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QUESTION 1:
Question 1 is assessing students on their understanding of the planning stage of the audit and undertaking a risk assessment of the entity.

You are undertaking the audit of a medium sized company which has been operating since 1997 and specialises in the sale of paintings from local artists. The balance date for the company is 30th June 2019. Around half of the paintings are sold on consignment on behalf of the local artists with the remainder of the paintings being sold by the company. There is no standard commission charged by the company for sales on consignment. The commission rates on consignment sales are negotiated directly between the company and the individual artist. The company also sells various products made by artists including hand-made pottery and assorted souvenirs of the local area also made by local artists. This is the first year that you are auditing this company. The company employs 2 experienced accountants who prepare the reports, both of whom are retired and are good friends with the CEO of the company. The accountants have solid but limited experience with computerised accounting systems.     

A manual accounting system has been used up until this year when a computerised accounting package was installed due to the increase in sales in the last 2 years resulting in record profits for the last 2 years (and significant increases in the volume of transactions). The increase in cash flow has allowed the company to purchase new premises which they purchased using a bank loan with a fixed interest rate of 3%. The fixed rate is contingent on the ability of the entity to maintain their current ratio above 2.0. The current ratio for the current reporting period was calculated as 3.7, an improvement from 3.2 in the previous period.

The old premises (which are also owned by the company) have been sold to a third party for a profit of $600,000. The sale has been finalised but the premises will not transfer to the third party until the 17th of September 2019 when the final payment is made by the third party and the sale is settled.

The CEO of the company pays for a consultant to review the entire operations on a yearly basis. The consultant offers advice how to improve the performance of the entity and to improve the controls over both the assets of the entity and the processes used to record events in the company. The controls over the inventory are considered effective but there have been a number of errors in the accounting reports in previous periods resulting in adjustments being made to the reports before they are finalised. You have been given the working papers from the prior audits but they are limited in their coverage and you have been asked to provide comprehensive documentation associated with the current audit.

Required:

Using the information provided, recommend an appropriate evidence mix for the audit of the company. In your recommendation, and using the audit risk model (the components of the audit risk model), provide a brief justification for the evidence mix you have recommended.

Question 2: This question is about inherent risks
You are undertaking the audit of a medium sized finance company Cut Price Financing (CPF) which has been operating since 2000 and specialises in the provision of short term cash loans to customers and is considered the lender of last resort for those requiring immediate access to cash. It is estimated that around half of the loans made by CPF are for short term loans to customers who are unable to secure finance through traditional sources such as the larger banks. The majority of the customers of CPF cannot secure finance elsewhere as their credit rating is too low and their credit rating precludes them from gaining access to cheaper finance. Total loan receivables held by CPF at 30th June 2018 are approximately $256 million. Total number of new loans granted for the year ending 30th June 2018 is $56 million.

As a result, the interest charged on these types of loans is higher than the normal market rate for short term loans. The interest charged is around 25% per annum (per year) compared to the average market rate of 12.5 – 15% per annum. CPF also offers a variety of loan products including long term loans (minimum loan amount $20,000 up to a maximum of $400,000). These loans can take the form of fixed interest rates or variable market rates or a combination of fixed and market rate. 

Interest only loans can also be provided by CPF whereby the customer only pays the interest owing on the amount borrowed for a fixed period of 5 years. At the end of the 5 years the loan reverts to a fixed interest rate of 20% with the full amount borrowed by the customer to be repaid over a 10 year period. CPF also has a credit card in addition to offering customers the option of an interest free balance transfer credit card allowing customers to transfer amounts owed with other financial institutions and pay no interest on the amounts transferred for a period of 12 months. A one off administration fee of 2.5% of the transfer balance is charged by CPF for balance transfers. After the end of the interest free period, the interest rate on the amounts owing on balance transfers reverts to a rate of 26% per annum.

CPF employs 10 loan officers who assess all loan product applications and they report to the Chief Financial Officer (CFO). The CFO provides guidance to the loan officers but all five loan officers for CPF have been provided with extensive training and have the authority to grant loans for all products available from CPF. Loan officers are paid a flat commission of 2% of the amount borrowed by the customer for all types of loan products. A bonus of $40,000 is paid at the end of the period if a loan officer reaches total loan approvals of $10 million.

The company employs 2 experienced accountants who prepare the reports, both of whom are retired and are good friends with the CEO of the company. A relatively basic computerised accounting system has been used up until this year when a new software computerised accounting package was installed due to the increase in loans in the last 2 years and record profits for the last 2 years (and significant increases in the volume of transactions). The increase in cash flow has allowed the company to purchase new premises valued at $20 million which they have subsequently sold during the current period and leased back for a period of 10 years.

Question continued over the page…

QUESTION 2 (Continued)

During the period, CPF negotiated with a 3rd party to sell off a large amount of property, plant and equipment (PPE) which would no longer be used by CPF in day to day operations. The sale was to be finalised in August 2018 but the paperwork was finalised during the reporting period. The carrying amount of the PPE assigned to be sold was estimated to be $35 million at the 30th of June 2018. CPF negotiated to sell the PPE for $25 million.

During the year, CPF initiated legal proceedings against one of its major customers who was refusing to pay the interest and amounts owing on a loan taken out with CPF. The matter was with the courts and CPF was attempting to sue for $2.5 million representing the amount owed by the customer, interest owing on the loan, plus costs. It was the opinion of the legal team for CPF that the likelihood of success of the court action was high but it may take well into 2019 to receive a ruling.

The CEO of the company pays for a consultant to review the entire operations on a yearly basis. The consultant offers advice on how to improve the performance of the entity and how to improve the controls over both the assets of the entity and the processes used to record events in the company. The controls over the reporting are considered effective but there have been a number of errors in the accounting reports in previous periods resulting in adjustments being made to the reports before they are finalised. 

With reference to the information relating to Cut Price Financing (CPF) above:

(a)    Identify FIVE (5) inherent risks related to the audit of Cut Price Financing, which the auditor would need to identify before finalising the audit planning. You are only required to provide a brief discussion for each of the risks identified.
(b)    For each inherent risk identified in part (a), identify a specific potential ERROR that could occur in the financial reports. 

(Hint: Try to think about what could go wrong in the financial reports as a result of each of the inherent risks you identify. You can use the Accounting Standards if you wish to but it is not a requirement for you to do so).

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