SOLUTIONS MANUAL

to accompany

MODERN AUDITING
&
ASSURANCE SERVICES

4th edition

Prepared by

Philomena Leung, Paul Coram, Barry Cooper

and Peter Richardson

© John Wiley & Sons Australia, Ltd 2009

Solution Manual to accompany Modern Auditing and Assurance Services 4e

Chapter 6
Client evaluation and planning the audit

Review Questions

6.11 Explain the procedures to be followed in evaluating a prospective audit

client.

The engagement partner shall be satisfied that appropriate procedures regarding the
acceptance of a new client have been followed and conclusions documented (ASA
220). The factors to consider in evaluating a prospective audit client are as follows:
 obtain and review available financial information on the prospective client;
 make inquiries of third parties, such as bankers, as to information which may
influence the evaluation of the prospective client;
 communicate with the existing auditors with the view to evaluating the
integrity of the client’s management;
 identify circumstances that require special attention or that carry unusual risks;
 evaluate the audit firm’s independence and whether the firm is able to properly
serve the client;
 establish that acceptance of the client would not violate codes of professional
ethics.

6.12 Identify applicable ethical considerations in accepting a new audit

engagement.

Before accepting a new client the auditor should consider whether acceptance would
create any threats to compliance with the fundamental principles (APES 110). The
auditor should:
 evaluate whether there are circumstances that would compromise his or her
independence such as the existence of personal or financial relationships with
the proposed client or any conflict of interest between the auditor or any
existing client and the proposed client;
 assess competence to perform the audit, especially the availability of the
necessary expertise relative to the nature of the proposed audit clients business
or scale of operations;
 determine the ability to use due care, especially with respect to the timing of
the audit work and the availability of competent staff to complete the work to
the required standard within the time available.

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 Chapter 6: Client evaluation and planning the audit

6.13 Discuss the suggestion that if all auditors reject, as clients, entities
identified as being too risky, those entities most in need of an audit will be
unable to secure the services of an auditor. As professionals, should
auditors be required to provide their services to any entity requiring an
audit?

This shows the potential conflict between the firm’s self interest and the interests of
the profession. There is no ‘right’ answer for this question it is more to try and raise
discussion about the issues. Points that could be noted include:
 Firms must manage their own ‘business risks’
 There will often be firms willing to take on riskier clients for appropriate fee
premiums.
 Perhaps more audit reporting options will enable audit firms to take on riskier
clients?
 Greater restriction on legal liability for auditors may also encourage firms to
take on these clients?

6.14 Discuss the contention that the engagement letter understates the
auditor’s legal responsibilities so as to discourage litigation.

See ASA 210. The contents of an audit engagement letter are based on factual
responsibilities of the auditor. However, it is quite possible that some users/managers
may look at the engagement letter and perceive it as an attempt by auditors to reduce
their responsibilities. For example, they may draw this conclusion when reading the
letter and noting that only reasonable assurance is provided by auditors and that
management is responsible for adequate accounting records and the internal control
structure. However, users would be incorrect in drawing this conclusion because the
letter is a statement of factual responsibilities and auditors cannot contract out of their
responsibilities.

6.15 Discuss the steps involved in the audit planning process.

Planning an audit involves establishing the overall audit strategy for the engagement
and developing an audit plan, in order to reduce audit risk to an acceptably low level
(ASA 300). Planning starts with an understanding of the entity and its environment.
Planning also involves (1) setting materiality levels, (2) assessing audit risk and its
components, (3) obtaining an understanding of the internal control structure and then
(4) developing a preliminary audit strategy for significant assertions. Auditors should
also perform analytical procedures as part of the planning process as well as consider
the risk of fraud.

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

6.16 What is the purpose of touring operating facilities and offices?

A tour of the operating facilities and offices is a significant help to an auditor in

obtaining knowledge about a new client’s operating characteristics. During a tour of
the factory, auditors should become familiar with the factory layout, the
manufacturing process, storage facilities and potential trouble spots such as unlocked
storerooms, obsolete materials and excessive scrap.

