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Chap 6 Assessing Inherent Risk and Other Risks

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Chap 6 Assessing Inherent Risk and Other Risks

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Assessing Inherent Risk and Other Business Risks
Summary and Additional Learning

Page 229

CHAPTER 6
Assessing inherent risk and other speciﬁc business risks

LEARNING OBJECTIVES (LO)

6.1 Explain the factors that inﬂuence the assessment of inherent risk.
6.2 Explain the auditor’s consideration of the risk of fraud.
6.3 Explain the auditor’s consideration of related parties.
6.4 Explain the auditor’s consideration of the appropriateness of the
going concern basis.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

ASA 200/ISA 200 Overall Objectives of the Independent Auditor and the
Conduct of an Audit in Accordance with Australian
(International) Auditing Standards

ASA 240/ISA 240 The Auditor’s Responsibilities Relating to Fraud in an

Audit of a Financial Report

ASA 250/ISA 250 Consideration of Laws and Regulations in the Audit of a

Financial Report

ASA 315/ISA 315 Identifying and Assessing the Risks of Material

Misstatement through Understanding the Entity and Its
Environment

ASA 330/ISA 330 The Auditor’s Responses to Assessed Risks

ASA 550/ISA 550 Related Parties

ASA 570/ISA 570 Going Concern

AASB 124/ IAS 24 Related Party Disclosures

APES 110/IFAC Code of Ethics for Professional Accountants

CHAPTER OUTLINE
Inherent risk and other speciﬁc business risks have a signiﬁcant impact on the
auditor’s decisions concerning audit evidence. The auditor considers these
concepts in developing an overall audit strategy and in planning the nature,
extent and timing of audit procedures.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

The major topics of this chapter are inherent risk, the specific business risks
associated with fraud, related parties and the appropriateness of the going
concern basis. How this chapter fits into the overall financial report audit is
illustrated in Figure 6.1 , which is an expansion of part of the flowchart
provided in Chapter 1 .

Page 230

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FIGURE 6.1 Flowchart of planning and risk-assessment stage of a financial report audit
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LO 6.1 Inherent risk
ASA 315.25(a) (ISA 315.25(a)) requires the auditor to address the assessed risks of materi
al misstatement at the financial report level, while ASA 315.25(b) (ISA 315.25(b))
requires the auditor to assess risks of material misstatement at the assertion level. The
levels of risk assessment are illustrated in Figure 6.2 . As discussed in Chapter 4 ,
ASA 200.13 (ISA 200.13) and ASA 200.A39 (ISA 200.A39) indicate that the risk of
material misstatement at the assertion level consists of two components: inherent risk and
control risk. Inherent risk will be covered in this chapter and control risk in Chapter 7 .

FIGURE 6.2 Levels of risk assessment

Inherent risk is the susceptibility of an account balance, class of transactions or

disclosure to material misstatement given inherent and environmental characteristics, but
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

without regard to internal control. Inherent risk at the financial report level is considered in
general planning because it specifically affects other decisions made at this time, such as
staffing requirements, and other aspects of the audit plan. For example, some of the
possible responses to high inherent risk are to assign more experienced audit personnel, to
increase the extent of supervision and to conduct the audit with a heightened degree of
professional scepticism (ASA 330.A1/ISA 330.A1). The auditor’s responses to inherent
risk will be discussed in Chapters 8 –10 .

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ASA 200.A42 (ISA 200.A42) points out that the auditing standards no longer ordinarily
refer to inherent and control risk separately, but rather to a combined assessment of risk of
material misstatement. However, the auditor may make separate or combined assessments
of inherent and control risk depending on preferred audit techniques or Page 231
methodologies and practical considerations. Regardless of the approach adopted,
the auditor needs to assess inherent risk at the financial report level when developing the
audit strategy. This assessment must then be related to the assertions at the account
balance, class of transactions and disclosure level, when developing the audit plan or audit
program (see Global example 6.1 ).
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

H Ltd is a construction company. Control of the company is in the hands of

the H family, who have been majority shareholders for more than 20 years.
Mr H is chairman and managing director. The other three directors, one of
whom is a member of the H family, all hold senior positions within the
organisation. Seventy per cent of the company’s construction contracts are
government contracts, with the remaining contracts being small shopping
centres or business centres.

Mr H has informed you of the following facts concerning the past year and
future trends:

1. During the year the company won a major contract to construct a number
of buildings on a university campus. The project is particularly interesting
as all the facilities must be capable of transmitting and receiving
videoconference broadcasts and acting as high-tech virtual classrooms. H
Ltd has not been involved in this type of work before but believes that it will
lead to a lot of similar work in the private sector.
2. Reconciliations of debtors statements to the debtors ledger were
performed incorrectly for a three-month period while a clerk was on leave.
These reconciliations were approved by the accountant. The errors were
detected by the debtors clerk on his return and all errors were corrected.
3. H Ltd keeps a small store of building materials in its main Page 232
warehouse. The warehouse manager is responsible for ordering
goods, receipting goods and paying creditors.
4. A bonus incentive scheme was introduced for the supervisors at the
construction sites to ensure that buildings would be completed on time.

Eﬀects on inherent risk

The eﬀects on inherent risk are as follows:
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1. Being a construction company increases inherent risk, because of the

complexity of valuation of work-in-progress.
2. The extensive involvement of the family and the board of directors in
company management increases inherent risk, as the board may not
always act in the interests of all shareholders.
3. Economic dependence on the government may increase the risk of going
concern problems should a change of government occur. The new
government may restrict construction or open the market to other players.
4. Entry into a new market in which the company has little expertise increases
inherent risk, as the company may underestimate the cost and diﬃculty of

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this work, thus reducing the accuracy of any estimates of the value of work-
in-progress.
5. The bonus scheme increases inherent risk, as the scheme may encourage
poor construction work or premature recording of stages of completion.
This increases the possibility of error in the valuation of work-in-progress
and raises the possibility of future warranty claims on work performed.

The incorrect reconciliation of debtors statements and the lack of

segregation of duties for the warehouse manager aﬀect control risk only.

Inherent risk at the ﬁnancial report level and its

relationship with business risk
ASA 315.A122 (ISA 315.A122) indicates that the risk of material misstatement at the
financial report level refers to risks that are pervasive to the financial report as a whole and
that therefore may affect many assertions. These risks are not necessarily identifiable with
specific assertions at the class of transactions, account balance or disclosure level. Rather,
they represent circumstances that may increase the risks of material misstatement at the
assertion level through factors such as management override of internal control, which
could potentially affect several accounts and several assertions. These financial report level
risks may be particularly relevant, for example, to the auditor’s consideration of the risks of
material misstatement arising through fraud.

The entity’s business strategy and associated risks, as discussed in Chapter 5 , will
affect the auditor’s assessment of inherent risk at the financial report level. The auditor will
trace business risks to the areas of the financial report that are most likely to be misstated.
In addition, there are a number of factors that affect inherent risk at the financial report
level, including the following:
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1. Integrity of management If management lacks integrity they are more likely to be

prepared to produce materially misleading financial reports. Lack of integrity may be
indicated by a poor reputation in the business community, prior disputes with auditors,
unreasonable demands on the auditor, attempts to limit the auditor’s access to people or
information, a history of litigation or a reluctance to correct internal control weaknesses.
2. Management experience, knowledge and changes during the period Inexperience of
management and its lack of knowledge may affect the preparation of the financial report.
In addition, if poor business decisions are made, as identified by the business Page 233
risk analysis outlined in Chapter 5 , this may introduce pressure to bias the
results. If a single person dominates the entity’s operating and financing decisions, there
is a higher risk that a material misstatement could occur because these important
decisions may not be reviewed, and actions that are not in the best interests of the entity
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may be taken. When important operating and financing decisions are reviewed and
approved by the entity’s board of directors or audit committee, there is less risk that the
financial report will be materially misstated. This is part of the corporate governance
structure discussed in Chapter 3 . When the auditor observes frequent personnel
turnover in important management positions, inherent risk increases, because honest
individuals are likely to resign from management positions rather than perpetuate some
type of fraud.
3. Unusual pressure on management This may provide an incentive for management to
misstate the financial report. If the entity is facing cash flow problems, poor liquidity,
poor operating results or insufficient capital to continue operations, there may be an
incentive to make its financial position look better than it truly is. If the industry is
experiencing a large number of business failures and declining customer demand, there
may be pressure on management to report higher sales even if revenues are declining.
Significant issues may also arise in relation to valuation of items such as inventory and
accounts receivable in the financial report. In addition, the financial or operating
problems currently being faced by competitors are also likely to affect the entity being
audited. If management compensation schemes are tied to earnings or share prices, there
is an incentive for management to misstate the result in order to obtain a bonus. (Refer to
demand for audit services, discussed in Chapter 1 .) Similarly, if management has
significant shareholdings, they have a vested interest in reporting a good result. Pressure
may also be placed on management by head office, major investors or lenders to meet
budgets or forecasts. Similarly, new management may be under pressure to outperform
previous results. Management is also likely to be under pressure to show good results
where a takeover or public float of the entity appears likely.
4. Nature of the entity’s business Many of the inherent risk factors associated with the
nature of the entity’s business will be identified during the business risk assessment
(discussed in Chapter 5 ), and will have a flow-through effect on the inherent risk at
the financial report level. Some types of businesses are inherently risky. For example,
some companies will be inherently risky because their products are subject to a high
inherent risk of obsolescence—high-technology products such as computers or fashion
products such as designer clothes may become obsolete due to rapid changes in
technology or consumer tastes. The auditor considers both the supply chain and the value
chain (referred to in Chapter 5 ) in assessing business risk, which also affects inherent
risk. If an entity deals with many suppliers and prices tend to be relatively stable, there is
less risk that the entity’s operations will be affected by raw material shortages or that
production costs will be difficult to control. However, if an entity is dependent on a single
supplier to supply a critical component, such as a specialised computer chip, there is a
risk that the vendor may be unable to provide the component, causing the entity to suffer
production shortages and shipping delays that may significantly affect financial
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

performance. Industries that produce basic commodities such as oil, coal and precious
metals can have their financial results significantly affected by swings in the prices of
their products, while industries that use commodities such as oil as raw materials may be
subject to both shortages and price instability.
There are also a number of other factors associated with the nature of the entity’s
business. If the entity has a complex capital structure, this will increase inherent risk. The
existence of related-party transactions would also increase inherent risk, as the
transactions are not with an independent party and the required related-party disclosures
are complex. If the entity buys or sells goods in a foreign currency, inherent risk will
increase as there is a risk of incurring foreign exchange losses. If hedges are taken out,
the hedging contracts may be complex. The complexity of the relevant Page 234
accounting standard also increases the chance of an error. Operating in a number

