8.

21 Risk of Fraud

Fraudulent financial reporting involves intentional misstatements including omissions of
amounts or disclosures in the financial report to deceive financial users (ASA 240 11).
(Manipulation or falsification, misrepresentation or intentional omission).
Misappropriation of assets involves the theft of an entitys assets and is often perpetrated
by employees in relatively small and immaterial amounts (ASA 240 14). (Embezzling
receipts, stealing physical assets or intellectual property, causing an entity to pay for goods
and services not received, using an entitys assets for personal use).

Factor Fraudulent financial reporting (FFR) or
Misappropriation of assets (MA)
Incentives/Pressures (I/P) or
Opportunity (O) or
Rationalisation (R)
1 MA I/P
2 FFR O
3 FFR I/P
4 MA O
5 MA R
6 FFR I/P
7 FFR O
8 FFR R
9 FFR R
10 MA I/P
11 MA R
12 FFR O

8.25 Planning the audit
Planning the audit involves the development of an overall audit strategy that sets out the
general direction and scope of audit. Audit planning starts with obtaining an
understanding of the entity and its environment. It would yield best result if the analytical
procedure is followed and that both financial and non-financial information are properly
analyses and evaluated. Analytical procedures also encompass such investigation as is
necessary of identified fluctuation or relationships that are inconsistent with other
relevant information or that differ from expected values by a significant amount (ASA 520-
4).
It can be seen that the provided information will affect planning the audit at the stage
where we use analytical procedures because the validity of the ratios are doubtful in which
they might have been gently massaged. There are risks that can be identified in Gateshead
Pty Ltds situation; such as:
- Risk related to the industry: computer hardware. The introduction of new technologies
by competitors may make their inventories obsolete thus current valuation may no
longer valid
- Current ratio = 0.9 (current asset/current liabilities) The more assets a company has,
the healthier it appears to investors in the sense that company owned more than
owed. A ratio under 1 suggests that the company would be unable to pay off its
obligations if they came due at that point. In this case, company may try overstating
their current asset or understate liabilities to achieve a more desirable ratio.
- Gross profit was up to by 25% - this is a very sharp increase. Unless they have
successfully implemented a special cost cut-down strategy or generated an innovative
new products that yields huge profit margin in the current year; otherwise such big
increment is questionable and need to be attended to carefully. In some cases,
Gateshead might sell off their assets and misclassified to operation income whereas in
fact it should be investing activity.
- The debt-to-equity ratio = 0.4 (total liabilities/ shareholders equity) as observed
above, the current liabilities is larger than current assets while the D/E = 0.4 indicates
that Total Liabilities is only half of Total Net Assets. This can only be justified when
Gateshead Pty Ltd has a very little Long-term Debts and a large amount of Non-current
Assets which is an extreme case that need to be carefully looked into (Accounting staff
may misclassify the accounts to make Gateshead appear as a healthy company)
Given that Gateshead is required to meet certain ratios and restrictions not to break their
debt covenant, they apparently have the incentives to manipulate the figures to attain the
desired result. In this case, going concern may also be questionable if those ratios were not
calculated and disclosed correctly. This is possibly a case where Fraudulent Financial
Reporting prevails and risk factor is Incentives/ Pressures.



8.26 Planning the audit; analytical review
Analytical Procedure [ASA520]: to obtain a more detailed understanding and to identify
areas of potential risk. Involves a study and comparison of relationships among data to
identify expected or unexpected fluctuations and other unusual items. Analytical
procedure are also used in overall review of the Financial Statements immediately before
the issue of auditors report
Current ratio = Current Assets/ Current Liabilities
It is a slightly decline of 0.1 which means that Company is either have less current assets
(cash/inventories) or more current liabilities or both. It is not a big change.
Debt-to-equity ratio = Total Liabilities/ Shareholders Equity
There is an increase of 0.3 and means that Total Liabilities is raising significantly which
congruence with the previous ratio. It is definitely worth looking at because it represents a
60% increase comparing to previous year and relates to the ability of paying their debts,
which involves going concern.
Times Interest Earned = Earnings before Interest and Tax / Interest Expense (how many
times earning can cover interest expense)
Because the level of debt increased sharply (debt-to-equity ratio), interest expense will
also increase. Hence, the reduction of times interest earned could be justified.
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable (how
quickly company can collect their credit sales)
It now takes Sal Pty 6 weeks instead of 5 to collect the credit sales from customer which is
a worrying numbers. They may struggle managing their cash flow in the future. In this
circumstance, an auditor should expand the substantive tests of collectability. (For
example: if collectability is doubt, the auditor may want to suggest that the client increase
the provision in the allowance for doubtful debts account)
30/6/2011 30/6/2010
Current ratio 1.4 1.5
D/E 0.8 0.5
Time interest earned 4.1 6.2
AR turnover 43 days 33 days
Inventory turnover 56 days 45 days
Return on sales 9% 7%
Gross Profit Margin 35% 30%
Inventory Turnover = Sales/ Inventory
The inventory turnover ratio increased and means that it takes company longer to sell and
replace their inventories.
Return on sales = Net Income (before Interest and Tax) / Sales
Return on sales providing insight into how much profit is being produced per dollar of
sales. ROS has increased by 2% which can be a result of increase in product price. If this is
the case then the change in above figures can be justified
Gross profit margin = Gross Profit / Income
Gross profit margin indicated that the company was performing better with an increase of
5%. Still it could be a result of an increase in selling price (derived from companys pricing
strategy) which isnt always good (as it currently takes a lot longer to sell the product)

