Auditing and Assurance Services Assignment 2009

Subject Code: CO5118

Subject Name: Auditing and Assurance Services

Subject Co-ordinator: John Howarth

Student Name: Xinyu Chen

Student ID: 11906467

Due Date: April 25th 2009

Table of Contents

1. a) Factors Indicating a Going Concern Problem...........................3Financial...........................................................................................3Operating.........................................................................................4Others..............................................................................................5

1. b) Additional Information.................................................................52. Substantive Procedures to Address the Key Audit Assertions......6

2. a) Trade Debtors..........................................................................72. b) PC inventory............................................................................82. c) Returns Provision.....................................................................92. d) Operating Revenue................................................................10

3. What Effect Would this Information Have on the Audit?...............12References........................................................................................13Appendix A: Charts...........................................................................14

1. a) Factors Indicating a Going Concern Problem

What are the key factors that indicate that the company may have a going concern problem?

‘Going concern’ means that an entity can pay for its debts when they are due, and continue in operation without any intention or necessity to liquidate or wind up its operations. Generally, there are three factors that contribute to a firm having a going concern problem: financial factors, operating factors, and other factors (From CPA website).

Financial

Factor Analysis Net liability or net current liability position? For ABC, net liability was 58,513

in 2001. Inability to pay creditors on due dates? More unlikely to pay money to

creditors Inability to meet with the terms of loan agreements

More likely not to meet the terms of loan agreements

Inability to get financing or basic new product development or other investments

Maybe ABC has a problem to finance its investments due to a bad financial position

Adverse key financial ratios Debt ratio was 1.64 >1, which means ABC has more liability than assets.

Negative operating cash flows From the income statement, we can conclude that ABC has negative cash flows

Substantial deterioration in the value of assets which used to generate cash flows

More than 50% value of plant and equipment depreciated.

Arrears or discontinuance of dividends ABC probably has an inability pay dividends to its shareholders due to its negative equity.

Debtors or other creditors withdraw money Not illustrated that debtors withdrew money in the article.

Over reliance on short-term debt to fund long-term assets or fixed-term borrowing approaching maturity without repayment

Not mentioned in the article.

Change from credit to cash-on-delivery transactions with suppliers

Not mentioned in the article.

Operating

Factors AnalysisLoss of key management not replacement

Not mentioned in the article.

Loss of a major market, license, franchise, or majority suppliers

ABC loss PC market.

Labour difficulties or shortage of important supplies

Not mentioned in the article.

Lack of strategic direction ABC’s strategy is now to sell Modems and Spares.

Deficiencies in the governing team Yes, there are deficiencies in governing team, such as managers intently treated tax loss as assets

Lack of variety of products to reduce risks

ABC only produces three different type of IT products. This is not enough variety of products to reduce risks.

Difficulty to prolong industrial relationships

Not mentioned in the article.

Deficiencies in management information systems

No deficiencies in management information systems.

Unplanned development of business ABC has some plans for its development of business, for example its future market only focuses on Moderns and Spares.

Uninsured disaster No uninsured disaster happened in 2001.

Others

Factors Analysis Lack of sufficient back-up and recovery capabilities for key financial information systems

Not mentioned in the article.

Other same industry of entities failures Not mentioned in the article.

A key product obsolete due to rapidly technical developments

ABC not did very well in the PC market since rapid technological developments.were introduced

Undue impact by a market dominant competitor

From ABC’s perspective, its PC sales have been put out of the market as an undue impact by competitors.

It is expected that legislation or government policy.adversely affects the firm

Not mentioned in the article.

ABC not meeting capital or other statutory requirements

ABC met with capital requirements

1. b) Additional Information What additional information would you obtain to evaluate this problem?

I would obtain additional information listed below to evaluate the firm’s going concern problem:

Evaluating Management’s Assessment According to going concern assessment, review management’s future

actions Gather audit evidence to make sure that there exists a material

uncertainty Obtain written representations about future actions from management Obtains audit evidence to prove that the management’s plans are

workable

Obtain additional available facts or information from managers, who relied on certain dates to assess the going concerning problem

Discussing the entity’s recent interim financial report

2. Substantive Procedures to Address the Key Audit Assertions

Assume the audit partner has concluded that the company is likely to remain a going concern. Describe the substantive procedures to be performed to address the key audit assertions for the following balances:

Trade Debtors, PC Inventory, Returns Provision, Operating Revenue and Amount Owing to Parent Entity.

There are some key audit assertions for the following accounts, for example: Existence and occurrence, valuation, rights and obligations, presentation and disclosure.

To address these assertions, the auditor will most likely need to perform some standardised audit procedures such as risk assessment procedures supplemented by further audit procedures to shape control tests and substantive tests, because risk assessment procedures do not provide sufficient and appropriated audit evidence.

