (a) Critically analyse the draft management letter and outline suggestions for improvements.

Suggested improvements: Letter should be addressed to the audit committee with copies to Ms Poon and

Mr Sullivan. Letter refers to ‘major weaknesses’, however in reality all weaknesses are

usually reported. The matters in this letter do not appear to be particularly ‘major’.

Matters noted could be written in bullet point or tabular form to make them easier to read. The letter should also include recommendations as well as implications for the client in relation to each matter noted.



Trade receivables o How often was the reconciliation late? Letter should include the facts.o Reference to difficulties for audit staff should be removed and the

implications for the client should instead be described.o Reconciling items – examples should be given or a list provided.

Cash paymentso Details of the cheques should be given.

Petty casho Statement regarding tax deductions is speculative and should probably

be removed.o Comments re staff member should be re-written in a less accusatory

tone.o Details of the expenditure making up the amount should be included.

Request for response in writing. Reference to ‘undiscovered weaknesses’ sounds negative and could be

removed. It is usual etiquette to end the letter by thanking the client and staff for their

assistance during the audit.

(b) Assume you found some minor errors during the audit (such as an accrual not taken up) which were rectified by the time the financial statements were issued. Would you include these in the management letter? Why or why not?

Whether or not the minor errors were included in the letter would depend on whether or not they were considered matters of governance interest. Matters of governance interest would normally include ASA 260 (ISA 260):

The auditor’s responsibilities in relation to the financial report audit The planned scope and timing of the audit. Significant findings of the financial report audit, including: significant

qualitative aspects of the entity’s accounting practices, significant difficulties encountered during the audit, significant matters discussed with management, any written representations requested, and any other matters of the audit that, in the auditor’s professional judgement, are significant to the oversight of the financial reporting process.

Audit independence which includes statements that the engagement teams have complied with relevant ethical requirements, all matters that may reasonably be thought to bear on independence and safeguards that have been applied to eliminate identified threats to independence or reduce them to an acceptable level.

Other matters that the auditor may consider to include in the communication with those charged with governance are: The general approach and overall scope of the audit The selection of, or changes in, significant accounting policies and practices

That have, or could have, a material effect on the entity’s financial report The potential effect of any significant risks and exposures Audit adjustments Material uncertainties that may cast doubts on the entity’s ability to continue

as a going concern Disagreements with management

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Expected modifications to the auditor’s report Any other matters agreed on in the terms of the audit engagement.

(To reduce the risk of litigation some firms report all matters, even though some may be minor. Minor matters are generally included in an appendix to the main body of the letter.)

18.26 Evaluating going concern basis

Required

(a) Discuss whether there is a potential going-concern issue in each situation.(b) Describe the additional procedures that you would perform (if any) in each

situation.

1.(a) It appears as though GGS’s lease will be terminated in the ‘relevant period’ (12 months from the date of the current periods audit report) and therefore the issue is of relevance to the 30/6/11 audit. If GGS cannot obtain suitable alternative premises, it may be forced to wind up its operations. If this occurs, GGS will not be a going concern as at 30/6/11. Even if suitable premises can be obtained, it seems that they will not be in the existing complex, in which case GGS is likely to lose its existing customer base. Obtaining alternative premises is no guarantee GGS will continue as a going concern.

(b) Discuss with Gillian whether she intends to keep the business going and if so,

what her plans are. If her plans to move to other premises, investigate the likelihood of the move

being successful. Check whether there are any legal options available to Gillian to avoid having the

lease terminated or obtaining a large payout.

2.(a) The concerns regarding going concern are similar to (1). However, if council approval has not been granted for the redevelopment the complex owners may not have sufficient grounds to terminate the lease, in which case Frannie’s Florist may be able to continue trading.

(b) Determine the likely date of council reaching a decision regarding the

redevelopment. Read available newspaper articles to get an idea of local opinion as to whether or

not the redevelopment will be approved.

3. (a) Ms Gucci intends to close the shop during the relevant period. In this case although the business could continue as a going concern, there is an intention to wind up its operations so there is still a going concern issue.



(b) Confirm that Ms Gucci does intend to close her shop as at 31/12/11. There may be

some correspondence with arcade management. As there are no mitigating circumstances to consider, it would be appropriate to

advise Ms Gucci that the financial report should be prepared on a liquidation basis. If this is done, then audit procedures will need to be performed to check the reasonableness of the liquidation values.

4. (a) Although ZY has agreed to support ZX for the next 12 months, there is some doubt that it will be able to do so. ZX appears to be unable to continue without parent company support, so unless another source of finance is available, ZX appears to have a serious going concern problem.