During a tour of the office, an auditor should become knowledgeable about the types
and locations of accounting records and computer processing facilities and the work
habits of personnel. An important by-product of both tours is the opportunity to meet
personnel who occupy key positions within the organisation. The auditor should
document the information obtained from the factory and office tours.

6.17 How can analytical procedures assist the auditor in audit planning?

Analytical procedures will assist in assessing the areas of potential risk in the financial
statements (ASA 520). The procedures can assist the auditor in planning by:
 Enhancing the auditor’s understanding of the client’s business.
 Identifying areas of greater risk of misstatement by highlighting unusual
fluctuations and usual relationships.

6.18 What should the auditor do to identify the risk of material misstatement
because of fraud?

The auditor is required to consider the risks of material misstatements in the financial
statements due to fraud. ASA 240 requires the following:

When obtaining an understanding of the entity and its environment, including its
internal control, the auditor shall consider whether the information obtained
indicates that one or more fraud risk factors are present.

In making the assessment of whether fraud risk factors are present, the auditor should
understand the three conditions that are generally present when fraud occurs. These
are known as the ‘fraud triangle’, which includes the following:
 incentives/pressures
 opportunities
 attitudes/rationalisations.

The auditor should be concerned with fraud risk factors that relate to either
misstatements resulting from fraudulent financial reporting or from misappropriation
of assets.

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 Chapter 6: Client evaluation and planning the audit

6.19 Define the term ‘working papers’ and indicate their main function in
auditing.

Working papers are not defined in the auditing standards which refer to audit
documentation. “Audit documentation” means the record of audit procedures
performed, relevant audit evidence obtained, and conclusions the auditor reached
(terms such as “working papers” or “workpapers” are also sometimes used) (ASA
230).

So working papers may be defined as the records kept by the auditor of procedures
applied, the tests performed, the information obtained, and the conclusions reached in
the engagement. Working papers provide the principal support for the auditor’s report,
evidence that the audit was made in accordance with auditing standards, and a means
for coordinating and supervising the audit.

6.20 Explain why it may be important for the audit firm to retain custody of
audit working papers.

The audit working papers are the evidence to support the audit opinion on the
financial statements. It is important that they are retained for both professional and
legal reasons. They are the property of the auditor. If ASIC or a court order requires
the handing over of audit working papers they should be available and they should
‘stand alone’ i.e. someone should be able to read the audit working papers without
further information or explanation and be satisfied that sufficient evidence was
obtained to support the audit opinion given.

© John Wiley and Sons Australia, Ltd 2009 6.5

Solution Manual to accompany Modern Auditing and Assurance Services 4e

Professional Application Questions

6.21 For each of the foregoing risk factors, use the following codes to identify
the risk component that is most directly related to (a) fraudulent financial
reporting or misappropriation of assets and (b) incentives/pressures,
opportunity or rationalisation.
FFR= fraudulent financial reporting I/P= incentives/pressures
MA= misappropriation of assets O= opportunity
R= rationalisation

Fraud risk factors are identified in ASA 240.

(a) (b)
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

6.22 (a) Identify the fraud risks factors that are present in the case above.
(b) Identify the accounts and assertions that are most likely to be
misstated based on the fraud risk factors noted in this case.

(a) Fraud risk factors are identified in ASA 240:

● High degree of competition in the market
● Domination of the Rob Bigbucks
● Threatened employees with no payrises
● Significant portion of sales managers salaries are paid in bonuses
● Sales managers who do not meet targets three quarters in a row are replaced
● The industry is in a recession and it is starting to affect the company

(b) The financial statement assertions are identified in ASA 500. The most significant
threat is to the occurrence assertion for sales. There is very significant pressure on
the sales managers and there is a high risk that they will take any opportunity to
overstate sales, particularly given that there is a recession.

However, there is also a broader threat of financial reporting fraud on other

balances. This is because of the threatening behaviour of Rob Bigbucks over the
accounting department to ensure that they help him achieve “company goals”.

