Syllabus Area B- Audit Risks And Responses

Question 1

New audit client- 2 risks

Answer 1

RISK: being a new client, initially firm will have less knowledge of client which means there is more chance of audit failure which increases detection risk in the first year

Opening balance may be misstated as we did not conduct audit last year.

RESPONSE:
More time and resource should be spent understanding client.
a more experienced and senior audit team should be taken to the audit .
More substantive procedures
Larger sample sizes

Agree opening balances with last year signed FS. contact previous auditor for relevant working papers.

Question 2

Customers are struggling to pay debts

Answer 2

RISK: receivables may be overstated if bad debts are not written off
RESPONSE: Inspect after date cash receipt from customers to see if paid post year end proving the debt is appropriately valued

Review aged receivables listing, see if there are any old irrecoverable debts and discuss with management if any allowance needs to be made

Question 3

The client operates in a fast paced industry.

Answer 3

Risk: Inventory may be overstated if the inventory is obsolete and NRV is lower than cost.
Response: Obtain the aged inventory listing and review for old items. Identify if anything needs to be discounted or written off

Perform detailed NRV and cost testing to ensure the old items are valued appropriately
Discuss with management the need for these to be written down in the financial statements.

Question 4

Revenue is falling due to recession.

Answer 4

Risk: this could mean the company is unable to continue to trade for the foreseeable future and going concern disclosures may be required. There is a risk that adequate disclosure is not made.

Response:
Perform a detailed going concern review
Assess the client’s ability to continue as a going concern by obtaining examining the forecasts prepared by management and assess the reasonableness of the assumptions used in the forecasts.

Question 5

Inventory is stored at a third party warehouse.

Answer 5

Risk: It may be difficult to obtain evidence of the quantity and condition of inventory held.
There is increased detection risk over completeness, existence and valuation of inventory.

Response: Additional procedures to ensure that inventory quantities and condition have been confirmed for both third party and company owned locations, e.g.
• Attend the inventory count (if one is to be performed) at the third party warehouses to review controls IRL
• Obtain external confirmation from the third party regarding the quantity and condition of the inventory.

Question 6

Product takes up to 1 week to manufacture

Answer 6

Risk: There is likely a material WIP inventory balance at year end. Determining WIP value and quantity is complex and subjective as it involves estimates of management. Exact cutoff of wip at yr end will need to be assessed,
if cut off (percentage completion) is not correctly calculated, inventory may be misstated

Response
Consider bringing an expert to value WIP, if so arrange it with consent from management and in time for year end

Percentage of completion basis should be discussed with client and check if reasonable
WIP calculation should be agreed with supporting documents like purchase invoices for materials and timesheets for labor
Overhead calculation should be recalculated and reviewed for any non production overheads.

Question 7

Company refurbished the product assembly line during the year

Answer 7

Expenditure incurred may have been incorrectly capitalised or incorrectly expensed as repairs.
There is a risk that that non-current assets are over or understated

Response:
obtain breakdown of cost
Agree invoices to check the nature of costs
If capital agree to inclusion in asset register
If repairs agree to expenses in PNL

Question 8

New website records sales automatically

Answer 8

RISK: there is a risk of incompleteness of income if the system fails to record all sales made on the website
There is a risk of revenue being understated

RESPONSE: perform control testing of the sales cycle, by using test data where possible
Perform detailed testing to check completeness of income

Question 9

Website development costs have been capitalised

Answer 9

Risk: In order to be capitalised, it must meet all of the criteria under IAS ® 38 Intangible Assets. Research costs should be expensed rather than capitalised.
There is a risk that intangible assets and profits are overstated and expenses understated.