Conclusion: comparing all data and ratios, we can easily see that company is exposed to
higher risk (use of Debt), earning better returns but takes them longer to sell the stock.
The changes are significant and would suggest a change in audit plan to better adapt with
the circumstance.
(Most likely what happened is Sals Surfwear borrowed money to create a new line of
product which result in a higher gross profit and return on sales. However, the debt level
raised and the product is pricey so that it takes longer for them to turnover the stock)

8.28 Planning
a) Describe why it is important that auditor should plan their audit work

Figure 8.3 Steps in planning the audit

Referring to ASA 300.4 (ISA 300.3), it states the objective of the auditor is to plan the audit
so that it will be performed in an effective manner. Planning the audit allows the auditor
to:
- Have better understanding of the business where he/ she is capable of classifying
businesss transactions that may have a significant effect on the financial statements.
- Focus on setting materiality levels, assessing audit risk, and its components, obtaining
an understanding of the internal control system, which can assist the auditor in
choosing appropriate strategy on how the audit should be done.
b) Describe the matters you will consider in planning the audit and the further action
you will take.
1. It is a contrast between 30 November 2009 and 21 January 2009 for sales and profit
before tax. On 30 November, Sales increased 18% but PBT is halved than on 21 January.
- The profit would be understated or sales revenue may be overstated (check sales
receipts, price of products, cost of input material)
- Analytical procedures
2. There is possibility that the new computerised inventory control system could value the
inventory wrongly due to theft, broken etc. Hence, it would result in risks of material
misstatement.
- Require yearly (the more regular the better) physical count for the inventory to
match with the number showed in new system
- Test the system (eg try to move some products)
3. Customers have been making legal claims against the company and refused to pay for
the products. Hence, there would be misstatement in contingent liability and provision for
bad debts account.
- Discuss with managers to obtain details of such claims;
- Physical check the inventory to see if the products are saleable or obsolete
4. The company was trying to pursue more customers by offering extended credit, which
resulted to an increase in the receivables. Hence, they are having greater credit risk where
customers are failing to make payments. In this case, it would increase the risk of bad
debts.
- Assess credit approval processes and credit risk management to guarantee that the
risk is low;
- Re-evaluate account receivable
5. The chief accountant may not be familiar or thoroughly understand the preparing
process that CFO has prepared before thus may not provide satisfying answers to all
inquiries made by auditors

8.30
Adequacy of working paper is the subject of ASA 230 Audit Documentation.
- Accordance with auditing standards
- Proper planned and carried out
- Adequate supervision
- Appropriate review
- Sufficient and appropriate evidence to support audit opinion
- Record nature, timing and extent of audit procedures performed; the results of the
procedures and audit evidence obtained and significant matters obtained during
the audit; and the conclusion reached [ASA 230.8]
- Be tailored to meet specific audit engagement
1. Assessment:
a. Dockets did not result in production of invoice: 2/30 sales order
equivalent to 7% of test sample which is not material. However, the detail
of sale orders are not disclosed lack of evidence
b. Some prices dont match price list: Discount to customers should always
be accounted for in preparing accounts. Emily should also have inquired
with sales manager rather than the accounting clerk who would not be
able to answer such inquiry. Finally, explanation is accepted without
evidence
c. Quantity doesnt match between orders and invoices: Lack of evidence
2. Review of working paper:
- Adequacy of working paper: does not seem to be properly planned and carried out;
insufficient evidence to support her opinion; did not adequately record nature,
timing and extent of the audit procedures performed; did not disclose any
significant matter arisen while in fact there are suspicious activities.
- Level of documentation: Working paper files are supposed to be either Permanent
files or Current files. EBs working paper fails to be adequate for both of the
categories as it doesnt cover as much information to be classified as one.
- Matter arising: despite many questionable information exist, Emily fails to address
any of them properly but accepting some oral explanation.
- Conclusion: the conclusion where Emily determined that sales figure are valid
seems to be hasty. The ground that Emily bases her conclusion on could actually be
true however it takes a lot more evidence for her to conclude so. Furthermore, her
working paper doesnt indicate that she did follow correct auditing procedure.
Thus, the auditing must be carried out again.

Cloud9 Assignment 1
Potential Risks - Description Account
Stock purchased in USD foreign exchange risks Account payable
Stock and sales are influenced by seasons. Decreased/ Increased
sales may force managers to misstate revenues
Sales Revenue
Store merchandise is prone to theft Inventory
A loss for year is predicted difficult to make loan repayment Liabilities
Current economic environment may adversely affect the sales Account Receivable
Hiccups in the new Just in Time inventory system. Inventory might
be misstated
Inventory