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 Chapter 6: Client evaluation and planning the audit

Given the recession, company goals will be harder to achieve increasing the
pressure on the accounting department.

6.23 (a) How would the above two issues affect the audit partner’s decision on
whether to accept the engagement?
(b) What other information sources should you review to help the partner
evaluate the client?

(a) The article on 5 August might cause the auditor to review the integrity of
management (ASA 220) with respect to accounting policy choices and it would be
something that would be described as a ‘special circumstance’ to consider when
accepting the engagement. AASB 138 allows capitalisation of development costs
under certain circumstances but does not allow capitalisation of research costs.
The fact that it will cause improved short term profits and it was only done for the
first time in 2008 would be something that the auditor should investigate further.
It could be that the management is engaging in earnings management to mislead
investors. The fact that the media has picked up on the issue would also be
additional incentive for the auditor to follow this up and to investigate whether
there are other examples of ‘aggressive’ accounting in deciding to accept the
engagement.

The article on 27 September that discussed the two directors resigning should
make the auditor have a much closer look at the corporate governance of the client
and integrity of management when deciding to accept the engagement. The
auditor should try to get hold of the directors’ minutes that discussed the issue and
also try to talk to the two directors that resigned to ascertain their reasons. The
auditor should also try to talk to some of the current directors about the issue as
well.

(b) ● Talk to the prior auditor

● Talk to management and employees of the company
● Make inquiries of third parties where possible, such as bankers.
● Review industry publications

6.24 Write a letter to the managing director answering his concerns and
explaining why you need a signed audit engagement letter.

Date

The Managing Director

Dezigns Ltd

Dear Sir

We appreciate your concerns about the audit engagement letter and we are sorry if
giving you the letter has offended you in any way. However, please appreciate that the
preparation of the letter is in no way indicative of any lack of trust of you or your
firm. The letter is prepared because we are professional accountants and as such we

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

are obliged to follow professional standards to ensure that our work is at an

appropriate standard. As per the requirement of one of the auditing standards, (ASA
210) we are obliged to prepare an audit engagement letter outlining a number of
specific things. The audit engagement letter is therefore a fairly standard document
that is basically the same for most clients.

It is true that it does outline your responsibilities but it does not add to them in any
way. It is just a restatement of your responsibilities as they are outlined in the
Corporations Act. It does not just discuss your responsibilities though; it also goes
into quite a bit of detail about the audit process and what our responsibilities are as
auditors. This is to make everything clear from the start of our relationship and avoid
any confusion if there are any problems at a later date.

We would be pleased to talk to you in more detail about the contents of this letter at a
time of your convenience and we look forward to our future professional relationship
with Dezigns Ltd.

Yours sincerely

The Audit Partner

6.25 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

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 Chapter 6: Client evaluation and planning the audit

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.

6.26 Discuss the impact of the above analytical review procedures on your
audit plan for 30 June 2009.

[Note: Each procedure will be discussed individually and then there will be some
general comments at the end.]

Current ratio
The current ratio seems to be okay. There is a slight fall however you would not
change the audit plan in response to reviewing this current ratio.

Debt-to-equity ratio
This has increased significantly in 2009. This would be something you should have a
closer look at. It may have a potential going concern impact which would be of
concern to you in planning the audit. You should also look for any potential debt
covenants that must be complied with as part of any new financing arrangements.

Times interest earned

This has reduced consistent with the increase in debt observed from the debt-to-equity
ratio.

Accounts receivable turnover

This has slowed significantly from 2008 to 2009. This could possibly indicate that the
company is pursing sales from customers with greater credit risk, which would impact
the level of the doubtful debt provision. It could also mean that the company is
struggling with cashflow. The main concern for the auditor from this figure is in
establishing that the accounts receivable are recoverable and more work would need
to be performed in that area.

