Tut 3 - 342

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3.11 Explain the relationship between the risk assessment, risk response and reporting phases of an audit. ● All part of phases of an audit - all interconnected ● Starting with Risk assessment: planning an audit through familiarisaing with the client and developing a strategies ● Risk response: involves control of testing and (substantive testing - to detect material misstatement or fraud) ● Lastly, the Reporting phase: conclusive statements and forming an opinion. 3.13 Why does an auditor need to consider the client’s corporate governance as part of the preliminary risk assessment? ● Good corporate governance will be effective at identifying and controlling risks, ● Including the risk of material misstatement in the financial report. ● An auditor will be interested in whether the corporate governance system at the client will be more effective in reducing risks in the financial report. 3.15 What is a related party? Why is an auditor interested in identifying related parties during the risk assessment phase of an audit? Related party is: ● Companies that the auditing firm have a relationship with including high stakeholders, family, owners, ceo etc. ● Parent companies,subsidiaries, joint ventures and associates Auditors should be interest in identifying related parties during the risk assessment phase because: ● They need consider the risks associated with transactions between the client and the related parties - E.g if the transactions have been genuine ● Also, transactions between the client and related parties can give rise to higher risks of material misstatements. -e.g transactions not conducted under normal market terms and conditions

3.16 When gaining an understanding of an entity an auditor will be interested in the entity’s relationships with both its suppliers and customers. What aspects of these relationships will the auditor be interested in and how would they affect the assessment of audit risk? Customers An auditor can consider: ● The reputation of the client ● Terms of the relationship with the client ● Do they pay the client on a timely basis ● If client only has one or a few customers this increases the risk of audit Suppliers ● Reputation ● Supllies on an ongoing basis ● How many returns of products as faulty ● Terms of contracts and payment For both customers and suppliers, ● The auditor would be interested in whether the parties are located in foreign countries ● Because of the additional risks associated with international transactions and foreign exchange ● (which could apply to domestic trading partners as well). 3.19 In the context of fraud, explain what ‘opportunities’ means. ● Opportunities mean in the context of fraud to be putting yourself or an individual in a situtaation where you could attmeot a fraudulent act. ● E.g Misplacing inventory for asset misappropriation ● That's why auditors After identifying one or more incentives or pressures to commit a fraud, should assess whether a client has an opportunity to perpetrate a fraud. 3.20 Explain the difference between ‘incentives and pressures’ and ‘attitudes and rationalisation’ in the context of fraud. Incentives and pressures in the context of fraud: is more a practical implementation. ● Pressure from bosses to perform ● Greed - receive bonuses with what they do etc. -accounts that rely on estimates and judgement -a high volume of transactions close to year-end -significant adjusting entries and reversals after year-end -significant related party transactions

Attitudes and raionalisation in the context of fraud: Is more an individual implementation. -a poor tone at the top (that is, from senior management) -the implementation of an effective internal control structure is not seen as a priority -an excessive focus on maximisation of profits and/or share price 3.25 Understanding the client The audit team is preparing to audit a new client in the toy retail industry. The client imports items from manufacturers in several Asian countries and retails them in a chain of shops located throughout the country. You have access to the following information for the client: • prior period financial reports • anticipated results for the current year • industry averages. Required Explain how you would use the information to understand your new client. Prior period financial reports: ● Used to assess client financial performance and position over a number of yrs ● Previous periods can be used as a benchmark to compare current year -also, assess the risk of misstatements in previous accounts Anticipated results for the current year: ● How the client sees risk and how the implement plans to address them ● Forecast, can be applied to see what they client might think what will happen in the future Industry averages: ● Provides benchmarks ● Able to see where the client sits compared to competitors and how future economic conditions will impact them Allowing to see what accounts will be most at risk of misstatements 3.27 Risk assessment — considering going concern: financial A new client has been paying its suppliers late consistently; well in excess of the suppliers’ agreed credit terms. As a result, some suppliers have begun demanding cash on delivery from the client. You are also aware that a review of correspondence between the new client and its bank reveals that the new client has been experiencing cash flow problems for two years. Required