Firstly, the auditor should perform risk assessment procedures. After this, the auditor can conclude that ABC Pty Ltd has poor internal control, since management is keen to classify significant tax losses as an asset to improve the financial position. There is a risk of management override of internal controls and high risks of material misstatement at the ABC’s financial report and assertion levels. Therefore, the auditor can hardly use the internal resources to reach an opinion about the debtors account.

Secondly, the auditor should perform control test due to the fact that there may be system changes this year, event though ABC has a strong control in accounting systems for debtors, inventories and general ledger functions in prior years

Lastly, substantive tests can be conducted by one or more of the following ways: Inspection of records or documents, observation, inquiry, confirmation, recalculation, reperformance and analytical procedures. The auditor should examine each of these in turn.

2. a) Trade Debtors

Assertion Procedures Application

Existence and Occurrence

Ask ABC’s debtors to confirm the existence and amount of their indebtedness to the client

After the audit, the company had $9,133,000 debt

Valuation 1. Test of transaction processing and reviews of contracts can addressed the sales and receivables transactions initially recorded at their correct value

2. Determining the reasonableness of the provision for doubtful accounts to address whether ABC will likely collect the outstanding receivables in a timely fashion

Two of ABC’s largest debtors have gone into liquidation. Therefore, ABC only can get 50% of these debts from insurance company, but only if they provide sufficient evidence. On the other hand, it shows that the company under value its trade debtors from the note 3.

Rights and Obligations

1. Review all arrangements that ABC sells its account receivable to banks or other financial institutions, while making sure that they still take responsibility for collecting the receivables.

2. Make inquiries and review the minutes of the board of directors’ meeting for indications of discounted receivables

Not sure whether the company has sold its accounts receivable to banks or other financial institutions.

Presentation and Disclosure

1. Confirmations from banks and financial institutions

2. Review of loan agreements, board of directors’ minutes and the receivables trial balance

3. Inquiry of management

Not applicable.

2. b) PC inventory

Assertion Procedures Conclusion

Existence and occurrence

1. Review ABC’s physical inventory procedures

2. Observe the ABC’s count of annual physical inventory. Perform test counts of the observation and trace to the company’s compilation of inventory

All of ABC recorded inventory exists.

Completeness 1. Perform year-end cutoff test. Review the purchase and sales journal that record just before or after year end

2. Make inquiries to managers about the existence of goods on consignment or lied in outside warehouses

3. Ask managers about the company’s policy for expected return allowance. Review receipt of transactions during a selected period of time.

Not all of ABC’s PC inventory has been recorded on the reporting date

Rights 1. Test disbursement and Review supplier invoices to make sure that proper title is transferred

2. Review the company’s sale contracts to determine whether the customers has rights to return PC. And how the company recognize sale revenue if the contract included the goods return.

1. All of the recorded PC inventories actually belong to the company. 2. The company controls the rights to the PC inventory. 3. ABC customers have rights to return PCs

Valuation 1. ABC uses an appropriate valuation method

2. Ask production and warehouse staff about the existence of obsolete inventory

3. Find obsolete inventory. Trace obsolete items to the inventory compilation and decide whether they are correctly classify as obsolete items

4. Test inventory cost

5. Test the probability of obsolete inventory that should be written down to market value

The company undervalues its PC inventory.

Disclosure 1.The inventory valuation method used

2.inventory policy about returns and allowances

ABC established an allowances for returns of PCs

2. c) Returns Provision

Assertions Procedures Application

Occurrence and Rights and Obligations

1. Check the company’s sales contract to determine that acceptance of returns are included in warranty provisions

2. Approve acceptance of returns

ABC had a provision for goods returns

Completeness 1. Perform year-end cutoff test. Review the Returns provision journal entries that were recorded just before or after year end

2. Make inquiries to managers about how they grant credit warranty work related to returned goods

Note 9 shows that 2% of returns provision is not recorded on the company balance date

Classification and Understandability

1. Ensure proper classification of goods and determine that the return goods are not reshipped as if they were new goods

No application

Accuracy and Valuation

1.Value returned items for which full credit has been granted

2. Determine the potential obsolescence or defects in the goods returns and similar goods held in inventory.

ABC had established $480,000 returns provision for Modem items. However, the company has only used up 17% of this provision until October 2001.

2. d) Operating Revenue

Assertion Procedures ApplicationExistence and Occurrence

1. Trace sales invoices to customer orders and bills of lading2. Scan sales journal for duplicate entries

All of ABC’s sales invoices occurred and absolutely no sales journal were double recorded, since the number after audited are bigger than unaudited.

Completeness 1. Trace bills of lading to sales journal2. Account for sequence of sales invoices in sales journal3. Perform analytical procedures

From the Note 1, we can see that audited Modem sales account increased 44%, audited Personal computer sales increased 60%, and audited Other increased 64%. All of these figures show that ABC only recorded some parts of sales invoices in its sales journal and not all of them, which lead to the failure in completeness.