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of geographic locations would also increase inherent risk, as it becomes more difficult to
keep control of the entity’s operations.
5. Factors affecting the industry in which the entity operates While many of these
factors will be identified at the business risk analysis stage (such as through SWOT or
PEST analysis, as mentioned in Chapter 5 ), changes in economic and competitive
conditions would be expected to have a significant effect on the inherent risk of an entity.
The possibility of breaches of restrictive covenants in loan agreements increases during
economic downturns. Failure to maintain working capital and certain ratios at the level
stated in the debt agreements is a common violation. An entity that breaches a debt
covenant is considered to be in default and may be required to repay the loan and any
accrued interest on demand. This increases the risk of misstatements to avoid breach of
the debt covenants.

As indicated in an AUASB Bulletin (2012), economic downturns also often produce

uncertainty regarding the ability of an entity to continue as a going concern. If an entity is
reporting a significant increase in earnings while the industry is experiencing a decline, the
inherent risk concerning the truth and fairness of reported earnings would increase.
Generally, industries that are subject to rapid changes are more likely to have a materially
misstated financial report. For example, in the high-technology sector, frequent changes
may affect obsolescence and therefore the fair market value of products sold. As a result,
there is increased inherent risk of inventory overstatement due to the lower of cost or net
realisable value rule set out in AASB 102. Also, the amount of capital investment
necessary may be increased as a result of technological change and replacement of
equipment. Intense competition may affect inventory valuation, due to the lower of cost and
net realisable value rule. Foreign competition, in particular, often adopts a price-cutting
strategy to gain market share, which may affect inventory valuation.

Technological, marketing or manufacturing advancements by competitors may also affect

inventory valuation. Competition within the industry can affect the entity’s pricing policies,
credit terms and product warranties. Where accounting practices are common to the
industry, the auditor needs to determine whether the practice is in accordance with
generally accepted accounting principles and to be aware of the acceptable alternatives. In
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

addition, some reporting obligations may be unique to the industry, such as special
reporting requirements for insurance companies, thus increasing the risk of non-
compliance.

As information technology (IT) risks can be pervasive throughout the entity, factors
affecting overall inherent risk associated with IT are outlined here. Wright (1999)
identified the following six ‘red flag’ areas that will increase inherent risk in relation to IT:

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1. Significant change in IT Errors may occur through incorrect conversion of a new
system or because information in the previous system is unacceptable to the new system.
The new system may not be able to be delivered. New technology may not work, may not
work as expected or may be unreliable.
2. Insufficient IT skills and resources The skills of staff should be relevant and current
so that they can operate and understand the system. Sufficient staff resources need to be
available to operate the system. Excessive use of contractors can create risk of errors, and
disruption due to their unavailability. High turnover of computer staff will also increase
risk of errors.
3. Lack of entity support and focus Senior management needs to demonstrate their
accountability for IT by appropriate commitment and involvement, otherwise
fragmentation and lack of direction can occur. Positive management focus and support
directly affects the attitude of other staff members and is likely to result in IT issues being
given the appropriate degree of importance.
4. High dependence on IT An entity that requires IT to support its core business from an
operational perspective has a higher level of inherent risk than an entity that depends on
IT only to produce their financial information. Although the extent to which an Page 235
entity relies on IT can be influenced largely by the industry in which it operates,
entities in every industry are increasingly becoming more reliant on IT to transact their
financial dealings, automate their factories, link them to suppliers and produce
information to make faster and better decisions about their future. Where the survival
time without IT is very short, there may be a risk that the entity could go out of business
in the event of a disaster or disruption.
5. Reliance on external IT Outsourcing IT operations may mean that changes to response
time, service and capacity affect the user’s ability to meet customer needs. The entity also
needs to consider the long-term viability of the service provider. A likely reduction in the
number of people within the entity with computer knowledge will increase its
dependence on the service provider.
6. Reliability and complexity of IT The reliability of IT will directly affect the risk of
errors in processing. The more complex the system, the greater the risk of errors or
misinterpretation.

There are three major categories of risk arising from the use of e-commerce (discussed in
Chapter 13 ) that could increase inherent risk:
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

1. risks arising through the nature of the relationships with e-commerce trading
partners, such as the authenticity and integrity of trading partners
2. risk related to the recording and processing of transactions initiated through e-
commerce; for example, the integration of the entity’s internal reporting system with
the e-commerce system may mean that trade initiated by an unknown person using
the internet may generate accounting entries in the entity’s financial records
3. pervasive e-commerce business risks, such as the technical competency required by
staff, computer crime, computer viruses and legislation in different jurisdictions.

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Monroe et al. (1993) conducted an empirical study of auditors and found that auditors
perceived the following inherent risk factors at the financial report level to be the most
important:

Management bonus schemes are tied to reported earnings.

There has been a high turnover of top management in the past few years.
Top management has a reputation for taking unusual business risks.
This is the first year that your audit firm has conducted an audit of the company.
In the past, top management has been reluctant to accept audit adjustments.

Inherent risk at assertion level

ASA 315.A126 (ISA 315.A126) indicates that the risk of material misstatement at the
assertion level for classes of transactions, account balances and disclosures needs to be
considered because it directly assists the auditor in determining the nature, timing and
extent of further audit procedures at the assertion level necessary to obtain sufficient
appropriate audit evidence. The relevant financial report assertions are contained in ASA
315.A128 (ISA 315.A128) and were discussed in Chapter 4 .

ASA 200.A40 (ISA 200.A40) points out that inherent risk is greater for some assertions
and related classes of transactions, account balances and disclosures than for others. In
assessing inherent risk at the account balance, class of transactions or disclosure level, the
auditor makes a focused consideration of the implications of the auditor’s understanding of
the entity, its industry, its business and the nature of the account and the transactions for the
likelihood of a material misstatement existing in a particular account balance, class of
transactions or disclosure. Normally, the auditor will focus on the following six factors:
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

1. Accounts likely to require adjustment Accounts that were found to be misstated in

previous audits are likely to contain similar misstatements in the current year. Thus, when
an auditor has encountered material misstatements in previous audits the auditor Page 236
should assess inherent risk as being higher in the accounts where the past
misstatements have occurred.
2. Complexity of underlying transactions Transactions characterised by difficult
calculations or a complex accounting standard are more prone to error than simple
repetitive transactions. For example, complex calculations such as lease capitalisation are
more likely to be misstated than simple calculations such as straight-line depreciation.
3. Judgment involved in determining account balances The greater the degree of
judgment involved in determining account balances, the greater the chance of an error.
Accounting estimates, such as provision for doubtful debts, obsolescence and warranty,
are more likely to be misstated than routine factual data. Items or events that require
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using the work of an expert for verification, such as the value of properties, are more
susceptible to misstatement than those that can be verified by a non-expert. Decisions
involving subjective judgments, such as whether to capitalise mining exploration
expenditure, the percentage of completion of a construction contract and whether an
entity meets the definition of being subject to control (subsidiary) or significant
influence (associate), have a high inherent risk.
4. Susceptibility of assets to loss or misappropriation If an entity processes large
amounts of cash, such as in the case of a supermarket, susceptibility to misappropriation
is increased. Similarly, if an entity produces small, highly valuable products, such as
computer chips or gemstones, such assets are more likely to be stolen than an inventory of
steel pellets or coal.
5. Occurrence of unusual and complex transactions, particularly at or near year end
Material or unusual transactions occurring near the end of the year have a higher inherent
risk, as they may have been undertaken with the objective of manipulating profits or
covering a poor liquidity position.
6. Transactions not subject to ordinary processing Transactions that are not subject to
ordinary processing are more susceptible to errors or misappropriation. Similarly,
accounts with a highly visible audit trail are less risky than those with no audit trail.

The more that any one or a combination of the above factors influences an account, the
higher the value that should be placed on inherent risk, thus increasing the auditor’s
assessment of the likelihood of a material misstatement in that account.