Response: Obtain breakdown of development expenditure. Review and test in detail to ensure only costs that meet criteria are capitalised and the ones that don’t are expensed

discuss accounting treatment with finance director and ensure it is in accordance of IAS 8

Question 10

Employees were made redundant due to falling sales

Answer 10

Under IAS37, a redundancy provision will be required for any staff not yet paid their severance pay at the year end
There is a risk of understated liabilities

RESPONSE:

Discuss with management the progress of the redundancy programme and review and recalculate the redundancy provision

Question 11

Company is planning to list on stock exchange next year

Answer 11

Increased risk of manipulation of financial statements.
Risk of overstating of assets and profit , and understatement of expenses and liabilities

Response:

Maintain professional scepticism and be alert to the risks identified in order to achieve a successful listing.
Plan and perform procedures to ensure accounting estimates and judgmental areas are reasonable.

Question 12

Key client represents major chunk of revenue

Answer 12

Risk: Co may be over reliant on this client which could threaten its going concern status if this key client was lost. There is a risk that disclosures of material uncertainties relating to going concern are inadequate.

Response

Procedures should be designed at the planning stage to allow the auditor to assess the going concern risk faced by Hook Co.
Contracts and other correspondence from the key customer should be reviewed to identify any specific risks that the client may be lost. Analytical procedures should be designed to assess the impact on Hook Co’s financial position if the contract is not renewed.

Question 13

Company is negotiating a loan

Answer 13

Management may fabricate cash flow / liquidity position to show better current ratio , understate liabilities and overstate assets to show favourable picture to bank to secure the loan.

RESPONSE: apply skepticism, increase procedures and test all the balances to make sure they are correct and basis for them is reasonable

Question 14

Directors are paid bonus on a % of profit before tax

Answer 14

Incentive for them to manipulate FS. Risk of income and profit being overstated , expenses understated. If figures are given in scenario then include them.

Response:
Carefully review judgemental decisions and compare treatment of prior years
Increased audit procedures
Professional skepticism
Increase sample size for expenses and revenue

Question 15

Customers pay a 25% deposit in advance, rest is paid when product is delivered

Answer 15

There is a risk that the deposit is recognised as income due to which revenue and profit are at risk of being overstated . Deposit should be recognised as unearned revenue or deferred liability

Response:
Discuss with management their accounting policy regarding deposit
Or
Verify breakup of liability to ensure that the deposit is treated appropriately as an unearned income

Question 16

Audit team is only attending 5/16 inventory counts

Answer 16

Risk:
The location where audit team is not present will increase detection risk and more chances of management manipulating inventory balance

Response:
Ensure that number of sites selected are material and cover most of inventory available or which according to management have the most chance of misstatements

or increase the number of locations to cover maximum inventory.

Question 17

Warranty provision has been decreased without any reason

Answer 17

Risk- warranty provision is an estimate of the finance director and increases the risk that estimate has been lowered without logical basis to overstate profit and understate expenses

Response:
Discuss with finance director if there is no reduction in number of claims what is the logic behind decreasing warranty provision.

Question 18

Payroll function is outsourced to 3rd party.

Answer 18

Increased detection risk for auditor if auditor is unable to visit or get access to payroll records from company.

Response: inform directors at planning stage that they intend to visit chaz co when they come to perform final audit to gather evidence on payroll.
Allocate a team to visit chaz during audit

Question 19

Local Laws require more disclosure than company has currently given, and company doesn’t intend to give them as they are following Ac standards

Answer 19

Risk: local law prevails over international law. So the directors should give additional disclosure, currently they aren’t given so financial statements are materially misstated

Response: audit team should discuss with directors to give disclosure as they are important

Question 20

Gross profit of company has increased

Answer 20

Risk- revenue could be overstated, COGS could be understated

Question 21

Inventory holding period has increased

Answer 21

Inventory could be inappropriately valued ,

Question 22

Receivable collection period is rising

Answer 22

Receivables may not be recoverable
Risk that receivables are overstated

Question 23

Payable payment period is increased, current ratio has gone down

Answer 23

Co is taking longer to pay supplier, seems to have liquidity issues, company may have uncertainty regarding going concern must be disclosed, if not disclosed then FS are materially misstated

Question 24

Maintenance cost has been capitalised

Answer 24

Risk- PPE is overstated as this is impermissible

Response: discuss with management the right accounting policy and tell them maintenance cost is not permissible to be capitalised thus it needs to be adjusted.