Valuation and Accuracy

1. Verify accuracy of sales invoice and agreement of sales invoices with supporting documents2. Trace sales invoices to sales journal or customer’s ledger

The numbers listed above illustrate that the company under valued its operation revenue. Further more, This means that the company has not valued operation revenue accurately.

2. e) Amounts Owing to Parent Entity

Assertion Procedures Applications

Completeness

Confirmations with recorded payables(This procedures provided a high degree of reliability, however not used frequently since ABC have adequate control over disbursements

The Auditor can send confirmations to the parent entity requesting a statement of open account items, and afterwards the auditor may reconcile the parent entity confirmation with the accounts payable trial balance of ABC company.

Testing subsequent disbursements

The auditor may select a sample of cash disbursements made after the end of 2001. Afterwards, the auditor can examine this sample and decide whether the disbursements are for goods applicable to last year. If so, the auditor can ask management why management did not record liability in the previous year.

Analytical review of related expense accounts(This procedure is only used when ABC has a low control risk, no red flags, or even violates debt covenants, yet still can maintain its working capital)

Determine if the accounting date indicates a potential understatement of expenses. The auditor may perform the above two procedures to test accounts payable if understatement likely happened.

Year-end cutoff tests Determine whether the company timely recorded accounts payable and whether the company intentionally misstated the accounting records in order to understate liability or overstate inventory.

Review of contracts for purchase commitments

(long-term contracts to purchase inventory at fixed price or at a fixed price add inflation adjustments)

Examine contracts to determine penalties associated with default and assess the ABC’s estimate of the probability of contract default or losses.

3. What Effect Would this Information Have on the Audit?

Assume you were given the following information:

The parent company has advised local management that should ABC not show a turnaround to profits for the year ended 31 December 2002 it will proceed to wind up local operations early in 2003.

The first question illustrated that ABC had going concern problem. The company had unhealthy financial position in 2001. The parent company will proceed to wind up local operation early in 2003 if ABC still loses money at 31 December 2002. The auditor should recognise how ABC deals with its going concern problem and either ignore or try to change it.

If the auditor implements the control test at the end of year 2002, he or she can determine that the company have poor internal controls, inadequate capital, dependence on limited product offerings, technology subject to obsolescence and instability of future cash flows. However, the company’s financial performance improved a lot. This indicated that ABC was a high-risk company because of fraudulently manipulating its financial dates and increasing the engagement risk due to higher control risk, inherent risk or environment risk. This may result in ABC having higher motivation to misstate the financial statement. Therefore, the auditor should use more reliable evidence, such as that listed below:

1) Use External evidence (bank confirmation) rather than internal evidence

2) Obtain evidence by the auditor himself, and avoid evidence provided from the entity

3) Use documentary evidence and written representations instead of oral representations

4) Use original documents as audit evidence rather than using photocopies or facsimiles

The auditor should identify areas that are likely to be misstated as well. The company more likely will overstate key accounts related to its good performance, such as revenue and accounts receivable, while understating other accounts, such as expenses and liabilities. For these key accounts, the auditor should perform substantial tests of details of classes of transactions and account balances.

References

[1] CPA Australia (2007), ASA 570 Going Concern retrieved May 10th 2009 from the CPA Australia website: http ://www.cpaaustralia.com.au/cps/rde/xchg/SID- 3F57FECA6E5964B1/cpa/hs.xsl/14131_22174_ENA_HTML.htm

[2] PLS Australia, Audit Evidence (2006) retrieved May 10th 2009 from the PLS Australia website: http://www.plsaustralia.com.au/av/video/Chap%2020%20-%20Audit%20Evidence.pdf

[3] Auditing and Assurance Standards Board, Audit Evidence (1995) retrieved May 10th 2009 from the Australian Government website: http://www.auasb.gov.au/admin/file/content102/c3/AUS502_10-95.pdf

[4] Christine Jubb, Stephen Topple, Peter Schelluch, Larry Rittenberg, Bradley Schwieger. Assurance and Auditing: Concepts for a Changing Environment (2nd Edition). Thomson Learning, Melbourne.P391

[5] Christine Jubb, Stephen Topple, Peter Schelluch, Larry Rittenberg, Bradley Schwieger. Assurance and Auditing: Concepts for a Changing Environment (2nd Edition). Thomson Learning, Melbourne. P338

Appendix A: Charts

Unaudited10 months31/10/2001

$’000

Audited12 months31/12/2000

$’000Chang%

Notes to Accounts

Note 1 – Operating Revenue

Modem sales 28,702 41,313 44

Personal computer sales 16,448 26,369 60

Other (spare parts) 2,637 4,325 64

47,787 72,007 51

Unaudited10 months31/10/2001

$’000

Audited12 months31/12/2000

$’000Chang%

Note 3 – Receivables

Trade debtors 5,687 9,133 61

Unaudited10 months31/10/2001

$’000

Audited12 months31/12/2000

$’000Chang%

Note 9 - return provisions

Warranty and returns 769 785 2