Monroe et al. (1993) found that auditors perceived that the five most important inherent
risk factors at the account balance, class of transactions and disclosure level were:

1. The results from previous audits indicate that many errors are made in the recording
of accounts receivable.
2. There are a substantial number of accounts receivable that are significantly overdue.
3. The company has a history of inventory pricing errors.
4. Management estimates for the provision for doubtful debts have not been accurate in
the past.
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5. The company has a history of inventory cut-off problems.

As outlined earlier, the auditor is required to relate the assessment of the risks to the
assertions underlying the account balances, classes of transactions or disclosures. ASA
330.6 (ISA 330.6) requires auditors to perform further audit procedures whose nature,
timing and extent are responsive to the assessed risks of material misstatement at the
assertion level. For example, the risk of inventory obsolescence due to technological
development mentioned earlier affects the assertion of valuation and allocation in relation
to the account balance of inventory. This will help to direct the auditor’s evidence-

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gathering procedures when carrying out tests of controls or substantive testing, which are
broken down to the assertion level, as discussed further in Chapters 8 and 9 .

For an example of the flow of inherent risk through an account balance, see Figure 6.3 .

FIGURE 6.3 Effect of inherent risk on an account balance assertion

Page 237

QUICK REVIEW
1. Inherent risk is the risk of misstatement arising from the characteristics of
the entity and the environment and industry in which it operates.
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2. Inherent risk needs to be considered as part of the planning process

because it aﬀects other decisions made at this time.
3. Inherent risk must be assessed both at the ﬁnancial report level and at the
assertion level.

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LO 6.2 Fraud
At the planning stage of an audit, the auditor must consider the risk of fraud ; that is,
the risk that material misstatements resulting from fraud will not be detected. ASA 315.28
(ISA 315.28) requires the auditor to specifically consider whether there is a risk of fraud
when deciding which risks are significant.

The auditor is responsible for controlling detection risk by determining the nature, timing
and extent of audit procedures. It is easier to miss a material misstatement resulting from
fraud than a material misstatement resulting from error, because fraud usually involves acts
designed to conceal it, such as collusion, forgery or intentional misrepresentation to the
auditor.

Fraud is defined in ASA 240.12 (ISA 240.12) as ‘an intentional act by one or more
individuals among management, those charged with governance, employees, or third
parties, involving the use of deception to obtain an unjust or illegal advantage’. ASA 240.3
(ISA 240.3) points out that although fraud is a broad legal concept, the auditor is concerned
with fraud that causes material misstatement in the financial report. Therefore, as
illustrated in Figure 6.4 , there can be two types of misstatement that are relevant to the
auditor:

misstatement resulting from fraudulent financial reporting

misstatement resulting from misappropriation of assets.
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FIGURE 6.4 Elements of fraud

Fraudulent financial reporting may involve:

manipulation, falsification or alteration of records or documents

suppression or omission of the effects of transactions from records or documents

Misappropriation of assets may involve: Page 238

embezzling receipts
stealing assets
causing an entity to pay for goods not received
using an entity’s assets for personal use.

Errors are unintentional mistakes in or omissions of amounts or disclosures from

financial reports. Errors may involve:

mathematical or clerical mistakes in the underlying records and accounting data

oversight or misinterpretation of facts
misapplication of accounting policies.

ASA 240.A1 (ISA 240.A1) indicates that fraud usually involves incentives or pressures to
commit fraud, a perceived opportunity to do so and some rationalisation that justifies the
act to the perpetrator. These drivers of fraud are often referred to as the ‘fraud triangle’,
illustrated in Figure 6.5 , as when all three are present it is highly likely that fraud will
occur. This also illustrated in Global example 6.2 .
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FIGURE 6.5 Fraud triangle

Source: International Federation of Accountants (IFAC) (2011) Guide to Using ISAs

in the Audits of Small- and Medium-Sized Entities, 3rd edn, Vol. 2, p. 90.

Facts
Peter Ebert is the owner-manager of a kitchen renovation business. His
friend Jack has asked him to renovate his kitchen and has offered to pay
cash for a good price as he can’t afford the full retail price. Jack says that
Peter can do it off the books, as Jack doesn’t need any paperwork and then
Peter doesn’t need to include it in his taxable income.

Pressure or incentive Page 239

Peter is being pressured by a friend and has the incentive to reduce taxes he
would otherwise have to pay.

Opportunity
As the owner-manager of the business, Peter is able to override any controls
and not record the revenue in the company’s books.

Rationalisation
Peter may be able justify this deal to himself by saying that he is just helping
out a friend and that he already pays too much tax and lots of other people
do the same thing in the cash economy.

Risk of fraud
High risk of fraud, as all three drivers of fraud are present.

Responsibility for the detection and prevention of

fraud
The nature of fraud makes its detection intrinsically difficult and, as an element of audit
risk, it needs to be carefully considered. This is compounded by the nature of the audit
process itself (for example, the judgment necessary as to the nature, timing and extent of
testing, and the use of evidence that is persuasive rather than conclusive).

Auditors’ responsibilities in relation to fraud have been significantly increased as a result of

the acknowledgment of the existence of the expectation gap, discussed in Chapter 1 .

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Auditors now have to proactively consider fraud. This is reflected in the objectives of the
auditor in relation to fraud set out in ASA 240.11 (ISA 240.11), which are:

to identify and assess the risks of material misstatement of the financial report due to
fraud
to obtain sufficient appropriate audit evidence about the assessed risks of material
misstatement due to fraud, by designing and implementing appropriate audit responses to
the risks
to respond appropriately to both identified or suspected fraud.

The profession’s position, as expressed in ASA 240.5 (ISA 240.5), is that the audit should
be planned to obtain reasonable assurance that fraud that may be material has not occurred
or, if it has, that the effect of the fraud is properly reflected in the financial report and
therefore that the financial report is free from material misstatement due to fraud or error.

ASA 240.4 (ISA 240.4) continues to maintain the principle that the primary responsibility
for the prevention and detection of fraud rests with those charged with governance of the
entity and management. It emphasises that it is important that management, with the
oversight of those charged with governance, should place a strong emphasis on fraud
prevention and fraud deterrence.

The elements of audit risk due to the possibility of fraud are reduced where effective
internal control is in place. However, there is always a risk that the internal control will fail
to operate as designed. Moreover, internal control may be ineffective against fraud because
certain personnel within an entity are in a position to override controls designed to prevent
frauds.

In planning and conducting the audit the auditor must exercise reasonable care and skill,
and maintain an attitude of professional scepticism (ASA 200.15/ISA 200.15 and ASA
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240.13/ISA 240.13). Throughout the audit the auditor needs to consider the risk of any
fraud occurring that may result in a material misstatement in the financial report,
notwithstanding the auditor’s previous experience with the entity concerning the honesty
and integrity of management and those charged with governance (ASA 240.13/ISA
240.13). The auditor needs to be aware of the possibility of fraud, particularly in times of
economic recession. Audit staff must have the knowledge, experience and training to
identify danger signs of fraud, or red flags, and initiate appropriate actions.

If there is a particular risk of fraud because of the nature of an item, it should Page 240
receive more attention. For example, cash is subject to greater inherent risk of
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misstatement through fraud than are fixed assets. Accordingly, even where fixed assets
have a larger balance than cash, the tests of cash transactions may be more extensive.

The auditor needs to have a thorough knowledge of the client’s business in order to be able
to identify opportunities for the perpetration of fraud. The International Auditing and
Assurance Standards Board (IAASB) (2016) acknowledges that advanced data analytics
can assist in this area. Patterns or connections that might not have been discovered with
traditional methods are much more easily identified, analysed and visualised with advanced
data analytics. Also, the auditor must be open minded and aware of management’s practices
and conduct.

ASA 240 (ISA 240) has been revised several times over the years to require auditors to pay
greater attention to fraud. In planning an audit, the auditor now needs to specifically
consider the risks of material misstatements in the financial report owing to fraud (ASA
240.17/ISA 240.17), discuss with other members of the audit team the susceptibility of the
entity to material misstatements in the financial report resulting from fraud (ASA
240.16/ISA 240.16), and make more extensive enquiries of management with respect to
fraud (ASA 240.18–19/ISA 240.18–19).

Reporting fraud
The auditor has a duty to report fraud, irrespective of materiality, to an appropriate level of
management when suspicions are, or should be, aroused during the course of normal,
careful gathering of evidence. Auditors should obtain legal advice if there is any doubt as
to the appropriate course of action to take, or if they doubt whether what has been
discovered might properly be called a fraud. The effect of the fraud on the financial report
and on the auditor’s report must also be considered.
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In accordance with ASA 240.41 (ISA 240.41), the auditor should ensure that such matters
are reported to an appropriate level of management. The fraud or suspected fraud must be
reported promptly. It is not sufficient to wait until the preparation of the final auditor’s
report on the financial report to draw attention to such matters.

It is also very important that the auditor reports to a suitably senior level within the
organisation if it is suspected that management is involved in or is condoning the fraud. A
report may be made to the board of directors or, if appropriate, to the audit committee. It is
also suggested that, where the persons ultimately responsible for the overall direction of the
entity are involved, the auditor should seek legal advice on the appropriate procedures.
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ASA 240.44 (ISA 240.44) also acknowledges that the auditor may have a mandatory
responsibility to report fraud to appropriate authorities outside the entity under specific
legislation. This includes reports to relevant authorities under ‘Responding to non-
compliance with laws and regulations’ (NOCLAR), discussed in Chapter 3 . In
addition, ASA 240.9 (ISA 240.9) and ASA 240.A6 (ISA 240.A6) indicate that the auditor
may need to communicate identified or suspected non-compliance with laws and
regulations to other auditors within a group, including a group engagement partner or
component auditors.