Question 25

Company borrowed loan from bank of 8 yrs, at 5% interest, 3 risks

Answer 25

Risk 1- loan shud be split into current and NCL.if its not split correctly it will result in incorrect disclosure

Response- obtain and review breakup to confirm that current part of loan is classified correctly as a current liability

Risk 2- there is a risk that additional finance cost is not recognised which will result in understated finance cost and overstated profit

Response: recalculate finance cost and ensure its recognised in PNL as finance cost.

Risk3- company may have given the bank charge over its assets as security for the loan so risk that adequate disclosure of securities is not made

Response:
Review loan documents to check if any security has been given.

Question 26

Customer credit terms have been increased , and receivable collection period has increased as well

Answer 26

Customers are taking advantage of this. increased risk of customer not paying on time. So allowance for bad debts should be set appropriately. If this isnt done receivables will be overstated and expense understated.

Response: review allowance for bad debts, inspect the working of management and check if there is any rise in allowance by them

Question 27

Company intends to create a refund liability, because they have a price promise

Answer 27

risk: refund liability is the estimate of management so it is subjective. so there is a risk it may not be appropriately determined and it could be understated.

response: review the basis used by management in calculating refund liability and assess for reasonableness

Question 28

Management was disappointed with 20X4 results and hence undertook strategies to improve the 20X5 trading results.
Risk and response

Answer 28

Risk

There is a risk that management might feel under pressure to manipulate the results through the judgments taken or through the use of provisions.
There is a risk of misstatement of the financial statements to improve

Response:
Skepticism and alertness
Carefully review judgemental decisions and carefully review past treatment.

Question 29

A generous sales‐related bonus scheme has been introduced in the year.

Answer 29

Risk

This may lead to sales cut‐off errors with employees aiming to maximise their current year bonus.
There is a risk that sales are overstated.

Response

Increased sales cut‐off testing will be performed along with a review of post year‐end sales returns as they may indicate cut‐off errors.

Question 30

Revenue has increased alot, COGS has not increased

Answer 30

Sales may be overstated , even if advertising or whatever but this does not explain why COGS has not increased

Response:
During the audit a detailed breakdown of sales will be obtained, discussed with management and tested in order to understand the sales increase.

Question 31

Gross profit margin has increased and operating profit margin has DECREASED.

Answer 31

Risk that costs have been misclassified and all costs are included in operating costs

Response

The classification of costs between cost of sales and operating expenses will be compared with the prior year to ensure consistency.

Question 32

Current and quick ratios have decreased , but are above optimum level

Answer 32

This means co might be having liquidity problems. Even if they are above optimum levels this decrease could result in going concern
There is a risk adequate disclosure is not made in the notes of FS.

Response:
Perform detailed going concern review and check forecast and assess reasonableness
If there is any loan discuss how it will be paid

Question 33

Company now uses bad quality materials and more customers are claiming warranty

Answer 33

Provision should be higher, if not increased, there is a risk that provision is understated

Response:
Review warranty provision and check if it has been increased in light of recent events, if not discuss with management

Question 34

Directors have increased life of PPE resulting in reduced depreciation

Answer 34

Risk: according to ias 16 this is to be reviewed annually and only to be increased if genuinely asset life is increased. There is risk this is done to manipulate profit so PPE is overstated and profit overstated

Response
Discuss logic with directors
Compare life with how often the asset is replaced as this will give evidence of useful life of asset

Question 35

Company has a policy of revaluing its land and buildings and this year has updated the valuations of all land and buildings.