(b) Obtain the latest audited accounts of ZY and compare solvency levels to those of

prior years. Discuss the issue with ZX management and see if they have any reliable

information regarding ZY. Read financial press for latest news of ZY and the rumoured takeover bid. Inquire of ZX management whether any alternative sources of finance are

available.

18.27 Final assessment of materiality/effect on auditor’s report

Required

(a) What do the auditing standards require in relation to estimating the final dollar error in the financial statements before the signing of the audit opinion?

In formulating an opinion on the financial statements, the auditor should assimilate all the evidence gathered during the examination. An essential prerequisite in deciding on the opinion to express is a final assessment of materiality and audit risk. The auditor should assess whether the aggregate of the uncorrected misstatements identified during the audit is material. Normally the aggregate of uncorrected misstatements will be recorded on a summary schedule at the front of the audit file.

The data that have been accumulated on the summary schedule are then compared with the auditor’s preliminary judgements concerning materiality. Any adjustments in planning materiality that have been made during the course of the examination should be included in this assessment. If the aggregate level of uncorrected misstatements is material, then the auditor needs to consider reducing audit risk by extending audit procedures or requesting management to adjust the financial statements.

(b) Using the above information, prepare a summary of audit differences workpaper for the audit manager.

Description $ error in fin statements (A)

Projected error (B)

Total estimated error (A) + (B)

Adj to Assets dr/(cr)

Adj to Liabs dr/(cr)

Adj to Profit dr/(cr)

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1. Cut-off incorrect

5,600 5,600 (5,600) 5,600

Inventory adj 3,294 3,294 3,294 (3,294)

2. Year end stocktake

11,250 11,250 (11,250) 11,250

3. Debtors(i) 2,510 2,510 (2,510) 2,510

1,476 1,476 1,476 (1,476)(ii) 2,080 2,080 (2,080) 2,080

4. Loan confirmation

1,000 1,000 (1,000) 1,000

TOTAL (16,670) (1,000) 17,670

5. Does not affect the profit – only a recommendation for disclosure in the notes.

6. Does not affect the profit – just a differing disclosure category.

(c) Discuss how you would use the summary of audit differences workpaper in determining whether the financial statements are materially misstated.

The objective of the summary schedule is to be able to assess the aggregate errors to compare them to materiality. This also has a benefit in that some of the errors may offset one another and the summary schedule enables the auditor to gain a better overall perspective.

In relation to a determination of whether the financial statements are materially misstated for the above, a determination of final materiality would firstly need to be performed. The most common method would be by using final profit (and you should already have a planning materiality calculated). However, there are no details given of the planning materiality or the final profit, so as an alternative an estimate of the profit can be calculated (for the purposes of this example). If profit is 5% of sales it would make it about $70,000, this would make the total errors clearly material at 25%. If profit was towards the quite high level of 10% of sales, it would be about $140,000 and the accumulated errors would still be over 10% and therefore material.

Case Studies




Required

(a) Outline the key additional procedures you should have performed in relation to each of the above events.

(b) What actions should you have recommended to management in relation to each of the above events?

1.(a) The auditor will need to discuss with management regarding the settlement of the

legal dispute and review the evidence of what amounts have been agreed upon to be paid etc. The auditor should also contact the audit client’s solicitor about through a solicitor’s representation letter regarding this before the audit report is due to be signed so as to establish any loss that should be recorded in the accounts.

(b) This is a post balance date event relating to conditions existing at balance date i.e. it is an adjusting event. Any loss or costs payable that can be verified should be recorded as litigation costs or liability in the accounts. As the dispute has been there for a number of years, the company would have a contingent liability account for this dispute. This would have been transferred to liability account which is incorporated within the financial statements as the legal dispute has been resolved.

2.(a) The auditor should also contact the audit client’s solicitor about through a

solicitor’s representation letter regarding this and confirm with management the dates on which the legal dispute is settled.

(b) This is an event occurred after the date of audit report but it relates to conditions existing at the balance date. The auditor would have to discuss with management the need to amend the accounts for this change and the audit report would also need to be reissued on the amended accounts.

3.(a) The auditor should discuss with management about the faulty product lines and

the launch of a full product recall. The further evidence to be obtained would be documentation to ensure that the dates given by the management were correct.

(b) This event occurred after the balance date but before the audit report date. The appropriate action for the auditor is to request that management disclose the facts of the fire in the financial report.

4.(a) The auditor should confirm the dates on which the cyclone hit and discuss with

management how it will affect the company.(b) It is a post balance date event not relating to conditions existing at balance date

i.e. a non-adjusting event. The cyclone hit on 2 August, after the audit report was signed. No action recommended for this year’s accounts.

5.(a) The auditor should confirm the dates on which Queenscorp has applied for a

patent for a new type of margarine. The auditor should also confirm with the patent registration office or discuss with a patent expert on the probability of the

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granting of Queenscorp’s application as well as discuss with management the implications of this event.

