Part A: Independence Threats and Safeguards
According to APES 110, Section 210, Professional Appointment, at the time to get engaged in the audit procedures, it is the obligation on the auditors to determine the fact that whether the engagement in the audit operation leads to the violation of the audit ethical as well as fundamental principles (Chapple et al. 2014). For this reason, the auditors are responsible to gain sufficient knowledge as well as understanding about the client’s business for the determination of ethical and corporate governance related issues. As per the given scenario, the audit partner of DPPL is needed to consider two major ethical aspects. The toxic chemical spill into the river because of the production process of DDPL is the first aspect that needs to be considered; the involvement of DDPL’s management teal to hide the case of toxic chemical spill is the next issue. These two issues are needed to consider as they lead to the violation of APES 110 ethical standards while accepting the engagement operation by R David & Associates (Chapple et al. 2014).
After identifying the loopholes and errors in the internal control, the audit partner with R David & Associates is responsible to provide the management of DDPL with the required recommendations to improve the internal control so that the repetition of these kinds of errors can be avoided. The next step from the auditors would be to issue qualified audit opinion for DDPL. The man intention behind the issue of qualified audit opinion is to make the shareholders and other stakeholder aware about the problems DDPL is facing in hedging strategy. For this reason, the audit partner is needed to provide the reason for qualified audit opinion in the audit report (Vovchenko et al. 2017).
The most important part in audit procedure is to inspect the business entities’ financial reports so that they can gain information about the presence of material missstements in them. For this process, the obligation on the auditors is to obtain enough audit evidence about the presence of material misstatements. It needs to be mentioned that the audit engagement letter contains the nature of engagement along with the required details; and the audit client is needed to acknowledge this letter before the commencement of the audit engagement (Tsipouridou and Spathis 2014). In this situation, it can be assumed that the audit partner with R David & Associates has provided the audit engagement letter to Reaction Pty Ltd the audit engagement letter that includes the audit engagement letter. Hence, in the presence of the audit engagement letter, the audit operation cannot become the review engagement.
Part B: Withdrawal of AASB 1031 Materiality
According to the requirement of modified audit opinion, the audit partner with R David & Associates is required to issue the Disclaimer of Audit Opinion. This kind of audit report is issued to the clients when it is not possible for the auditors to gain needed information of the financial reports of the client. The given case of Reactions Pty Ltd states indicates the fact that the auditor is not able in gaining required information related to the accounts receivables due to lack of documentation. Hence, the presence of all these aspects supports the decision of the auditor to issue the disclaimer of audit opinion (Vichitsarawong and Pornupatham 2015).
Part A-4
- According to APES 110, Section 290.167, it is the prime responsibility of the management of the client organizations to prepare as well as present the financial reports while make compliance with the needed financial principles and standards. The provide situation shows that the auditor has helped the management of the client in the accounting of impairment of assets. Hence, as per APES 110, Section 290.167, this particular scenario can lead to the development of Self-Review Threat of auditor’s independence due to the delivery of accounting and bookkeeping services to the audit client for the preparation and presentation of financial reports (Clout, Chapple and Gandhi 2013).
- One major safeguard of this threat can be the removal of the audit associate from the engagement program who has helped in the accounting of impairment. In this case, Hail Pty Ltd can take the help of accounting regulatory bodies.
- According to APES 110, it is not in the duty of the auditors to promote the business position of the audit client due to the fact that this can lead to Advocacy Threat of auditor’s independence. As per the given scenario, it can be observed that the auditor of the company has agreed on recommending the services of Travel Time Ltd to others as he/she is satisfied with the company’s services. It indicates towards the promotion of the business of audit client by the auditor that can lead to the advocacy threat to auditor’s independence.
- It is needed for the implementation of effective corporate governance mechanism in this scenario as major safeguard (Lemonakis et al.2018).
- According to APES 110, Section 100.12, there can be the creation of the Familiarity Threat of auditor’s independence when the presence of any close relation can be seen between the auditor and the client. In the given scenario, there is a relation between one of the auditors’ wives and Civil Constructions Ltd because of a large shareholding in the organization. This scenario can lead to the creation of familiar threat of auditor’s independence (Ball Tyler and Wells 2015).
- The main safeguard in this situation can be the removal of that particular audit associate whose wife has the relation with the company.