Inventory turnover
This has also slowed significantly from 2008 to 2009. It may indicate a couple of
different possibilities. The company may have a higher level of obsolete stock at the
end of 2009 which has not been provided for. This would indicate that the company is
attempting to show a higher inventory figure at the end of the year to improve profits
though their method of inventory costing or overstating the quantity of inventory.

Return on sales
This has improved which is good, provided the earnings are valid.

Gross profit margin

This has improved significantly. If this increase is valid it would be a good thing for
the company. However, the slowing in inventory turnover (noted above) could
indicate that ending inventory is overstated which may have resulted in the
improvement in gross margin. As part of the audit plan the auditor should carefully

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

evaluate these figures, paying particular attention to the value of ending inventory. If
the figures have been misstated it also has implications for validity of the good return
on sales ratio.
General Comments
From reviewing these ratios there are some possible concerns highlighted in relation
to inventory and accounts receivable. The auditor should focus more work in the audit
plan on substantive testing in these areas.

6.27 (a) Describe why it is important that auditors should plan their audit
work.
(b) Describe the matters you will consider in planning the audit and the
further action you will take concerning each of the five matters listed
above.

(a) According to ASA 300 "adequate planning of the audit work helps to ensure that
appropriate attention is devoted to important areas of the audit, that potential
problems are identified and that the work is completed expeditiously. Planning
also assists in proper assignment of work to assistants and in co-ordination of
work by other auditors and experts."

From the knowledge of the business the auditor will be able to identify
transactions or balances that may require special expertise in verifying and the
need to appoint experts and locations that may require assistance from other
auditors.

From obtaining the understanding of the internal control system the auditor will
determine the audit strategy applicable for each audit component and the nature
and level of audit procedures to be undertaken.

From discussions with management the auditor will identify timing requirements
for completion of the audit, the timing of physical inventory and any additional
procedures management requires the auditor to undertake.

From a review of draft financial reports the auditor will determine the appropriate
level of planning materiality and will identify any matters that appear unusual or
that have changed since previous years that will need to be given special attention.

From these procedures the auditor will be able to draw up a detailed audit program
and determine a time and staff budget to ensure that adequate resources and
expertise are available to undertake the necessary audit procedures.

(b) 1. Sales revenues have increased substantially whereas profit margins appear to
have fallen. Revenues could have risen due to the more favourable credit terms
being offered. The fall in profit margin additionally suggests a fall in selling
prices that will require the net realisable value of inventory to be carefully
considered. Also if the organisation has chased sales by selling to customers
with poorer credit ratings we will need to carefully consider the recoverability
of receivables. The fall in profit could be unrelated to sales and be due to an
increase in overheads so there should be consideration of the possibility of

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unusual costs.

2. The company's proposals mean that extensive testing will need to be

undertaken on controls over the new inventory system. The auditor will need
to be satisfied that control risk is low and thus transactions are likely to be
properly recorded. The auditor will also require that control procedures call for
regular test counts of inventory, of comparison of test counts with book
inventory, of identification of the causes of differences and correction of the
records as necessary. The audit plan will need to provide for attendance at
several of such test counts to comply with auditing standards requiring
physical inspection of inventory. I will also need to warn management that, if
control risk over inventory records is not assessed as low or if the test counts
do not provide sufficient evidence as to the reliability of the inventory records,
I may not be able to accept inventory records as providing sufficient,
appropriate audit evidence for inventory. If a physical inventory is not then
undertaken I might need to qualify my opinion on the basis of a limitation in
scope.

3. I will need to obtain details of such claims so that I can write to the company's
solicitors to obtain their opinion as to the likely outcome of claims and
consider the need for a provision or to disclose a contingent liability. I would
also need to consider the effect on inventory valuation if the products in
question become unsaleable. I would also need to consider the likelihood of an
increased bad debt provision from customers refusing to pay.

4. The extension of credit terms increases the risk of bad debts if credit controls
are otherwise unchanged. I would need to review controls over credit approval
to ensure the risk of supplying goods to customers who are poor credit risks is
low. The ratio does not indicate an alarming fall in collection but the slight
deterioration will necessitate increasing audit attention being given to evidence
as to the valuation of accounts receivable and determination of the provision
for bad debts. (It could be that much of the relative deterioration in collections
is due to the problems discussed in 3 above.)