(b) The auditor should recommend the management to disclose the event and its implications within the notes of the financial statements as Queenscorp has invested significant funds in developing the new type of margarine. The application has just been lodged and there is uncertainty about the results so there isn’t a need for adjust in the financial report.

6.(a) This event occurred after the financial reports have been mailed did not exist at

the date of the mailing of the financial reports; therefore it is of no concern to you for this year’s accounts. The further evidence the auditor would seek would be documentation and contracts to ensure that the dates given to you by the general manager were correct.

(b) No action recommended for this year’s accounts.

7.(a) The auditor should confirm with management that this event did occur and

examine the notice letter received to check the date on which the notice letter was received.

(b) This is a post balance event that is not connected to conditions existing at balance date i.e. non-adjusting event. The auditor should request the management to disclose the fact that 30% of the land owned will be forcibly acquired by the federal government should the new Sydney airport proceed and how it will affect the company.

8.(a) The auditor should obtain an external confirmation from that particular debtor to

ensure that it had gone into receivership and the amount that would be recoverable. The auditor should also confirm the date of receivership was in fact before the date of the audit report.

(b) This is a post balance date event relating to conditions existing at balance date. In early June, the debtor has informed Queenscorp that it has been experiencing serious financial difficulties and it had gone into receivership on 5 July. The auditor should request management to adjust the provision for bad debts account or the trade receivables account based on the preliminary reports that only 10% of the receivables are recoverable.


Required



(a) Explain what further evidence you would seek in relation to each of the above matters.

(b) Describe the action, if any, you would recommend to management in relation to the accounting treatment of each of the above items.

1.(a) This is difficult because the evidence on the exact amount will be not available for

two months. The auditor will need to discuss with management and review the evidence of what amounts can be proven before the audit report is due to be signed to establish any loss that should be recorded in the accounts.

(b) This is a post balance date event relating to conditions existing at balance date. Any loss that can be verified should be recorded as a loss in the accounts. There should also be a note to the accounts relating to the fraud and explaining that there was a significant uncertainty as to the total amount of the fraud as at the date of signing the financial report.

2.(a) You would need to review the press release issued by the government to clarify

the proposal. You would also want to review the media since the announcement to get a feel for the likelihood of the legislation passing and you may want to get an expert opinion on this matter as well. Discuss with the board why they would be so confident that the tax concessions will remain in place. You would also need to consider whether there were any potential going concern issues associated with the new legislation being implemented.

(b) This is a post balance date event relating to conditions that did not exist at balance date. There would need to be a note to the accounts explaining the potential effect of this legislation if it was implemented. If you thought it appropriate, reference to going concern issues would also need to be raised.

3.(a) Although this event is after the date of signing the audit report, the auditor has an

obligation to consider events that come to his or her attention in this period. In this case you would want to review all documentation in relation to this action and obtain independent legal advice on the likelihood of success (and $$) of the action.

(b) This is a post balance date event that does not relate to conditions that existed at balance date. You would consider the independent legal advice on the merit of the claim (and the potential cost) to decide whether it was appropriate to amend the accounts and include a note to make users aware of this matter.

4.(a) You have a requirement to consider this event as it has come to your attention.

You would need to evaluate the estimate of quotes to repair the damage and compare this to the insurer’s coverage to evaluate the amount that would need to be covered by the company (if any). You should also evaluate whether there are any going-concern issues from this event.

(b) This is an event that has occurred after the year-end so it should be included in the notes to the accounts. The auditor would have to discuss with management the need to amend the accounts for this change and the audit report would also need to be reissued on the amended accounts.

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5. (a) The main evidence of this matter is the minutes of the meeting. It appears that the

decision to put the merger to a vote has been made on the 15 July. You may want to review pre-year end minutes for evidence of previous discussions on the matter.

(b) If the decision to have a vote was made on the 15 July, it is an event that occurred after the year-end that related to conditions that existed at balance date (as discussions had been occurring for a while). Therefore it could be argued that a provision should be made in the 30 June 2007 accounts for the $50 000.

6. (a) This event occurred after the audit report has been issued and did not exist at the

date of the audit report; therefore it is of no concern to you for this year’s accounts. The further evidence you would seek would be documentation and contracts to ensure that the dates given to you by the general manager were correct.

(b) No action recommended for this year’s accounts.

7.(a) This event occurred after the year-end and did not relate to conditions that existed

at year-end. However it is before the audit report is signed so you need to consider the appropriate accounting treatment. The main audit evidence would be to review the contract for the upgrade. You may want to review whether there are any workers’ compensation actions relating to non-compliance?

