Posted: November 26th, 2015



Question 1 (50 marks)
Case: Far East Plastics Ltd.
You are the audit manager in charge of the audit of Far East
Plastics (‘FEP’) Ltd., for the year ended 31 December 2014. Your
CPA firm, Au & Au, has been the auditors for FEP for ten years
from a time when it only produced two products to today when it
is a successful diverse company. FEP was started by Joe Lee who
owns 51% of the shares with the balance held by about ten silent
partners with no operational responsibilities.
Historically, the company has presented no unusual audit
problems and Au & Au had issued an unmodified report every
year. The audit approach used has always been a ‘substantive’
audit approach. Under this approach, the in-charge auditor
obtained an understanding of internal controls as part of the risk
assessment procedures, but control risk was assessed at the
maximum (100%). Extensive analytical procedures were done on
the income statement and unusual fluctuations were investigated.
Detailed audit procedures emphasized statement of financial
position accounts. The theory was that if the statement of
financial position accounts were correct at year-end and had been
audited as of the beginning of the year, then retained earnings and
the income statement must be correct.
In evaluating the audit approach for FEP for the current year’s
audit, you consider that a substantive approach is really only
appropriate for the audits of small non-public companies. In your
judgement, FEP, with sales of HK$200 million and 75
employees, has reached the size where it is not economical, and
probably not wise, to concentrate all the testing on the statement
26 ACT B416 Auditing I
of financial position. Therefore, you have designed an audit
program that emphasizes identifying internal controls in all major
transaction cycles and includes tests of controls. The intended
economic benefit of this ‘reliance’/‘compliance’ approach is that
the time spent testing controls would be more than offset by
reduced tests of details of balances on the statement of financial
position accounts.
In planning tests of inventories, you use the audit risk model to
determine the number of inventory items you should test at yearend.
FEP maintains 2,450 items in its perpetual inventory
management system.
You determine that the overall audit risk should be low (say 5%).
For inherent risk, you determine it to be high because inventory,
by its nature, is subject to many types of misstatements. Based on
your understanding of the relevant transaction cycles, you believe
that the internal controls are effective. Therefore, you assess
control risk as moderate before performing tests of controls. Of
course, you also plan to use analytical procedures for tests of
inventory. These planned tests include comparing gross profit
margins by month and reviewing for slow-moving items.
Substantive tests of details will include tests of inventory
quantities, costs and net realizable values at an interim date two
months before year-end. Cut-off tests will be done at year-end.
Inquiries and analytical procedures will be relied on for assurance
about events between the interim audit date and year-end date.
a Decide which of the following will likely be done under both a
reducing control risk approach and a substantive approach.
1 Assessing inherent risk
2 Obtaining an understanding of internal control
3 Performing tests of control
4 Performing analytical procedures
5 Assessing planned detection risk
(10 marks)
b Discuss the advantages that you foresee in using the
reliance/compliance approach versus the substantive approach
previously used in the audit of FEP. (8 marks)
c What advantages did the substantive approach have over the
reliance/compliance approach? (6 marks)
Assignment File 27
d Assume the audit partner agrees with your recommended approach.
Using the audit risk model in planning the audit evidence for detailed
inventory tests, the conclusion is that detection risk should be
moderate/low. Discuss what this means in this audit. (6 marks)
e Now assume (only for this part) that instead of your original control
risk assessment of moderate, you assessed control risk as high. All
other risks remaining as stated, explain the impact on the planned
audit procedures and sample size in the audit of inventory as
compared to your procedures in step (d) above. (8 marks)
f Although the planning went well, the actual testing yielded some
surprises. When conducting tests of controls over acquisition and
additions to the perpetual inventory, the audit staff found
deviations/exceptions for several key controls that were higher than
expected. Discuss the actions you should take in relation to arriving
at the appropriate audit opinion. (8 marks)
g Regarding (f) above, describe one other action you should take in
relation to the completion of the audit. (Hint: Audit committee)
(4 marks)
Question 2 (27 marks)
As the auditor of High-Tech Ltd., you have identified the following
internal controls during your audit:
1 All sales invoices are first matched with shipping documents and
customer orders before being recorded in the sales journal.
2 The company prepares prenumbered receiving reports and accounts
for them on a daily basis.
3 Sales invoices are independently checked by the sales supervisor
before they are sent to the customers.
4 Mail is opened by the receptionist. She prepares a listing of all
cheques received.
5 All overtime hours worked by employees must be approved by the
employee’s supervisor before payment is made.
6 Cheques are sent to the company president for signature along with
the underlying supporting documents.
7 Shipping documents that have not been matched with sales invoices
are noted daily.
8 Employees must have a valid employee identification number
assigned by the human resources department at the time of hiring
before they can be eligible to be paid.
9 The accounts receivable sub-ledger is reconciled to the general ledger
on a monthly basis.
28 ACT B416 Auditing I
a For each internal control listed, describe the type of specific internal
control activity to which it applies (i.e., proper authorization,
adequate document and records etc.) (4.5 marks)
b For each internal control listed, identify the key management
assertion to which it applies. (4.5 marks)
c For each internal control listed, design a test of control that you may
perform to ensure that the internal control is effective. (18 marks)
Question 3 (23 marks)
The following questions address the risk of misstatement in various
general ledger accounts in the companies that you audit.
a In general, which general ledger accounts are most susceptible to
overstatement and to understatement? Discuss the reasons why.
(5 marks)
b Why do you think a company would permit some accounts to be
understated? (4 marks)
c Why do you think a company would permit some accounts to be
overstated? (4 marks)
d Which direction of misstatement is most likely: income
overstatement or income understatement? Discuss why. (2 marks)
e As you learned, if you assess that control risk is high, it is necessary
for you to perform more audit procedures. Yet, it is possible for audit
procedures to be performed incorrectly or misapplied leading to audit
evidence that is misleading or irrelevant. Give one example of one
way the audit procedure could be misapplied for each of the
following procedures:
? Observation
? Confirmation
? Inquiry
? Analytical procedures


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