Exam Requirement

§  Identify and explain FIVE ethical risks

§  For each ethical risk explain the steps which ABC Co should adopt to reduce the risks arising.

Exam Technique

§  Case study Line

§  Identify Threat

§  Explain Threat

Write one or two safeguards and relate with the case study.

Example

The employees of LV Fones Co are entitled to purchase mobile phones at a discount of 10%. The audit

team has in previous years been offered the same level of staff discount.

Sample Answer

Ethical Threat

Safeguards

The audit team has in previous years been offered a staff discount of 10% on purchasing luxury mobile phones.

This is a self-interest threat.

The audit team may feel indebted to the client and reluctant to raise issues identified during the audit.

Only goods of an insignificant value are allowed to be accepted.

The audit firm should ascertain whether the discount is to be offered to staff this year. If it is then the discount should be reviewed for significance. If it is deemed to be of significant value then the offer of discount should be declined.

Ethical threat

Managing these risks

Bethan Oak was the audit engagement partner of Willow Wands Co (Willow) for the last seven years and has recently rotated off the audit.

It has been proposed that she should now become the independent review partner.

This represents a familiarity threat as the partner will have been associated with Willow for a long period of time and so may not retain professional

scepticism and objectivity.

As Willow is a listed company, then Bethan Oak should not serve as the independent review partner for a period of two years. An alternative review partner should be appointed instead.

Willow has requested the previous engagement partner, Bethan Oak, attend audit committee meetings as a non-executive director of Willow has recently left.

This represents a self-interest threat as the audit firm may be perceived as performing the role of management by attending these meetings and

this threatens objectivity.

The firm should politely decline this request from Willow, as it represents too great a threat to independence.

A non-executive director of Willow has recently left and the management of Willow have asked whether the partners of Beech & Co can assist them in recruiting to fill this vacancy.

This represents a self-interest threat as the audit firm cannot undertake the recruitment of senior management of Willow, especially as non- executive directors have a key responsibility in

appointing the audit firm.

Beech & Co is able to assist Willow in that they can undertake roles such as reviewing a shortlist of candidates. However, they must ensure that they are not seen to undertake management decisions and so must not make the final decision on who is appointed.

The total fees received from Willow for last year equated to 16% of the firm’s total income. The fees for this year have not been finalised, but it is anticipated that they could be greater than 16%. There is a potential self-interest threat as the total fees could represent a significant proportion of Beech & Co’s income.

Beech & Co should assess whether audit and non- audit fees would represent more than 15% of gross practice income for two consecutive years. If the recurring fees are likely to exceed 15% of annual practice income this year, additional consideration should be given as to whether the taxation and non-audit assignments should be undertaken by the firm. In addition, if the fees do exceed 15% then this should be disclosed to

those charged with governance at Willow.

Last year’s audit fee was being paid monthly, however; the last three months’ payments are outstanding.

A self-interest threat can arise if the fees remain outstanding, as Beech & Co may feel pressure to agree to certain accounting adjustments in order to have the previous year and this year’s audit

fee paid.

Beech & Co should discuss with those charged with governance the reasons why the last three months’ payments have not been made. They should agree a revised payment schedule which will result in the fees being settled before much more work is performed for the current year audit.

The audit manager of Willow is leaving Beech & Co to become the financial controller at Willow. This represents a self-interest and familiarity threat as the audit manager is familiar with the audit plan which is to be adopted at Willow and he may also have commenced work on this year’s

audit.

A new audit manager should be appointed to Willow and any work already undertaken by the previous manager should be independently reviewed.

In addition, it would be advisable to modify the audit plan so that the manager would not be

overly familiar with the approach to be adopted.

Exam Requirement

§  Identify and describe audit risks; and

§  Explain the auditor’s response to each risk in planning the audit of ABC

Exam Technique

Audit Risk

Response

§  Case study Line

§  Accounting Treatment (If any)

§  Risk & Affect

This is eventually an “Audit Procedure”. Auditor’s action towards assessed risk. So use the same

technique of writing audit procedure.

Example

The finance director has informed you that although an allowance for receivables has historically

been maintained, it is anticipated that this can be significantly reduced.

Audit Risk

Response

An allowance for receivables has historically been maintained, but it is anticipated that this will be reduced.

Allowance can be reduced if there is a genuine change.

There is a risk that allowance may be reduced in order to improve profits. Profits and assets may

be overstated as a result.

Discuss with the director the rationale for reducing the allowance for receivables.

Extended post year-end cash receipts testing and a review of the aged receivables ledger to be performed to assess valuation and the need for an allowance for receivables.

Audit Risk

Response

Eagle Heating Co (Eagle) has decreased the selling price of products significantly since September 2014 and there are increased levels of inventory expected at the year end.

It is possible that the selling price may have fallen so that the net realisable value (NRV) of inventory is below cost. IAS 2 Inventory requires inventory to be stated at the lower of cost and NRV.

There is a risk that inventory may be overstated if

not recorded correctly.

The auditor should undertake detailed cost and NRV testing to assess whether inventory is overvalued and requires write down.

A key customer of Eagle has been experiencing financial difficulties and Eagle has agreed a six- month payment break; however, the finance

director does not believe an allowance is required.

If the six-months payment break has now ended, review after date cash receipts for this customer to assess whether any payments have been made.

The allowance should be recorded against the

struggling receivable. Receivables are overstated

if not provided against.

Discuss with the finance director the reason for not creating an allowance against struggling

receivable.

In light of the increased competition, reduction in selling price and financial difficulties of a key customer, there is an increased risk that Eagle is facing going concern difficulties.

The auditor should undertake detailed going concern testing. They should review the cash flow forecast for the foreseeable future to assess whether the going concern basis is appropriate or whether additional going concern disclosures are

required in the financial statements.

The financial controller of Eagle was dismissed in October and is threatening to sue the company for unfair dismissal.

If it is probable that Eagle will make payment to the financial controller, a provision for unfair dismissal is required. If the payment is possible rather than probable, a contingent liability disclosure would be necessary. If Eagle has not done this, there is a risk over the completeness of

any provisions or contingent liabilities.

The audit team should write to the company’s lawyers to enquire of the existence and likelihood of success of any claim from the former financial controller.

The financial controller has been dismissed and his tasks have been allocated between the finance department team, this has increased their workload.

This increases the inherent and control risk within Eagle as errors may have been made within the accounting records by the overworked finance team members and there is no one

working in a supervisory capacity.

The team should remain alert throughout the audit for additional errors within the finance department.

In addition, discuss with the finance director whether he will be able to provide the team with assistance for any audit issues as there is no financial controller available.

The purchase ledger supervisor left in August and no reconciliations of supplier statements and purchase ledger control account have been performed.

There is an increased risk of errors within trade payables and the year-end payable may be under

or overstated.

The audit team should increase their testing on trade payables at the year end, with a particular focus on completeness of payables. A detailed review of the year-end purchase ledger control account reconciliation should be performed with a focus on any unusual reconciling items.

Preliminary analytical review of the draft statement of profit or loss has identified a significant fall in administration expenses. Administration expenses tend to be fixed costs and hence would be unlikely to fluctuate significantly with changes in sales volumes.

Hence there is a risk that administration expenses are understated.

Update the analytical review with the full year results and if significant fluctuations on prior year remain, discuss these with management. Obtain supporting evidence to verify management explanations.