- APES 110, Section 100.12puts the obligation on the auditors of not compromising to act objectively in the presence of any pressure as it can lead to Intimidation Threat of auditor’s independence. In the provide scenario, the demand to get the additional time by Cruiser Ltd leads to the creation of indirect pressure on the auditor and this can deter the auditor from acting objectively as there is indirect pressure on him/her. For this reason, this whole situation can lead to the creation of intimidation threat of auditor’s independence (Eilifsen et al. 2013).
- The main safeguard in this situation is to develop and implement effective corporate governance policies in the company.
The Australian Accounting Standard Board (AASB) provided the auditors with all the guiding principles to deal with the aspect of materiality at the time to conduct the audit procedures through AASB 1031 Materiality (aasb.gov.au 2018). In this context, it needs to be mentioned that there were some major changes took place in the standard of AASB 1031 from the year of 1995 to 2015. It can be observed that the AASB introduced the standards of AASB 1031 Materiality in the year 2004. At the time of the inception of AASB 1031, there was the presence of very less guidance on the aspects of materiality in the Framework for the Preparation and Presentation of the Financial Statements. However, as a part of the initiative of AASB for the implementation of the principles of International Accounting Standard Board (IASB), AASB decided took the decision for retaining the standards of AASB 1031 Materiality in order to provide both the accountants as well as the auditors with full explained meaning of materiality (Joubert, Garvie and Parle 2017). It is also needed to be mentioned that AASB has a policy not to provide needless logical guidance on the matters covered by International Financial Reporting Standards (IFRS). For this reason, AASB has taken the decision to withdraw the standard of AASB 1031 Materiality and it was proposed in AASB Exposure Draft ED-243 Withdrawal of AASB 1031 Materiality. These are the major changes in AASB 1031 Materiality till the year 2015.
- At the time to conduct the audit procedures, the auditors are needed to consider the definition provided by both ASA 320and AASB 1031. As per ASA 320, materiality in relation to information can be defined as the information that in case omitted, misstated or not disclosed has the potential to affect the decision related to the allocation of the scarce resources developed by the users of the financial statements. According to AASB 1031 Materiality, materiality can be defined as a factor that can influence the economic decisions of the users of the financial statements on the basis of the financial reports of the companies (aasb.gov.au 2018). In this context, it needs to be mentioned that materiality largely depends on the nature and size of the omission of misstatements in the financial statements. For this reason, the size or nature of the materiality can be the determining factor for the determination of materiality.
- According to ASA 320 Materiality, at the time of the preliminary assessment of materiality in the financial statements, it is needed for the auditors to consider both the qualitative and quantitative guidelines of materiality; and they are discussed below:
Part C.1: Audit Risks and Responses for Gifts Ltd
At the time of the quantitative evaluation of materiality at the level of financial reports, transaction classification, account balances and disclosure, it is the obligation on the auditors for the selection of benchmark that is appropriate to the circumstances of the business enteritis (auasb.gov.au 2018). After that, for the determination of materiality, the auditors are needed to apply a percentage to a selected benchmark as an initiation point. Moreover, the auditors are needed to consider the factors like nature of entity, industry, lifecycle, size of the entity, economic environment, ownership, financing and others (legislation.gov.au 2018).
As per the guiding principles of qualitative material factors, the auditors are needed to consider the magnitude of a misstatement as the only factor for the assessment of materiality (Mio 2013). For this reason, it is needed for the auditors for the review of each misstatement in relation to the users of the financial statements after the consideration of the qualitative factors of materiality along with the circumstances where the materiality judgment has been made. The auditors use the qualitative factors of materiality for the assessment of the significance of misstatement, the pervasiveness of the misstatement and the impact of the misstatements on the financial statements on the whole basis.
- It needs to be mentioned that the concept of materiality has influence on the professional judgment of the auditors on material misstatements. There may be difference between the assessment of materiality and audit risk by the auditor at the time of the initial planning of the audit engagement. The main reason for this can be the change in circumstances or the change in the knowledge of the auditor due to the audit result. In this process, it is needed for the auditors to bring the attention of the management towards the identified material misstatements during the audit process (Sullivan and Mackenzie 2017). At the same time, the issue of the appropriate kind of audit report largely depends on the materiality factors of the financial statements. For example, in case the financial reports of a company are highly materially misstated, the requirement for the auditor is to issue adverse audit opinion. It implies that materiality influences the professional judgment of the auditors (auasb.gov.au 2018).