If, after taking account of any adjustments made, the fraud materially affects the view
given by the financial report, the auditor needs to modify the auditor’s opinion accordingly.

Further, notwithstanding the fact that the fraud may not have a material impact on the
financial report, the auditor may still be required to report it under other reporting
responsibilities. For example, if directors are involved in the fraud, they have probably
breached their fiduciary requirements, such as safeguarding the assets of the company,
under the Corporations Act 2001. Section 311 requires an auditor to report any significant
contravention of the Act to the Australian Securities and Investments Commission (ASIC),
in writing.

The auditor may be reluctant to report fraud due to the risk of defamation litigation if the
suspicions are not substantially proved, and fraud convictions are often difficult to obtain.
In addition, the auditor owes a duty of confidentiality to the client, which makes it difficult
to report fraud to third parties without the client’s permission. While these are not valid
reasons for the auditor failing to fulfil reporting responsibilities, they are practical
difficulties that need to be acknowledged.

As discussed in Chapter 3 , APES 110 sections 140.7 and 225.35 state that Page 241
reporting breaches of NOCLAR would not be a breach of confidentiality. Also, in
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most cases the auditor is protected from defamation actions by qualified privilege if
reporting matters in good faith and without malice to people who have a proper interest in
receiving the information. For example, refer to section 1289(1) of the Corporations Act
2001. Therefore, the auditor should check whether this protection exists under the
legislation governing the specific audit. The auditor may also be legally bound to make
disclosure of a criminal offence if ordered to do so by a court of law or a government
officer empowered to request such information. Further, section 6 of the
Commonwealth Crimes Act 1914 states that:

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Any person who receives or assists another person, who has, to his
or her knowledge, committed any offence against a law of the
Commonwealth, in order to enable him or her to escape
punishment or to dispose of the proceeds of the offence commits an
offence.

Therefore, if an auditor knows that an offence, in the form of fraud or other illegal acts, has
been committed and fails to report it, the auditor may be held to be guilty as an accessory
after the fact under the Crimes Act 1914.

Legal advice should be obtained if the information sought may lead to prosecution of a
client or former client. If the disclosure would entail a breach of confidence with the client,
the auditor should decline unless such disclosures are required by a statutory or other legal
duty or a court of law, the client’s permission has been obtained or legal counsel advises
such disclosure.

In the absence of a specific mandatory auditor’s reporting requirement, and where an

entity’s governing body fails to take appropriate action, an auditor may need to seek legal
advice on whether to report fraud or an illegal act to a third party. However, before
reporting any fraud or illegal act to a third party, the auditor should perform sufficient audit
procedures to verify the accuracy of the facts that are to be disclosed.

Fraud risk factors

In the assessment of inherent and control risk the auditor needs to consider and assess how
the financial report might be materially misstated because of the presence of fraud risk
factors (see Global example 6.3 ). ASA 240 (ISA 240) specifically requires the auditor
to consider risks of fraud in revenue recognition and the possibility of management
override of controls. Identified fraud risk factors and the auditor’s response to them should
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be documented and should be addressed specifically in the design of audit procedures.

Examples of possible audit procedures to address the assessed risks of material
misstatement owing to fraud are contained in Appendix 2 to ASA 240 (ISA 240). The
auditor needs to consider whether an identified misstatement may be indicative of fraud
and the implications of this on other aspects of the audit, including the reliability of
management representations. The auditor should obtain written representations from
management about the disclosure of all facts relating to any fraud or possible fraud; for
example, management’s belief that the effects of the uncorrected financial report
misstatement aggregated by the auditor are immaterial to the financial report taken as a
whole.
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GLOBAL EXAMPLE 6.3 Risk of fraud

Facts
Toys Ltd is an Australian toy retailer that has been under considerable
pressure recently due to competition from lower priced toys from overseas
via online sales. As a result, it has found itself in a net current liability
position, with current liabilities exceeding current assets. As part of the
renegotiation of its bank loan, the bank has inserted a loan covenant that
requires Toys Ltd to maintain a positive net current asset position at all times
or the loan may be recalled immediately. In your review of this year’s Page 242
ﬁnancial information, you note that inventory has increased by 20
per cent while cost of sales has decreased by 10 per cent, and gross margin
has increased from 20 per cent to 35 per cent.

Fraud indicators
Given the tough industry conditions, a dramatic increase in gross margin
does not appear to be reasonable. Toys Ltd is under pressure to meet its
loan covenant requirements, so there is an incentive to overstate inventory
to increase current assets. Therefore, there is a risk of fraudulent ﬁnancial
reporting, as it is possible that inventory is not being transferred to cost of
sales when sold. Also, given the industry conditions and the buildup in
inventory, there is a possibility that inventory has been impaired, but not
written down.

Impact on audit
As there is a risk that some of the recorded inventory has been sold, the
auditor may increase stocktake attendance and select items from the stock
listing to sight and count to ensure they exist. To test for obsolete stock that
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needs to be written down the auditor may increase net realisable value
testing by checking the carrying value of inventory items to subsequent
sales invoices to ensure that they are valued at the lower of cost and net
realisable value.

Appendix 1 to ASA 240 (ISA 240) provides guidance to the auditor in planning and
conducting the audit by outlining factors that should be considered in assessing the risk of
material misstatement resulting from fraud.

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Conditions or events that indicate an increased risk of fraud are often referred to as red
flags (see Table 6.1 ). The existence of these red flags or danger signs does not
necessarily mean that fraud is being perpetrated. However, it does indicate that the inherent
risk of fraud has increased, and this may cause the auditor to modify the nature, timing or
extent of audit procedures with a view to detecting it.
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Management

Motivation exists for management to engage in fraudulent reporting due to

factors such as management bonuses for achieving specific results.
Management is dominated by a particular person or small group of people,
and there is no effective oversight board or audit committee.
There is evidence of management override.
The corporate structure is complex and appears unwarranted.
There is a lack of board members who are independent of management.
There is a failure by management to display and communicate an
appropriate attitude regarding internal control.
There is or has been a high turnover of key accounting and financial
personnel.
There is understaffing of the accounting department.
There are or have been frequent changes of legal advisers.
There are or have been frequent disputes with current or previous auditors.
The internal audit function is not properly constituted or staffed. Page 243

Unusual pressures within the entity

There is inadequate working capital due to declining proﬁts or rapid

expansion.
The quality of earnings is deteriorating; for example, there is increased risk
taking with respect to credit sales or changes in business practice.
The entity needs a rising profit trend to support the market price of its shares
due to a contemplated public offering, a takeover or some other reason.
The entity has a significant investment in an industry or product line noted for
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rapid change.
The entity is heavily dependent on one or a few products or customers.
Pressure is exerted on accounting personnel to complete the ﬁnancial report
within an unusually short period.

Market pressures

The industry is declining and failures are increasing.

The industry is subject to speciﬁc or complex legislation.
The industry is volatile, with numerous corporate takeovers or mergers.

There are unusual transactions, especially near the balance date, that have a
significant effect on profit.
There are transactions with related parties.
There are payments for services (for example, to solicitors, consultants or
agents) that appear excessive in relation to the services provided.
There are payments for goods that appear to be significantly above or below
market price.
There is evidence of falsified documents.
There are large payments in cash or by banker’s draft to, or via, overseas
‘shell’ companies or numbered bank accounts.
There are payments made to officials of domestic or overseas authorities or
governments.
There is correspondence between the entity and its regulatory authority
regarding problems.
There is correspondence between the entity and its legal adviser, the
substance of which is to advise against a particular course of action, which
the entity has ignored.
There has been investigation by a government regulatory body or by the
police.
There is evidence of unduly lavish lifestyles of officers or employees.

Unsatisfactory records

There are inadequate accounting records, such as incomplete ﬁles,

excessive adjustments to accounts, transactions not recorded in accordance
with normal procedures and out-of-balance control accounts.
There is inadequate documentation of transactions, such as lack of proper
authorisation, unavailability of supporting documents and alteration of
documents (these documentation problems assume greater signiﬁcance
when they relate to large or unusual transactions).
There is an excessive number of diﬀerences between accounting records
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and third-party conﬁrmations, conﬂicting audit evidence and inexplicable

changes in operating ratios.
Management provides evasive, unreasonable or unsatisfactory responses to
audit enquiries (for instance, failure to adequately explain trends or results
that do not accord with expectations, unusual items in the reconciliation of
suspense accounts, or the unusual investment of funds held in a fiduciary
capacity).
The auditor receives significantly fewer responses to confirmation requests
than expected.

IT environment

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There has been minimal planning for the installation of new hardware and/or
software technology.
There are inadequate computer skills among relevant entity staﬀ and/or a
concentration of IT knowledge in a particular individual or individuals.
Inappropriate hardware or software is used to perform important functions.
There are poor physical or logical access controls. Page 244

There is an inadequate or inappropriate ﬁle access hierarchy.

There is no clear audit trail and transaction log.
There is shared or non-speciﬁc ownership of data.
There are hardware failures, including excessive amounts of downtime and
resultant input backlogs.
There are software failures.
There is a failure to restrict access to software and documentation to
authorised personnel.
There have been program changes that have not been documented,
approved and tested.
There is inadequate overall balancing of computer transactions and
databases to the ﬁnancial accounts.
There are inappropriate data and program storage media in place.
There are inadequate detection procedures in place for system viruses.