(b) You would recommend that management include a note in the accounts disclosing the commitment made under the contract.

8.(a) This event occurred after the year-end and did relate to conditions that existed at

balance date. You would want to review the minutes of the board’s meetings as well as sales performance of the restaurant.

(b) This does not really affect any balances at year-end therefore the closure should just be disclosed by way of a note.



Research question

18.30 Analytical procedures and going concern

Required

(a) Discuss IOL’s overall financial position with reference to the ratio analysis undertaken as part of the analytical procedures

(b) Nominate other factors listed above that may indicate that the company has going concern problems.

(c) List factors that may help IOL resolve this going concern problem. Outline the information that you would need in relation to each factor identified.

(a) Days in debtors This ratio has increased significantly over the three years. It may indicate greater leniency in credit terms to try and generate sales. This may have a subsequent effect on the collectability of debtors.

Current ratioThis ratio has decreased significantly. This is an indicator of short-term liquidity concerns for the company. This is of particular concern given it appears that debtors have gone up over this period (inferred from the ‘days in debtors’ ratio). It would be useful to review the company’s cash flows to gain more information about its short-term liquidity.

Debt/equity ratioThis ratio has increased over the three years, indicating a higher reliance of the company on debt compared to equity. Given that much of the investment in productive assets occurred in the companies earlier years, it would be worth trying to evaluate what the recent borrowings have been used to finance.

Gross profit ratio This has decreased substantially over the last three years. This indicates that the company may have been discounting to generate sales.

Net profit ratioThis is very poor and getting worse. Three years in a row of losses like this indicate that the company may not be around for very long.

Net assets per shareThis has been declining over the past three years – although not dramatic. It does seem to indicate that the company has not been investing in productive assets of late. It would be important to ascertain whether any R&D has been capitalised or not.

(b)

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The evidence suggests that the company is a ‘one product wonder’. There is no evidence that Mr Tinta can produce a product to match the success of the original product.

The second product on the market was not particularly successful. Substantial expenditure has been made on R&D into the third product (much of it

from borrowings). There are no indications of the success of the third product in what is a very competitive market.

Given the tenuous financial position of the company (from the ratio analysis), the failure of the third product would probably be the end of the company.

(c) Some evidence would need to be obtained to evaluate the potential success of the

new product? Has there been any market research? Evaluate whether Mr Tinta’s parents/friends have provided any guarantees of

financial support? Is there anything in writing? Obtain an independent valuation of IOL’s assets. Review correspondence with financiers? Are there any debt covenants that IOL

should comply with? Are they breaching these covenants? What are the implications of breaching them?

Review minutes of directors’ meetings. Review sales figures post year-end.

18.31 Earnings management and completing the audit

Required

(a) Discuss the meaning of earnings management and how it affects the final stages of a financial report audit.

(b) Identify means whereby the auditor may reduce earnings management.

You should undertake a research on earnings management and its relationship with the role of the auditor. Refer to published articles including those listed in Further Reading.

The following points should be included in the student’s answers.

(a) Earnings management occurs when financial statements and transactions are managed in order to achieve a certain ‘favourable’ outcome, and to influence people’s perceptions of the performance of the entity. The desirable outcome may not be the direct consequence of the economic substance of the transactions involved. Earnings management is an issue of judgement and may result in the financial report being materially misstated. Extreme cases of earnings management may amount to fraud.Incentives for earnings management are inherent in the management structure and can spring from political considerations, executive remuneration, the ambiguity and inability of accounting standards to deal with complex transactions, or situations including financial distress or related party transactions. The capital market may also present incentives where pressure



comes from market expectations, analysts’ forecasts, management transition and so on.Many earnings management techniques involve accruals, revenue recognition, restructuring charges, estimation of liabilities, delaying sales, and manipulating research and development write offs. Auditors should be aware of the possible earnings management techniques and maintain professional scepticism in management judgement (page 58).

(b) The means with which the auditor may reduce earnings management include: Comparing and evaluating accruals and request for justifications; Discuss with management the assumptions for estimates and the

consequences of the estimates used; Proper cut off tests Identify the recognition of revenue procedures and undertake tests to

ensure accuracy Trace through restructuring charges and research and development

expenses and discuss with management the policies used in accounting for them. Ensure the compliance with accounting standards.

Review very carefully minutes of the board and the systems whereby remuneration are paid.

Undertake an analytical test with previous years and expected results of items.

Require disclosure by management any particular accounting treatments used which are not in line with accounting standards.

Students should access articles and published accounts for the purpose of answering this question.

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ch18 sm maas5

Documents

auditor report

auditors report

revised audit report

revised financial report

audit solution manual

auditors responsibility

auditors responsibilities

companys financial statements