It can be seen from the above discussion that AASB 1031 Materiality used the provide the guidelines for the auditing to treat different aspects of materiality while conducting the audit operations. However, AASB has taken the decision to withdraw AASB 1031 Materiality and it is expected that there will not be any material effect of the withdrawal of this standard (Sanderson 2014). The main aim of the withdrawal of this standard is not to provide unnecessary local guidance to IFRS related to the materiality treatment by the auditors. At this moment, there is a need for AASB to develop new standards for addressing the materiality issues. Until the development of new standards, AASB has reclassified AASB 1031 Materiality so that they can be used for the reference only. In this context, it needs to be mentioned that the new standard of AASB for the accounting treatment of materiality will bring common regulations for the auditors in order to deal with materiality. For this reason, it will be possible in the establishment of harmony in the accounting treatment of material misstatements by the auditors. In addition, this will help the auditors in more appropriately treat the cases of material misstatements in the financial reports (Mio 2013).
Part C.2: Considerations for Establishing an Internal Audit Department
Requirement [a]
It can be seen from the provided information that the auditor of Gifts has the responsibility to gain understanding about the businesses of Gifts. The following discussion shows two sources of information to gain understanding about the company:
1st Source of Information: According to the given scenario, Gifts spent $2.1 million for refurbishing all of their stores and extending their central warehouse; and for this purpose, the company has take $2 million as loan from a bank that needs to be repaid over five years. This can be considered as crucial information for assessing the financial condition of the company. It needs to be mentioned banks put some condition on the companies before providing loans like to maintain a certain level of liquidity ratios like current ratio, certain level of debt ratio, certain level of profit margin; and the information regarding these financial aspects is helpful for assessing the financial condition of Gifts (Louwers et al. 2015).
2nd Source of Information: It can also be observed from the provided scenario that the management of Gifts uses selling price less average profit margin for the valuation of their business inventories and the year-end inventory count will take place in the central warehouse on 30 June 2018. This can be considered as an important information for the auditor of Gifts as this information can help the auditors in gaining understanding about all the details as well as assumptions related to the valuation of inventory. At the same time, this information can be considered as a major source in identifying the assertions of the management in the valuation of the business inventories. For these reasons, these sources of information can be considered as crucial (Knechel and Salterio 2016).
The details of the audit risks along with auditor’s responses are shown below:
- The first audit risk can be found in maintaining the debt covenant by Gifts at the time to get the loan of $2 million as it could be happened that the management of Gifts has manipulated the financial situation of their company in order to get the loan. For this risk, the auditors is needed to perform substantive audit procedure of checking the financial reports of Gifts prior to the sanction of the loan (Griffiths 2016).
- The second audit risk can be found in the year-end inventory count process at the central warehouse as incorrect mathematically physical count of the inventory can create material effect on the financial statement of Gifts like balance sheet. In response of this risk, the auditor is needed to perform substantive audit test of physical inventory count along with verifying all the documents related to the inventory.
- The third audit risk can be found in the process of inventory valuation by the management of Gifts as it can happen that the adopted inventory valuation process is not relevant to the fair value process. Thus, it is needed for the auditors to physically inspect the inventory valuation process along with all the documents related to it (Bahr 2014).
- It can be seen from the provided information that there is not any central process for maintaining the financial records as each store maintains its own financial records and the absence of central recording process can create the chances of financial fraud and manipulation in the store financial records. In response, the auditor is needed to inspect the samples of the financial statements of some stores to check for any financial fraud or manipulation.
- As per the provided scenario, the management of Gifts centralized all accounting records within the head office. Thus, there can be the development of audit risk in case there is a lack of verification by the company of the financial records while centralized them. In response, it is needed for the auditors to verify the process for recording the financial information by each store (Contessotto and Moroney 2014).
- It can be seen from the provided information that there is increased workload at the head office and the financial controller left the job in May 2018. This can lead to the development of audit risk as excessive work load can lead to unintentional errors in the financial reporting process that can have material effect on the financial statements of Gifts. In response, the auditor is needed inspect the financial statements of Gifts in order to find material misstatements in them.
Following are the factors that the finance director of Gifts needs to consider before the establishment of internal audit department:
- Most importantly, the finance directors of Gifts needs to take into account the cost of establishing the internal audit department and for this reason, he/she is needed to perform the cost-benefit analysis in order to get the clear idea about the total expenditure as he/she needs to finance the process (Alzeban and Gwilliam 2014).