Source: Adapted from the Appendices to Australian Auditing and Assurance

Standards Board (AUASB) (2017), ASA 240 The Auditor’s Responsibilities
Relating to Fraud in an Audit of a Financial Report.

Although this list of red flags or danger signs of fraud is extremely useful, it is not
exhaustive. Given the nature of fraud—including its great variability in design, execution
and underlying motive—it is not possible to reduce the auditor’s consideration of the
possibility of fraud to a checklist. An analysis of the danger signs of fraud highlights the
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need to put into place effective monitoring mechanisms as part of internal control.
However, employees may circumvent even effective internal controls through collusion,
either among themselves or with outsiders.

Appendix 3 to ASA 240 (ISA 240) provides further examples of circumstances that
indicate the possibility of fraud.

In the KPMG ‘fraud barometer’ (2017) (see Auditing in the global news 6.1 ), the firm
reported that their fraud survey found that the most common perpetrators of fraud are

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employees and management, accounting for over half of all reported frauds; 22 per cent of
frauds were facilitated through the use of technology; and the proportion of frauds
perpetrated in groups had doubled, pointing to increased collusion, making detection of
fraud more difficult. The survey also found that 40 per cent of frauds took place over a
five-year period before being discovered—showing that detection of fraud is taking too
long.
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KPMG survey reveals surge in fraud in Australia

KPMG’s latest six-monthly Fraud Barometer shows a large rise in the value of
fraud being committed in Australia. For the period April 2016 to September
2016, the total value of frauds rose by 16 percent to a total of $442m, from
$381m in the previous six month period—although average value per fraud
fell slightly, from $3.3m to $3.1m.

Frauds perpetrated by professional criminals notably rose by 300 percent—

although the majority of frauds are still carried out by company insiders—with
technology playing an increasing role.

Gary Gill, Head of Forensic at KPMG Australia, said: ‘Our Barometer shows
that fraud continues to rise relentlessly in Australia …’

Key ﬁndings include the following:

The most common perpetrators are business ‘insiders’, with 36 Page 245
percent of frauds attributable to company management—but
professional criminals are now to blame for 20 percent.
Frauds are now being more evenly spread across the age range – 46–54
year-olds are highest with 28 percent, but 25 percent are carried out by
people below 36 – a big rise compared to previous studies and high by
international comparison
There has been an 8-fold rise in the value of frauds carried out against
ﬁnancial institutions, although government agencies and investors are still
the likeliest victims
40 percent of frauds in Australia take place over a ﬁve-year period before
being discovered—detection is taking too long
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62 percent is motivated by personal greed

Queensland has cemented its unwelcome title as fraud capital of Australia
—more than half (55 percent) of the frauds were reported in the Sunshine
State, and is largely attributed to the number of investor frauds
22 percent of frauds used technology—including credit card fraud; hacking
into ﬁnancial systems; use of fake adverts; creation of regular electronic
transfers and the use of online betting accounts to launder money ...

KPMG also urges companies to recognise the important role of whistle-

blowers. Gary Gill said: ‘A number of frauds in the research were uncovered
by whistle-blowers, who noticed suspicious behaviour and appropriately
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raised these concerns so they can be actioned. This is often the way that
fraudsters are caught and held accountable for their actions. No matter what
systems and controls are put in place, the best defence is often an employee
noticing something amiss. It is important that they have a safe and
conﬁdential mechanism to report suspected fraud ...’

Source: Extract from KPMG (2017) ‘KPMG survey reveals surge in fraud in Australia’, media release, 25
January, [Link]
[Link].

Earnings management
Earnings management occurs when judgment in financial reporting and in structuring
transactions is used to alter financial reports to influence the perceptions of stakeholders
about the underlying economic performance of the company or to influence outcomes that
depend on reported accounting numbers. Earnings management affects the transparency of
underlying economic reality and stakeholder decisions in the allocation of scarce resources.
Incentives for earnings management may be classified as either behavioural or market-
based.

Behavioural incentives include:

political considerations to avoid regulation or enhance eligibility for concessions

executive remuneration based on financial or share price performance
discretionary transactions over which there is ambiguity or flexibility within accounting
standards or where no accounting standard exists
financial distress and closeness to debt covenant constraints
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restructuring
complex ownership and financial structures
related-party transactions
limitations to corporate governance mechanisms.

Market-based incentives include:

pressure to maintain excessive dividend payout rates

extreme positive or negative performance

equity offerings or takeovers

management buyouts or privatisation
significant following by analysts and media
declaration of expected future growth by a high-growth company
material insider shareholdings.

There are four broad categories into which earnings management by clients may fall:

1. Intentional violations of accounting standards and other reporting requirements

that are individually immaterial A number of immaterial breaches that all have the
effect of increasing profit may result in a material increase in profit.
2. Inappropriate revenue recognition This involves recognising revenue in this period
that will not really be earned until a future period and should have been deferred to the
future period. For example, in the Enron scandal in the US, Enron booked revenue on
long-term energy contracts that would not be performed for decades based on
management estimates, using an innovative mark-to-market accounting practice which,
while not illegal, pushed the boundaries of generally accepted US accounting principles.
3. ‘Big bath’ charges This strategy involves manipulating a company’s income statement
to make poor results look even worse. The big bath is often implemented in a bad year to
artificially enhance next year’s earnings. For example, if management believes that the
minimum earnings targets cannot be met this year, they have an incentive to move
earnings from this year to future periods since management compensation does not
change—irrespective of whether the targets are missed by a little or a lot. By shifting
profits forward—by taking write-offs this year that are not required, prepaying expenses
and treating them as expenses of the current period, or delaying the realisation of
revenues—management increases their chances of getting a large bonus the following
year. New CEOs also sometimes use the big bath so that they can blame the company’s
poor performance on the previous CEO and then take credit for the following year’s
improvements.
4. Improper accruals and estimation of liabilities in good times This may involve being
overly pessimistic this year about subjective estimates, such as the amount required for,
say, the provision for warranty. These pessimistic estimates are then reversed in the
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

following year. As a result, the profit for the good year is reduced slightly, but it is still a
good year and some profit has effectively been put aside for next year when times may be
tougher.

In the US, the financial scandals involving companies such as WorldCom and Xerox
revealed numerous examples of inappropriate earnings management over several years.
Levitt (1998) accused auditors of directly or indirectly assisting management by not
challenging management’s actions. In the US, this resulted in a number of Securities and
Exchange Commission (SEC) investigations. It also led to the introduction of the
Sarbanes–Oxley Act 2002, which requires management to certify the financial report and
has severe penalties for misleading statements. A similar requirement was introduced in
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Australia through the CLERP 9 amendments whereby section 295A(2) of the Corporations
Act 2001 now requires a CEO/CFO declaration regarding the truth and fairness of the
financial report, compliance with accounting standards and proper maintenance of
financial records. Also in Australia, ASIC has directed its accounting surveillance program
at areas of accounting abuse such as those uncovered in the US.

A sound knowledge of the entity and its industry, coupled with professional
scepticism, discussed in Chapter 4 , is crucial to the auditor’s judgment of what are
acceptable and unacceptable levels of earnings management. Many earnings management
techniques involve accruals, particularly those of a discretionary nature. Abnormal levels
of, or unexplained changes in, discretionary accruals may be indicative of earnings
management.

Page 247

Illegal acts
Certain categories of illegal acts have greater potential than others to affect the
financial report directly and to result in material misstatements. If the client entity operates
under a particularly complex legal framework, the auditor may need to seek expert advice
when planning the audit to help identify such laws and regulations. ASA 250 (ISA 250)
establishes standards and provides guidance regarding the auditor’s consideration of non-
compliance with laws and regulations in the audit of a financial report.

ASA 250 (ISA 250) includes specific guidance on understanding the legal and regulatory
framework applicable to the entity and industry, and on reporting of non-compliance to
management, users of financial reports and third parties.

ASA 250.13–14 (ISA 250.13–14) emphasise that when planning and performing an audit,
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

the auditor needs to obtain a general understanding of the legal and regulatory framework
within which the entity operates and how the entity complies with that framework. Further,
the auditor needs to obtain sufficient appropriate audit evidence concerning compliance
with those laws and regulations that have a direct effect on the determination of material
amounts or disclosures in the financial report. However, unless there is an identified or
suspected non-compliance, the audit procedures required by ASA 250.15–18 (ISA 250.15–
18) are limited to enquiry of management and those charged with governance about
compliance with laws and regulations, and inspection of correspondence with relevant
licensing or regulatory bodies, as well as remaining alert to the possibility that other audit

An audit provides only a reasonable assurance that material misstatements in the financial
report due to illegal acts will be detected: the audit normally does not include procedures
designed specifically to detect illegal acts, although these may be identified by other
procedures. Further, there are many laws and regulations relating to operating aspects of an
entity that do not affect the financial report and are not captured by the entity’s financial
reporting system. Also, the auditor may not be in a position to determine the legality of an
act, as this may involve the exercise of professional legal judgment.

The auditor must recognise any circumstances that require special attention. For example, a
debenture deed may require that a specific current ratio be maintained, which would
require increased attention to items classified as current. Transactions that are not
consummated at arm’s length are commonly considered to be of special significance; and
transactions with officers and employees receive more attention than similar transactions
with outsiders. (Consideration of related-party transactions was referred to in
Chapter 5 and will be discussed further later in this chapter.) Errors that arouse
suspicion of fraud are given greater attention than other errors of an equal amount.