Answer 35

PPE may be misstated if valuation has not been carried out
And
Adequate disclosures may not be made

Response
Discuss with management the process of valuation
Ask if whole class is valued
Was it valued by an exert
Check if process is in compliance of IAS 16

Review disclosures in FS for compliance with IAS 16

Question 36

Due to staff availability company will do inventory count few days before yr end and adjust movements

Answer 36

Risk that adjustment are not made accurately or completely, inventory may be misstated

Response
Increased testing of inventory cut off, check supporting documentation of adjusting items

Question 37

Company recorded insurance proceed as income, when it’s not received yet

Answer 37

Overstated profit and receivables

Response
Discuss with management any correspondence with insurance company
If virtually certain, treatment is correct
If not ask them to remove
If probably, ask them to include contingent asset in disclosure note.

Question 38

It is requested to start audit earlier than normal as management wishes to report results earlier

Answer 38

Audit may be rushed , shorter subsequent events period to obtain evidence, increased detection risk, increased pressure on team to obtain sufficient and appropriate evidence

Response:
Confirm timetable, if it really is to be reduced
Consider performance of interim audit to reduce pressure on final audit
Maintain professional skepticism

Question 39

Old director left was doing fraud

Answer 39

Possible that full impact of fraud hasn’t been quantified, any additional fraudulent transactions will need to be written off. If not uncovered, FS could include errors (overstated profits)

Response:
Discuss with management what procedures they have adopted to identify the full impact
Discuss what controls have been put into place to identify further frauds

Review balances of items the director was doing fraud of (inventory if stealing inventory etc) identify unusual things as this could be further evidence of fraudulent transactions

Maintain professional skepticism and alert to further risk

Question 40

New director was in unrelated industry before

Answer 40

May not be qualified to prepare FS, Might contain errors

Response:
Alertness skepticism
Be careful of any changes in accounting policies and any judgemental decisions by the finance director .

Question 41

Increased sales returns happened post year end

Answer 41

These shud be removed form revenue
And added back in inventory
If not correctly recorded, revenue will be overstated and inventory understated

Response:
Review a sample of the post yr end sales returns to ensure correctly recorded in revenue and inventory
Discuss reason of these sales returns, to help assess if there are any underlying issues with the NRV of inventory

Question 42

Inventory count was not controlled, there was movement of goods

Answer 42

There is a risk goods have been omitted or counted twice, inventory could be over or understated.

Response
During the final audit, the GRNs and GDNs received during inventory count shud be reviewed and followed through into the inventory count records as correctly included or not

Question 43

Big gain on disposal, 2 risks

Answer 43

1- Risk that it maybe incorrectly calculated to manipulate profits, thus overstating profit
Response: recalculate the discposal calculation and agree all items to supporting documentation

2- Significant profit or losses means depreciation policy is not appropriate
Depreciation may be overstated as a result

Response: discuss depreciation policy with director to assess reasonableness

Question 44

Ordered machinery, two thirds of it is not received at yr end

Answer 44

Only assets that physically exist must be included in PPE
If not PPE will be overstated

Also consideration needs to be given as to when depreciation needs to start being charged
If dep is not appropriate, assets and profit will be misstated

Response
Discuss with management, check that only appropriate assets are in NCA register
Determine if asset use has begin and if so, depreciation has commenced at an appropriate point

Question 45

Company purchased a patent

Answer 45

It shud be included as an intangible asset in SOFP and amortised over its life
If not correctly accounted for, intangible assets and profit could be overstated

Response:
Agree purchase price with supporting documentation
Confirm the useful life is 5 yrs

Amortisation charge shud be recalculated to ensure intangible is correctly valued at year end

Question 46

During the year co outsourced payroll function to third party- 2 risks

Answer 46

1 risk
Controls will need to be verified at third party
Detection risk arises, evidence needs to be collected for completeness and accuracy
If not, another auditor may be required to do testing at third party

Response- discuss the extent of records, any monitoring of controls by management. Contact the third party auditor to confirm that controls are in place

2 risk
Errors may have occurred during transfer process
Loss of data
so risk that payroll charge balance is misstated

Response
Discuss with management the transfer process and any controls to ensure completness and accuracy of data,
perform testing on the transfer of information from new to old system to ensure that all balances at transfer date have been correctly recorded in the new system