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Discuss whether there are any events or conditions that may cast significant doubt on the new client’s ability to continue as a going concern. ● Idea of going concern is the company to remain in business for the foreseeable future ● Events that cast doubt include: -Late payments to suppliers - indication of cash shortages -Banks identified cash flow problems for the past 2 years - added stress on cash flow 3.28 Risk assessment — considering going concern: operating Wisteria World is a theme park operated by an audit client of Salmon Partners. It is located on the Gold Coast and, due to its proximity to the ocean, the rides are prone to rust and corrosion. During the 2020 school holidays, two of the most popular rides experienced major breakdowns. Children were trapped on the rides for several hours, resulting in several being taken to hospital with minor injuries. An inspection following the incident revealed that key parts needed urgent replacement. The parts are made in the United States and imported by Wisteria World. The cost of the replacement parts is $4.5 million (against profit after tax in the previous year of $400 million). The repairs are scheduled to begin in April, with completion in July 2020. Required Discuss whether there are any events or conditions that may cast significant doubt on Wisteria World’s ability to continue as a going concern. ● Idea of going concern is the company to remain in business for the foreseeable future ● Events that cast doubt -Major break down of rides - Service and maintenance expenses - impact cash flow -Children hospitalised - impact reputation of the company which will decarese sales revenue - Profit made after tax $400 million - going concern considered to be strong but may produce lower profits due to the two most popular rides being out of service. 3.31 Fraud risk An airline company has been adversely affected by a slump in business travel during the last two years. In addition to lower overall demand, the airline company faces increased competition from other airlines who are heavily discounting flights. The airline company policy for revenue is to credit sales to revenue received in advance, and subsequently transfer to revenue when passengers or freight are uplifted or tours and travel air tickets and land content are utilised. In preparing for the 2021 audit, you review the 2020 financial statements and note that revenue from passengers represents 9 per cent of total revenue. The interim financial information for the 2021 year shows a 7 per cent fall in revenue from passengers, and a 12 per cent decrease in revenue from passengers in

advance. You read in the financial press that the global airline industry is facing an increased incidence of fraud and the majority of these frauds are committed by company directors and senior managers. Required Explain why the revenue from passenger accounts in the income statement is at significant risk of fraudulent financial reporting by management. Its at a significant risk because: ● Lower demand and increased competition puts pressure on meeting revenue targets ● Revenues received in-advance account with subsequent transfer to revenue, leading to an opportunity to corrupt this system to allow revenue to be transferred at a time that suits management. 3.33 Financial reporting fraud risk Onyx Operating Ltd has experienced sustained growth in recent years under the leadership of the last two CEOs, both of whom were promoted from within the business. The company began by making steel, but has now diversified into manufacturing and supplying all types of packaging, including metal, plastic and paper-based products. It has also diversified into a range of other businesses including household appliances in Europe, the United States and Asia. At the beginning of last year, the incumbent CEO died of a heart attack and the board took the opportunity to appoint a new CEO from outside the company. Despite the company’s growth, returns to shareholders have not increased during the last decade. The new CEO has a reputation of turning around struggling businesses by making tough decisions. The new CEO has a five-year contract with generous bonuses for improvements in various performance indicators, including sales/assets, profit from continuing operations/net assets, and share price. During the first year, the new CEO disposed of several segments of the business that were not profitable. Very large losses on the discontinued operations were recorded and most non-current assets throughout the business were written down to recognise impairment losses. These actions resulted in a large overall loss for the first year, although a profit from continuing operations was recorded. During the second year, recorded sales in the household appliances business in the United States increased dramatically, and, combined with various cost-saving measures, the company made a large profit. The auditors have been made aware through various conversations with middle management that there is now an extreme focus on maximising profits through boosting sales and cutting costs. The attitude towards compliance with accounting regulations has changed, with greater emphasis on pleasing the CEO than taking care to avoid

breaching either internal policies or external regulations. The message is that the company has considerable ground to make up to catch up with other companies in both methods and results. Meanwhile, the share price over the first year and a half of the CEO’s tenure has increased 80 per cent, and the board has happily approved payment of the CEO’s bonuses and granted the CEO additional options over the company’s shares in recognition of the change in the company’s results. Required (a) Discuss the incentives, pressures and opportunities to commit financial report fraud, and attitudes and rationalisations to justify a fraud in the case. Incentives: ● Board shows toughness for hiring a new CEO ● Incentives for growth, profit and share price ● Incentives for new CEO to sustain his reputation Opportunties: ● CEO has a bonus associated with profits ● Bonus payments will be higher because a lower amount of depreciation will be charged ● Selling off certain divisions reduces recurrent depreciation charges and provides a cash resource to invest in other areas Atitiudes and rationalisations: ● Focus is now on maximising profits through boosting sales and cutting costs ● Less emphasis on compliance and more on pleasing the CEO ● Increasing share prices also seem to say that the market approves the new actions (b) What financial report frauds would you suspect could have occurred at Onyx? Potential frauds: ● Reclassifying assets and expenses as part of discontinued operations ● Inappropriate classification of revenues and expenses in current period to accentuatereported growth in profit

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