When preparing audit plans or audit programs, the auditor should consider whether fraud,
earnings management or illegal acts are likely to cause an overstatement or an
understatement in an account balance or transaction total or an inadequate or misleading
disclosure. For example, a management that wants to improve the appearance of liquidity
in its financial position may do so either by overstating current assets or by understating
current liabilities.

In considering the possibilities that an account may be misstated, the auditor should bear in
mind that a test of one account simultaneously tests one or more other accounts. An
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

overstatement or understatement of one account affects one or more other accounts by an

equivalent amount. The direction of an error (understatement or overstatement) depends on
whether the account being tested is an asset, liability, revenue or expense. For example, a
test of an asset account for overstatement simultaneously tests one or more of the
following:

other assets for understatement

liability accounts for overstatement
revenue accounts for overstatement
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expense accounts for understatement.

This characteristic of the original data of accounting allows the auditor to use tests which,
when taken together, test most of the accounts for both understatement and overstatement.

Page 248

Whistleblowing
If the auditor concludes that fraudulent, illegal or unethical behaviour has occurred, they
need to consider whether it is necessary to whistleblow on the offender and, if so, to
whom to report. A typical definition in the US Civil Service Reform Act of 1978 defines a
whistleblower as a person:

. . . who discloses information he (or she) reasonably believes

evidences a violation of any law, rule, or regulation, or
mismanagement, a gross waste of public funds, an abuse of
authority, or a substantial or specific danger to public health or
safety.

The main characteristics of whistleblowing are:

a disclosure of information showing objectionable misconduct, which is not otherwise

known or visible
a reasonable belief that disclosure of this information will allow stakeholders to
determine that there has been misconduct
the disclosure is made in good faith, without malice
the disclosure is made in the public interest
the disclosure is not specifically prohibited by law or contrary to considerations of
national security or defence (Starke, 1991, p. 210).
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As indicated in Auditing in the global news 6.1 , whistblowers are often responsible for
perpetrators of fraud being held accountable.

It may be argued that auditors have a whistleblowing role imposed upon them by section
311 of the Corporations Act 2001. The auditor’s primary responsibility is to the
shareholders, and the auditor has a duty to report to ASIC as soon as practicable, and in
any case within 28 days of finding it, any significant contravention of the Corporations Act
2001 that they discover in the normal course of their duties.

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Section 311 does not require the auditor to actively look for contraventions of the
Corporations Act 2001. The responsibility of the auditor under section 311 is not to detect
contraventions per se but rather to act upon those matters that come to the auditor’s
attention during the course of the audit. Section 311 requires an auditor to take action
where the auditor has ‘reasonable grounds’ to suspect a contravention of the Corporations
Act 2001. This requires that there must be some facts or some evidence that would lead a
reasonable auditor to hold that suspicion. The auditor’s reporting responsibilities are
discussed further in Chapter 12 .

ASA 250.A30 (ISA 250.A30) indicates that the ethical requirements of the profession may
also require the auditor to determine whether to report non-compliance or suspected non-
compliance with laws and regulations (NOCLAR) to an appropriate outside authority.

Examples of whistleblowing

Sherron Watkins, a vice-president at Enron, became concerned about the company’s

accounting treatment of special purpose entities, which it used for off-balance-sheet
financing, the creation of false asset values and the generation of false gains from swaps of
its own shares. Watkins wrote to Enron chairman, Ken Lay, in August 2001 saying that the
business world would consider Enron’s results ‘nothing but an elaborate accounting hoax’
and that Enron ‘would implode under a series of accounting scandals’. Soon after writing
the letter, Watkins arranged a meeting with Lay to discuss the matter further. She also put
her concerns to the auditors, Arthur Andersen. However, she did not inform the audit
committee, as she mistakenly believed that the chairman would rectify the situation since
he had indicated to her that there would be an investigation into the matters she raised.
Enron subsequently collapsed and Watkins gave evidence at the congressional inquiry into
its demise. Ken Lay resigned in disgrace and was subsequently prosecuted for his part in
the scandal, along with several other key executives.
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In another example, in 2001, Cynthia Cooper, who at the time was head of internal audit at
WorldCom, was informed by a wireless division executive that corporate accounting had
taken US$400 million out of his division’s reserves to boost company profit. When Cooper
went to the external auditors, Arthur Andersen, about the matter, she was Page 249
informed that it was not a problem. When she went to the chief financial officer,
Scott Sullivan, he became angry. When she would not relent, he told her to back off.
However, she intensified her investigations and found that the company had also capitalised
billions of dollars in telephone expenses as property, plant and equipment, turning a
US$662 million loss into a US$2.4 billion profit. Cooper went to the audit committee,
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which requested an immediate investigation. The CFO was subsequently fired when he was
unable to justify the accounting treatment and WorldCom informed the market of a US$3.8
billion overstatement of profits, which was later found to be more than US$9 billion.

As a result of their whistleblowing actions, Watkins and Cooper were named as two of
TIME magazine’s persons of the year for 2002. Watkins has, however, been criticised for
not going to the audit committee or to the regulator, rather than just to the chairman. She
did, however, also inform the external auditor, and Arthur Andersen’s failure to act was one
of the factors cited in their subsequent prosecution.

In another high-profile example, Harry Markopolos was undertaking competitive research

in 1999 on Bernard L. Madoff Investment Securities, which was using a similar investment
strategy to that of the company Markopolos worked for, but far outperforming it.
Markopolos consulted mathematician Dan diBartolomeo, who analysed Madoff’s numbers
using data distributed to prospective investors and concluded that it was impossible to get
the returns reported using the strategy Madoff claimed to be using. As a result, Markopolos
advised the US Securities and Exchange Commission (SEC) in May 1999 that it was
impossible for the profits Madoff was reporting to have been obtained legally. However, no
action was taken at the time. In 2005, Markopolos submitted a detailed report to the SEC
stating that it was ‘highly likely’ that ‘Madoff Securities is the world’s largest Ponzi
scheme’. A Ponzi scheme is a fraudulent investment scheme that pays returns to its
investors from their own money or from money paid by subsequent investors rather than
from any actual profit earned by the entity running the scheme, and entices new investors
by offering higher returns than other investment schemes. It was not until December 2008
that Madoff, a legendary Wall Street figure and former chairman of the NASDAQ stock
exchange, was arrested for running the largest (US$65 billion) Ponzi scheme in history.
Madoff was later convicted and sentenced to 150 years in prison.

Risks of whistleblowing
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One of the chief concerns for whistleblowers is retaliative action that may be taken against
them. Enron’s legal counsel wrote an email to Ken Lay two days after he had met with
Sherron Watkins, stating: ‘the following are some thoughts on how to manage the case
with the employee who made the sensitive report . . . Texas law does not currently protect
corporate whistleblowers’. The obvious implication is that someone at a high level at Enron
wanted to fire Watkins because of her willingness to come forward regarding the
accounting improprieties. Although Watkins was not fired, she was made to feel like an
outcast at Enron after her revelations, and eventually resigned in November 2002. One of
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the responses in the US to these accounting scandals has been the introduction of strong
provisions in the Sarbanes–Oxley Act 2002 to protect employees who report securities
fraud. However, a few years later in the Madoff case, Harry Markopolos still stated in his
2005 report to the SEC that he was fearful for his and his family’s safety because he
realised his report could ruin people’s careers, and asked the SEC to be discreet about
circulating the report and his name.

In Australia, as a result of the CLERP 9 amendments, Part 9.4AAA of the Corporations

Act 2001 provides protection for officers, employees and contractors of a company who
report contraventions or suspected contraventions of the corporations legislation to ASIC,
the company’s external auditor, a director or another authorised person. However, in
accordance with section 1317AA, this protection is provided only where:

the person has reasonable grounds to suspect a contravention of the corporations

legislation
the disclosure is made in good faith
before making the disclosure, the person provides their name to the person to whom they
are disclosing the information.

In terms of section 1317AB, a person making a disclosure under Part 9.4AAA Page 250
cannot be subject to civil or criminal liability, or to the enforcement of contractual
rights or remedies on the basis of the disclosure. Sections 1317AC and 1317AD
specifically prohibit victimisation, which carries a fine of $2750 and/or imprisonment for
six months, and provide whistleblowers with a right to compensation where victimisation
has occurred and damage has been suffered. If the whistleblower discloses information
under Part 9.4AAA to the auditor, the auditor can disclose the information or the identity
of the whistleblower only to ASIC, the Australian Prudential Regulation Authority (APRA)
or the Australian Federal Police (AFP) without the consent of the whistleblower. This
means that a member of an audit team who receives such a disclosure cannot pass on the
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

revelation to an audit partner unless the whistleblower has consented to this occurring.

ASA 240.A67–A68 (ISA 240.A67–A68) recognise that, in the absence of any specific
mandatory reporting requirement, where an entity’s governing body fails to take
appropriate action in regard to a fraud, an auditor may seek legal advice as to whether to
report the fraud to a third party. If no action is being taken in relation to the fraud, the
auditor may also have a reporting responsibility under the Crimes Act 1914.

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The decision to blow the whistle is seldom easy, and it often involves both anguish and cost
to the whistleblower. Accountants who make known their opposition to unethical practices
may risk their jobs, but if they do nothing they risk action from their professional body and
from regulatory authorities.