5. I would need to inquire into the reasons for the dismissal such as through
reading the relevant directors' minutes. If the reason was misconduct it is
possible that the financial results are affected by fraud even if not specifically
identified. I would need to ascertain whether such is the case. If the financial
effect cannot be determined it may affect my ability to provide an unmodified
audit report. Reliance on the chief accountant for preparing the financial report
may increase the risk of error in matters of judgement and estimation through
lack of experience or of familiarity with the approach adopted by the chief
financial officer.

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

6.28 Discuss the effect that each of these five items in the minutes of the board
of directors meeting will have on specific aspects of the audit plan.

Revaluation of land and buildings

This will require further work by the auditor in the non-current assets section of the
audit work program. The auditor should evaluate whether the directors have obtained
the use of an expert in making this valuation and whether the valuation is part of a
normal policy of valuations. The auditor will need to consider AASB 116 in
performing the audit on this section and ensure the revaluation is on the “class” of
assets. The auditor should also evaluate the materiality of the revaluation to consider
whether he/she should obtain the services of an independent expert to ensure that the
valuation is not greater than recoverable amount. The auditor should consider ASA
620 if an in independent expert is used.

Takeover of a major customer

This is of interest to the auditor because Lincoln Traders will need to consolidate the
company. The auditor should take extra care to ensure that intercompany transactions
are properly identified and recorded for elimination on consolidation. The auditor
should also take particular care to ensure that all intercompany balances are
eliminated at the end of the year. Any large transactions between the two companies
around balance date should be carefully reviewed to ensure that cut-off has been
properly effected.

Bonus scheme
These schemes are popular to attempt to align shareholders’ interests with
management's. However, they raise some concerns for auditors in relation to profit
manipulation. The auditor should be careful to ensure that all provisions are properly
stated, all liabilities are recorded in the period, and that accounting policies are
consistent with prior years. The auditor should also be careful to ensure that all sales
towards the end of the year are valid and that there are no unusually large returns after
balance date.

New factory
The auditor should ensure that all costs are properly accumulated at the end of the
year for the construction in progress of the new factory. The auditor should perform
adequate work on the ‘construction in progress’ account and should visit the
construction site to evaluate the existence of the factory and obtain an estimate of its
percentage of completion. Depending on the materiality of the factory, the auditor
may want to consider using the work of an expert, ASA 620.

Loan to subsidiary in Fiji

The auditor should firstly ensure that the loan is adequately disclosed in the accounts
of the subsidiary in Fiji. The auditor should then consider the collectability of the
loan. This may include a review of the draft financial statements of the subsidiary and
discussion with management in both companies. It should be carefully evaluated to
ensure that the amount is actually a loan rather than a payment to support the
subsidiaries operations.

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 Chapter 6: Client evaluation and planning the audit

6.29 Review the above working paper (Note: it is the only documentation on
file that relates to this test performed by Emily Bohn). Comment on the
adequacy of the working paper, the level of documentation, the matters
arising and the conclusion reached.