- After this, the finance director of Gifts needs to assess the current control environment. The main aim of assessing the control environment is to ascertain the fact that whether there is any deficiency in the present control environment so that effective strategies can be developed to address them (Lenz and Hahn 2015).
- After that, the finance director of Gifts needs to take into consideration the size and complexity of their business operations. There is a greater need for the establishment of internal audit department is the company is larger in size and has more complex business operations (Ege 2014).
- Lastly, the finance director of Gifts is needed to identify the role of internal audit department. After the process of role identification, the financial director is needed to take into consideration the fact that whether these members are skilled or there is need to recruit new members for the internal audit department (Badara and Saidin 2013).
References:
AASB 1031. (2018). Materiality. [online] Available at: https://www.aasb.gov.au/admin/file/content105/c9/AASB1031_07-04_COMPdec09_01-11.pdf [Accessed 28 Aug. 2018].
AASB 1031. (2018). AASB 1031 – Materiality – July 2004 . [online] Available at: https://www.legislation.gov.au/Details/F2005B01419 [Accessed 28 Aug. 2018].
Alzeban, A. and Gwilliam, D., 2014. Factors affecting the internal audit effectiveness: A survey of the Saudi public sector. Journal of International Accounting, Auditing and Taxation, 23(2), pp.74-86.
ASA 320. (2018). Auditing Standard ASA 320 Materiality in Planning and Performing an Audit. [online] Available at: https://www.auasb.gov.au/admin/file/content102/c3/ASA_320_Compiled_2015.pdf [Accessed 28 Aug. 2018].
Badara, M.A.S. and Saidin, S.Z., 2013. Impact of the effective internal control system on the internal audit effectiveness at local government level. Journal of Social and Development Sciences, 4(1), pp.16-23.
Bahr, N.J., 2014. System safety engineering and risk assessment: a practical approach. CRC Press.
Ball, F., Tyler, J. and Wells, P., 2015. Is audit quality impacted by auditor relationships?. Journal of Contemporary Accounting & Economics, 11(2), pp.166-181.
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Contessotto, C. and Moroney, R., 2014. The association between audit committee effectiveness and audit risk. Accounting & Finance, 54(2), pp.393-418.
Ege, M.S., 2014. Does internal audit function quality deter management misconduct?. The Accounting Review, 90(2), pp.495-527.
Eilifsen, A., Messier, W.F., Glover, S.M. and Prawitt, D.F., 2013. Auditing and assurance services. McGraw-Hill.
Griffiths, P., 2016. Risk-based auditing. Routledge.
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Joubert, M., Garvie, L. and Parle, G., 2017. Implications of the New Accounting Standard for Leases AASB 16 (IFRS 16) with the Inclusion of Operating Leases in the Balance Sheet. Journal of New Business Ideas & Trends, 15(2).
Knechel, W.R. and Salterio, S.E., 2016. Auditing: Assurance and risk. Routledge.
Lemonakis, C., Malandrakis, I., Garefalakis, E. and Balla, V., 2018. Corporate governance and internal audit: A Review on performance indicators. Interdisciplinary Journal of Economics and Business Law, 7(1), pp.98-119.
Lenz, R. and Hahn, U., 2015. A synthesis of empirical internal audit effectiveness literature pointing to new research opportunities. Managerial Auditing Journal, 30(1), pp.5-33.
Louwers, T.J., Ramsay, R.J., Sinason, D.H., Strawser, J.R. and Thibodeau, J.C., 2015. Auditing & assurance services. McGraw-Hill Education.
Mio, C., 2013. Materiality and assurance: building the link. In Integrated Reporting (pp. 79-94). Springer, Cham.
Sanderson, J., 2014. Audit issues. SMSF Guide: Current Issues and Strategies for the Self-Managed Superannuation Funds Adviser, p.377.
Sullivan, R. and Mackenzie, C. eds., 2017. Responsible investment. Routledge.
Tsipouridou, M. and Spathis, C., 2014, March. Audit opinion and earnings management: Evidence from Greece. In Accounting Forum (Vol. 38, No. 1, pp. 38-54). Elsevier.
Vichitsarawong, T. and Pornupatham, S., 2015. Do audit opinions reflect earnings persistence?. Managerial Auditing Journal, 30(3), pp.244-276.
Vovchenko, G.N., Holina, G.M., Orobinskiy, S.A. and Sichev, A.R., 2017. Ensuring financial stability of companies on the basis of international experience in construction of risks maps, internal control and audit. European Research Studies Journal, 20(1), pp.350-368.
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