An auditor who is considering going public with some information needs to resolve the
conflict between the principles of independence, objectivity, integrity and public interest
on the one hand, and the principle of confidentiality on the other. Legislative requirements
aside, the principle of beneficence appears to be the main force driving whistleblowers.
Not only should one not participate in causing harm, but one should also act to prevent
harm. Further ASA 250.A30 (ISA 250.A30) refers to the fact that APES 110 sections 140.7
and 225.35 state that reporting breaches relating to NOCLAR would not be a breach of
confidentiality.

QUICK REVIEW
1. The auditor needs to pay attention to the possibility of fraud at the
planning stage and make enquiries of management concerning the
existence of fraud.
2. Auditing standards maintain that the auditor must have a reasonable
expectation of detecting material misstatements arising as a result of fraud
or error.
3. The auditor has a duty to report fraud, irrespective of materiality, to an
appropriate level of management.
4. The auditor must consider red ﬂags or indicators of fraud when assessing
fraud risk.
5. Earnings management has been involved in a number of major corporate
scandals.
6. Auditors have a whistleblowing role imposed on them by section 311 of the
Corporations Act 2001, ASA 240 (ISA 240), APES 110 and the Crimes Act
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1914.

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LO 6.3 Related parties
As mentioned in Chapter 5 , it is an important part of the planning process that when
obtaining knowledge of the business the auditor identifies any related parties . Related
parties are defined in AASB 124 (IAS 24) Related Party Disclosures. Entities are related if
one entity is able to significantly influence or control the operating, financing or investing
decisions of another; or if several entities are subject to control from the same entity; or if
the party is a joint venture in which the entity is a venturer. Key management personnel
(including directors), their close family members and entities controlled by them are also
related parties, as are superannuation funds for the benefit of employees or related parties
of the entity.

The identification of the existence of related parties has been given greater attention
because of the growing recognition that transactions with related parties can have a
significant impact on an entity’s financial report. For example, in Cambridge Credit
Corporation Limited & Anor v Hutcheson & Ors (1985) 9 ACLR 545, Rogers J made
several references in his judgment to the auditor’s apparent failure with regard to Page 251
transactions with related parties, and the consequent unreality or lack of
‘substance over form’ concerning certain transactions. In another example, related-party
transactions played a major role in the collapse of Enron, which used a complex web of
special-purpose entities, such as limited partnerships with outside parties, to undertake off-
balance-sheet financing. The substance of these related-party transactions was not
disclosed.

ASA 550 (ISA 550) requires auditors to specifically assess the risk that related parties and
related-party transactions will not be identified, or appropriately disclosed and/or
measured. ASA 315.28 (ISA 315.28) requires the auditor to specifically consider whether
there is a risk of misstatement involving related parties when deciding which risks are
significant (see Global example 6.4 ).
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Facts
Ainsworth & Family Pty Ltd is a privately held company with many members
of the Ainsworth family being shareholders, directors, employees and
suppliers.

Risk
Due to the heavy involvement of family members in various aspects of the
business, there are likely to be a number of related-party transactions, which
may result in related-party disclosures being a signiﬁcant risk area.

Impact on audit
The auditor will need to increase the level of work on identifying related
parties and transactions with those related parties.

The auditor needs to be aware of the identity of related parties for the following reasons:

The existence of related parties or related-party transactions can affect the financial
information. For example, the accounting standards require the disclosure of information
relating to related parties, and the tax laws may require special consideration of related-
party transactions, thereby affecting the client’s tax expense and liability.
The reliability of audit evidence is a function of the source of that evidence. Because
related parties are associated with the client, evidence from such parties and transactions
with those parties need to be more carefully evaluated.
The initiation of a related-party transaction may be motivated by other than ordinary
business conditions, such as fraud; because such a transaction may be more readily
accepted than others, there is greater potential for error.
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ASA 550.A19 (ISA 550.A19) provides the following examples of possible frauds involving
related parties:

creating fictitious terms of transactions with related parties

fraudulently transferring assets at amounts significantly above or below market value
engaging in complex transactions with related parties, such as special purpose entities,
that are structured to misrepresent the financial position or performance of the entity.

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The existence of a related party with dominant influence may indicate a significant ris
k of misstatement. ASA 550.A29 (ISA 550.A29) provides the following examples of
indicators of dominant influence being exerted by a related party:

The related party has vetoed significant business decisions that have been taken by
management or those charged with governance.
Significant transactions are referred to the related party for final approval.
There is little or no debate among management and those charged with Page 252
governance concerning business proposals initiated by the related party.
Transactions involving the related party (or a close family member of the related party)
are only rarely independently reviewed and approved.

ASA 550.11 (ISA 550.11) requires the auditor to perform audit procedures designed to
identify the risk of material misstatements associated with related-party relationships and
transactions. Procedures for identifying related parties include:

reviewing the previous period’s working papers for known related parties
making enquiries of management concerning the names of all related parties
reviewing the entity’s procedures for identifying related parties
enquiring about management’s and directors’ affiliations with other entities
reviewing shareholder records for principal shareholders
reviewing minutes of the meetings of shareholders, the governing body and other
important committees, and statutory records such as the register of directors’ interests
reviewing bank and legal confirmations for indications of the existence of related parties
enquiring of other auditors involved in the audit, including previous auditors, as to their
knowledge of additional related parties
reviewing the income tax return and other information supplied to regulatory agencies
enquiring as to the names of pension and other trusts established for the benefit of
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

employees, and the names of their management and trustees.

ASA 550.14 (ISA 550.14) also requires the auditor to understand the means by which
management fulfils its responsibility for the control and recording of related-party
transactions. If the auditor identifies information that suggests the existence of related-
party relationships or transactions that management has not identified or disclosed to the
auditor, the auditor must confirm the existence or otherwise of those relationships or
transactions.

are overly complex (for example, transactions involving multiple parties within a
consolidated group)
have abnormal terms of trade, such as unusual prices, interest rates, repayment terms or
guarantees
lack an apparent logical business reason to justify their occurrence
have been processed in an unusual manner.

QUICK REVIEW
1. The identification of the existence of related parties is important because
transactions with related parties can have a significant impact on an
entity’s financial report.
2. Related-party transactions have been used to misstate financial reports.
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LO 6.4 Appropriateness of the going concern basis
There have been a number of high-profile corporate collapses in Australia over the last 20
years, including HIH Insurance, [Link], ABC Learning and Westpoint. HIH Insurance,
which collapsed with potential losses of $4 billion, was the subject of a Royal Commission.
Such corporate collapses naturally raise the question of what are the auditors’
responsibilities in relation to assessment of the going concern basis.

For reasons similar to those discussed in relation to fraud, auditors at the planning stage of
the audit consider the likelihood of a client becoming insolvent after the audit. An
imminent business failure may have an effect on the appropriateness of the presentation of
the financial report, or may motivate management misrepresentation. In addition, a
liquidation increases the chance that the auditor will have to defend the quality of Page 253
the audit in court. ASA 570.10 (ISA 570.10) requires that when planning and
performing audit procedures and evaluating the results, the auditor must consider the
appropriateness of the going concern assumption that underlies the financial report.
ASA 570.2 (ISA 570.2) defines the going concern assumption as meaning that the entity is
viewed as continuing in business for the foreseeable future without any intention or
necessity to liquidate or otherwise cease its operations. When the going concern
assumption is appropriate, assets and liabilities are recorded on the basis that the assets will
be realised and the liabilities discharged in the normal course of business.

Also, for audits undertaken in accordance with the provisions of the Corporations Act
2001, section 295(4) requires the directors to state their opinion as to whether at the date of
the directors’ declaration there are reasonable grounds to believe that the entity will be able
to pay its debts as and when they fall due. The auditor’s duty to report on the financial
report under sections 307–8 includes examining the directors’ declaration.

The auditor’s general interest in the going concern assumption and the specific statutory
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

provision require that the nature, timing and extent of the audit procedures be planned to
meet these requirements.

Certain circumstances may indicate that the going concern basis requires audit attention.
The auditor should be aware of these matters when assessing risk both at the beginning of
the audit and throughout the audit process. ASA 570.10 (ISA 570.10) requires the auditor
to specifically assess the risk of going concern problems as part of the planning process.
As part of this process, the auditor must determine whether management has already
performed a preliminary assessment of the entity’s ability to continue as a going concern

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and evaluate management’s assessment. Early identification of such a problem helps focus
audit effort on the appropriate assertions in the financial report, for example the valuation
of assets, and permits early communication with management and preparation and
examination of any additional information that may be necessary.

Typical indications of going concern problems are contained in ASA 570.A3 (ISA 570.A3)
and illustrated in Table 6.2 . The listing is not all-inclusive, and the existence of one or
more of these indications does not necessarily signify that the going concern basis needs to
be questioned.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Financial indications

High gearing or a net liability position

Fixed-term borrowings nearing maturity without realistic prospects of
renewal or repayment
Reliance on short-term borrowings to finance long-term assets
Withdrawal of financial support of creditors
Negative operating cash flows
Adverse key financial ratios
Substantial operating losses
Dividend arrears or discontinuance
Inability to pay creditors on time
Difficulty in complying with the terms of loan agreements, or the need to
restructure debt
Denial of trade credit by suppliers
Inability to obtain necessary financing

Operating indications

Management intention to liquidate or cease operations

Loss of key management personnel without replacement
Loss of a major market, licence or franchise
Labour diﬃculties, such as prolonged industrial action
Shortages of important supplies or loss of a major supplier
Emergence of highly successful competitors
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Other indications

Non-compliance with capital or statutory requirements

Legal proceedings against the entity that may result in judgments Page 254
that could not be met or in restrictions on trading opportunities
Adverse changes in legislation or government policy
Uninsured or underinsured disasters

Source: Extracted from Australian Auditing and Assurance Standards Board (2015), Australian Auditing
Standard (ASA) 570: Going Concern (c) 2018 Auditing and Assurance Standards Board (AUASB). The text,

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graphics and layout of this publication are protected by Australian copyright law and the comparable law
of other countries. No part of the publication may be reproduced, stored or transmitted in any form or by
any means without the prior written permission of the AUASB except as permitted by law. For
reproduction or publication permission should be sought in writing from the Auditing and Assurance
Standards Board. Requests in the ﬁrst instance should be addressed to the Technical Director, Auditing
and Assurance Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria, 8007.