Review of working paper

Audit documentation should include information relating to the nature, timing, and
extent of the audit procedures performed, the results of the audit procedures, the audit
evidence obtained; and significant matters arising and the conclusions reached (ASA
230). Specific issues here are:
1. There should be details of the objectives [management assertion(s)] to which this
test relates – i.e. the completeness of sales.
2. Sample selection? There are no details about the basis for determining sample
size, the sample selection method or whether any items were selectively sampled.
3. A sample selected from a single month would appear to be biased unless some
specific justification is stated.
4. The test does not work through to the ledgers and financial statements which
would be needed to conclude on the completeness assertion.
5. Dispatch dockets that did not result in the production of an invoice. There should
be more information on these two exceptions. Is this a breakdown in the control?
Need to have discussed the matter with the client. Materiality is not an issue in
testing samples. The possible error needs to be projected to the population and the
need for further testing considered.
6. Discounts. Verbal assurance from staff who could possibly be responsible for the
misstatements is not adequate evidence. The matter needs to be raised with the
sales manager. Failure to authorise discounts in writing by a person in the
organisation of appropriate seniority appears to be a control weakness that needs
to be brought to management's attention. If the sales manager fails to confirm the
discounts it may be appropriate to warn management of a possible fraud and to see
that appropriate action is taken.
7. Extra stock. Again verbal assurance from staff possibly implicated in improper
behaviour is not sufficient. The matter needs to be followed up in a similar manner
to the discounts above.
8. All of these matters arising should be highlighted to management in the
management letter.
9. If the matters in items 4, 5 and 6 are found to be errors there should be a
projection of the likely error rate in the population as a whole and the resulting
projected error compared with testing materiality determined for this particular
test. If there is a possible material error then the matter should be highlighted for
the manager's attention.
10. Conclusion. The conclusion is far too general for the work that has been
performed, not all assertions relating to sales transactions have been tested.

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Case Studies

6.30 Prepare a memo to the audit partner outlining potential problem areas
and their impact on the audit plan.

Listed below are some points that could be included in a memo:

 The company has recently listed on the stock exchange. This increases the
number of possible users of the annual report and also significantly increases
the extent of reporting requirements.
 The change of auditors should be carefully followed up. Some information has
been provided from the prior auditors that would be useful in conducting the
audit as discussed as follows:
 Tom Green does not seem to have much knowledge of or interest in the
financial side of the business. This will have implications in the
assessment of the control environment.
 The discussion with the prior auditor also found that there had been
disputes with Wendy Chong over accounting policies. This should be
noted and the auditor should be prepared to argue over accounting
policies that he or she believes to be appropriate. It should also cause the
auditor to take care in relying on representations from Wendy.
 The bonus paid to Wendy Chong based on growth in net profitability is a
concern. This is because it gives incentives for Wendy to take aggressive
accounting choices to achieve the bonus.
 There is a very large contract with a UK supermarket chain. Whilst this is a
good thing for the company, the percentage of the company’s sales that relate
to this chain should be reviewed to assess the implications for the business if
problems occur with this contract.
 Another risk is that part of the company’s success in exporting is due the low
value of the A$. The auditor should do some sensitivity analyses on the impact
of variations in this exchange rate and the possible impact it might have on the
operations of the company.
 The company hedges to reduce its foreign exchange risk (which is good).
However, there would be a concern from the comment that healthy profits
have been made on hedging contracts. These contracts should not be used to
try and ‘make money’ but to cover foreign currency obligations. This is
something that should be considered in assessing control risk.
 The stock held overseas should be carefully reviewed to assess its valuation.

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6.31 (a) Suggest possible sources of information that would help you gather
sufficient knowledge of the business to perform the audit of
Telechubbies Ltd.
(b) Perform preliminary analytical procedures using the information
provided. Identify key areas that would require special attention
during the audit of the 31 December 2009 financial statements.
(c) Outline the ways that the analytical procedures performed could be
extended using the information collected in (a).
(d) Suggest ways of using analytical procedures as a substantive test
during the audit of Telechubbies Ltd.

(a) ASA 315 suggests sources of information for obtaining an understanding of an

entity and its environment. Information could come from:
 previous experience of the industry;
 discussion with people within the entity;
 discussion with internal audit and a review of their reports;
 discussion with the previous auditors and with legal and other advisers;
 discussion with knowledgeable people outside the entity;
 publications related to the industry;
 legislation and regulations that significantly affect the entity;
 visits to the entity's premises and plant facilities; and
 documents produced by the entity such as minutes, material sent to
shareholders, promotional literature, previous annual reports, internal
management reports etc.