Question 47

Co PLANS to make employees redundant

Answer 47

If it’s announced before yr end, a provision will have to be made, failure to do this will result in understatement of provisions and expenses

Response
Discuss with management the status of redundancy announcement, of before yr end, review supporting documentation to confirm timing, also review the basis of and recalculate the redundancy provision

Question 48

Company included training cost in PPE

Answer 48

according to ias 16, cost includes purchase costs and directly attributable costs only, training costs r not permitted. Thus PPE and profit is overstated

Response
Obtain breakdown
Test to confirm the training costs
Discuss accounting treatment
Tell them adjustment is required for it to be in accordance with IAS 16

Question 49

Reconciliation were not performed at yr end by client due to shortage of staff

Answer 49

Reconciliation are important as they provide comfort that records are being maintained accurately and completely, this is an example of a control procedure being overridden by management and raises concerns over the overall emphasis placed on internal control
Risk that balances are misstated

Response
Discuss and request that they undertake reconciliation
Test reconciling items in detail and agree them to supporting documentation

Question 50

Payables ledger was closed down a week later than reporting date

Answer 50

Risk that cutoff may be incorrect and purchases and payables may be overstated or understated

Response
Undertake testing of transactions posted to the payables ledger between this period to identify if any next year’s transactions have been added or previous yrs transactions removed

Question 51

Company has damaged goods in inventory or faulty products

Answer 51

Risk that inventory is overvalued as it’s Nrv may be below cost

Response
Discuss if any write downs will be made
Ask if any modifications will be required
Testing shud be done to confirm cost and nrv

Question 52

General overheads are included in inventory

Answer 52

According to ias 2, costs incurred that helped bring inventory to present location and condition can be included in cost

General overheads dont meet this criteria, if they r included inventory will be overstated

Response
Discuss nature of overheads
Ask them to remove general oh in draft financial statements
Review supporting documentation to make sure production overheads are actually related to production

Question 53

Company issued shares at a premium to raise finance for their project

Answer 53

This needs to be accounted for correctly, adequate disclosure needed, equity needs to be allocated correctly between SC AND SP. If not done, accounts may be misstated due to lack of disclosure or SC SP may be misstated

Response
Confirm that proceeds were received
Split is correctly recorded
Disclosure shud be reviewed to ensure compliance with accounting standards and local legislation

Question 54

Compayny intends to propose a dividend

Answer 54

A provision should not be made as the obligation arises only when dividend is announced.
Dividend should only be disclosed, if it is included, liabilities will be overstated and equity understated

Response
Discuss with mgmgnt
Confirm that dividend isn’t included
Review Fs to ensure adequate disclosure abt proposed dividend is made

Question 55

Customer intends to sue company legal action for faulty goods

Answer 55

If it’s probable that company will have to pay customer, legal provision is required
If possible then liability disclosure is necessary

If not done, risk over completeness of provision or disclosures.

Response
Write to lawyers
Enquire about existence and likelihood of payment
Then assess if provision is made / disclosure made accordingly

Question 56

Product recall is being done

Answer 56

This will result in refunds , sale to be removed and refund liabilities recognised and inventory reinstated according to its NRV
FAILURE TO ACCOUNT FOR THIS CORRECTLY cud result in revenue overstated and liabilities and inventory understated

Respond
Review sales and ensure refunds have been removed
If refund has not been paid post year end, agree it is included in current liabilities.

Question 57

As part of the interim audit which was completed earlier in the year, an audit assistant attended a perpetual inventory count in September and noted that there were a large number of exceptions where the inventory records were consistently higher than the physical inventory in the warehouse. When discussing these exceptions with the finance director, the assistant was informed that this had been a recurring issue all year.

Answer 57

Yr end inventory quantity will be based on these records, this is likely to result in overstated inventory

Response:
Discuss with management as it may not be possible to rely on these inventory records, this could result in a requirement for full year end inventory count, so request them to do it