(b)

Ratio Basis 2009 2008 2007

Current ratio C Assets / C Liabilities 2.18 2.39 2.63
Quick ratio (CA – Inventory) / CL 0.99 1.23 1.54
Debt/equity Non-CL / Equity 2.1 1.8 1.6
Inventory turnover Cost of sales / Inventory 3.14 4.41 8.76
Receivables turnover Sales / Trade receivables 6.01 7.00 9.63
Payables turnover COS / Trade payables 5.75 8.23 31.21
Gross profit Gross Profit / Sales 28.9% 30.9% 29.7%
Depreciation/PPE Depreciation exp / PPE 38.3% 33.7% 29.2%
Marketing expense to sales Marketing exp / Sales 1.8% 2.6% 2.8%

Rate of change 2007 is the base year

Sales 81.3 83.5 100
Cost of sales 82.2 82.1 100
Inventory 229.2 163.0 100
Receivables 130.2 114.8 100
Property, plant & equipment 152.6 134.1 100

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Solution Manual to accompany Modern Auditing and Assurance Services 4e

Preliminary analytical procedures reveal the following key areas:

 Inventory shows a dramatic rise in absolute terms when cost of sales are
falling and a substantial fall in the rate of turnover suggesting that inventory
valuation requires careful attention. On this basis the reduction in the
provision for inventory obsolescence from 20% to 10% appears imprudent.
 Receivables show a similar but less marked tendency suggesting the
collectability of debts will need careful attention.
 Property, plant and equipment has increased at a time when the level of
activity is falling. Why the company continues to invest in expanding its plant
needs investigating. There is also the possibility of impairment.
 Current, quick and debt/equity ratios are all rising indicating that the
consideration must be given to the company ceasing to be a going concern.
This is further indicated by the increasing difficulty the company appears to be
finding in paying its creditors as indicated by the payables turnover. Moreover,
on present figures the company would appear to be in excess of the 2:1
restriction in its debt to equity ratio.

(c) Analytical procedures compare recorded balances with expectations. The

commonest expectations are prior period amounts and related amounts (ratios) or
a combination of both as is illustrated in (b) above. However, more sophisticated
expectations can be developed using internal information, such as budgetary
information and other plans and forecasts developed by management. Similarly
expectations can be based on external information sources such as industry
averages or known changes in regulations or markets.

(d) Analytical procedures can be used as a substantive test (ASA 520) in a number of
ways.
 Where there is a known or predictable relationship between two amounts such
as the provision for inventory obsolescence, this relationship may be verified
by analysis (This does not verify the appropriateness of the relationship).
 For profit and loss expense account balances where the transactions have
already been subjected to verification as purchase transactions in connection
with payables, analytical procedures may provide sufficient evidence to verify
the amounts allocated to specific account balances. For example, the
relationship of marketing expenses to sales may be considered sufficiently
constant as not to require further testing.
 The major use of analytical procedures is in confirming (or failing to confirm)
expected relationships such that the planned level of tests of details may be
relied upon (or extended if necessary). For example, it may be concluded that
the gross profit ratio is as expected and that additional tests of cut-off beyond
those already planned are unnecessary.

© John Wiley and Sons Australia, Ltd 2009 6.16

 Chapter 6: Client evaluation and planning the audit

Research Question

6.32 (a) Prepare a list of useful sources you can use to obtain the required
knowledge.
(b) Prepare a memo to the audit partner on the ‘state of the media
industry’ and associated risk factors.

(a) Useful sources of information could include:

 Previous experience with the entity and its industry.
 Discussion with people in the entity.
 Discussion with internal audit personnel and review of internal audit reports.
 Discussion with other auditors and with legal and other advisors who have
provided services to the entity or within the industry.
 Discussion with knowledgeable people outside the entity.
 Publications related to the industry.
 Legislation and regulations that significantly affect the entity.
 Documents produced by the entity.

(b) This will vary significantly over time and the main objective is to develop
students’ research skills. It would be expected that they would source material
mainly from the internet. Two important sources would be:
 Factiva – for newspaper articles.
 AspectHuntley – for financial information.

© John Wiley and Sons Australia, Ltd 2009 6.17