The significance of those going concern indications that are related to cash flow or
solvency can often be mitigated by the existence of, or management plans with respect to,
factors that increase cash inflow or decrease cash outflow, such as those illustrated in
Table 6.3 .

TABLE 6.3 EXAMPLES OF MITIGATING FACTORS

Asset factors

Disposal of surplus assets

Delaying the replacement of assets, or leasing rather than purchasing certain
assets
Factoring debtors or entering sale and leaseback arrangements for ﬁxed
assets

Debt factors

Availability of unused lines of credit or similar borrowing capacity

Extension of the due dates of existing loans
Establishment of debt restructuring agreements

Cost factors

Disposal of operations producing negative cash ﬂows

Postponing expenditures such as repairs and maintenance, or research and

development, provided that this does not adversely aﬀect operations
Reduction of expenditures on non-essential overheads and administration

Equity factors

Reduction of dividend payments

Additional contributions by owners
Increase in cash distributions from subsidiaries or associates

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Whether an entity is a going concern is an important factor both in assessing audit risk and
in audit planning. If, at any time, the auditor has reason to believe that the entity may not
be a going concern, special consideration should be given to the planning and performance
of audit procedures (see Global example 6.5 ). As possible events become more distant,
there is less likely to be reliable evidence available about them. Therefore, although the
auditor must be alert to the possibility that a going concern problem might arise at any time
in the future, ASA [Link] 13.1 (ISA 570.13) indicates that the auditor’s work will be
focused on anticipated events during the relevant period. In Australia, ASA [Link] 13.2
defines the relevant period as the period of approximately 12 months from the date of the
current auditor’s report to the expected date of the auditor’s report on the succeeding
financial period.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Facts Page 255

Electronics Ltd, a company that manufactures high-tech electronic

equipment, is financed by a mix of long-term debt and short-term bank loans.
As part of the planning process, you note that one of Electronics Ltd’s
longstanding customers, High Tech Ltd, a customer that represents 35 per
cent of Electronics Ltd’s annual sales, has indicated that it has commenced
manufacturing its own electronic equipment. The strength of the Australian
dollar against foreign currencies has had an adverse effect on demand for
locally produced electronic equipment and competition in the industry has
become intense, with some other customers of Electronics Ltd indicating
they may now procure products from overseas suppliers at a significantly
reduced cost. Electronics Ltd’s bank has requested cash flow forecasts for
the coming year to support the financing arrangement in place.

Risk
Due to the potential loss of one of its major customers that is now producing
electronic equipment itself, the possible loss of other smaller customers who
can obtain products more cheaply from overseas, and intense competition in
the local market making it harder for Electronics Ltd to secure contracts with
alternative customers, there is a signiﬁcant risk concerning its ability to
continue as a going concern.

Impact on audit
The auditor will need to obtain and evaluate information regarding
management’s action plans for Electronics Ltd to continue as a going
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

concern, and obtain suﬃcient appropriate audit evidence concerning any

mitigating factors. The auditor will also need to obtain and review the cash
flow forecast that Electronics Ltd’s management has provided to its bank, as
this is a significant factor for the bank to consider in deciding whether to
continue Electronics Ltd’s financing arrangements.

When a question arises concerning the appropriateness of the going concern basis, it may
be necessary to employ additional procedures, to modify or extend existing procedures or
to update earlier information. Details of significant documents examined and discussions
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held should be recorded and retained by the auditor, together with copies of cash flow,
profit and other forecasts and notes of special audit procedures. If it is not clear whether the
going concern basis is appropriate, most of the additional audit procedures necessary to
establish the position will be performed during the completion stage of the audit; these will
be discussed in Chapter 11 . ASA 570.A14 (ISA 570.A14) and ASA [Link] A15.1
indicate that the auditor does not have a responsibility to design audit procedures, beyond
enquiry of management, to test beyond the relevant period.

If the going concern basis is not appropriate, the auditor assesses the effect that a forced
sale of assets would have on the book values and the classification of assets. The auditor
also assesses the amount and classification of liabilities, including any provision for staff
termination payments and other closing-down expenses.

Some audit firms have introduced, as part of their going concern evaluation, audit tests
using models that attempt to predict firm failure. For example, the statistical techniques of
discriminant analysis or regression can be used in auditing for the prediction of bankruptcy.
However, Simnett and Trotman (1992) indicate that traditional financial distress models
have not been widely used in practice, for the following three reasons:

1. They have not been part of the formal training of most auditors.
2. The models have been criticised for both their data sets and their statistical assumptions.
3. The models have not been developed sufficiently to take into account factors that are
accepted as affecting an entity’s financial profile, such as size, industry, geographic
location and age.

Dean and Clarke (2001) point out that the functionality of the various distress- Page 256
prediction models currently in use is contestable. The empirical evidence indicates
that no unique bracket of financial ratios will outperform all others in distress prediction.
Dean and Clarke (2001, pp. 182–3) argue that ‘debate and uncertainty over when HIH
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Insurance and [Link] became insolvent serves to reinforce the difficulties of identifying
the onset of financial distress from financial data produced in compliance with the
accepted Accounting Standards. It suggests that a “wild card” in this type of analysis is the
extent to which adjustments for “creative accounting” need to be made’. The use of such
models is, of course, only one part of the evidence gathered to make a judgment as to
whether a client is likely to remain a going concern.

Analytical procedures, particularly ratio analysis, are commonly used to address the
appropriateness of the going concern basis for an entity. Simnett and Trotman (1992) found

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that cash flow ratios were the most significant class of ratios for predicting financial
distress, while earnings ratios were also significant and followed a similar trend to cash
flow ratios. Some other ratios that are not widely used, such as market value of equity to
book value of debt, also proved to be reliable and significant predictors.

QUICK REVIEW
1. When planning and performing audit procedures and evaluating the
results, the auditor must consider the appropriateness of the going
concern assumption that underlies the financial report.
2. An imminent business failure may have an effect on the appropriateness of
the presentation of the financial report, or may motivate management
misrepresentation.
3. Recent corporate collapses highlight the need to assess an entity’s risk of
experiencing going concern problems.
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Summary
A major component of audit risk is inherent risk, which is the risk of errors occurring due
to the characteristics of the entity and the environment in which it operates. Special risk
areas that need to be considered are fraud, including earnings management; related-party
transactions; and the appropriateness of the going concern basis for preparing the financial
report.
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Key terms
earnings management
errors
fraud
fraudulent financial reporting
going concern assumption
illegal acts
inherent risk
misappropriation of assets
related party
risk of fraud
risks of material misstatement
significant risk
whistleblowing
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References and additional readings
Auditing and Assurance Standards Board (AUASB) (2012) ‘Auditing considerations in a
prolonged uncertain economic environment’, AUASB Bulletin, August, Melbourne.
Dean, G. and Clarke, F. (2001) ‘Distressed businesses—predicting failure’, in Collapse
Incorporated: Tales, Safeguards and Responsibilities of Corporate Australia, CCH,
Sydney, pp. 147–84.
International Auditing and Assurance Standards Board (IAASB) (2011) ‘Economic
conditions continue to challenge preparers and auditors alike; focus must include going
concern assumption and adequacy of disclosures’, media release, 28 December, New
York.
International Auditing and Assurance Standards Board Data Analytics Working Page 257
Group (2016) Exploring the Growing Use of Technology in the Audit, with a
Focus on Data Analytics, September, International Federation of Accountants (IFAC),
New York.
International Federation of Accountants (IFAC) (2011) Guide to Using ISAs in the Audits
of Small- and Medium-Sized Entities, 3rd edn, IFAC, New York.
KPMG (2017) ‘KPMG survey reveals surge in fraud in Australia’, media release, 25
January, [Link]
[Link], accessed 15 December 2017.
Levitt, A. (1998) The Numbers Game, NYU Centre for Law and Business, 28 September.
Louwers, T.J., Henry, E., Reed, B.J. and Gordon, E.A. (2008) ‘Deficiencies in auditing
related-party transactions: insights from AAERs’, Current Issues in Auditing, Vol. 2,
No. 2, p. A10.
Martinov, M. and Roebuck, P. (1998) ‘The assessment and integration of materiality and
inherent risk: an analysis of major firms’ audit practices’, International Journal of
Auditing, Vol. 2, No. 2, pp. 103–26.
Monroe, G.S., Ng, J.K.L. and Woodliff, D.R. (1993) ‘The importance of inherent risk
factors: auditors’ perceptions’, Australian Accounting Review, Vol. 3, No. 2, pp. 34–45.
Simnett, R. and Trotman, K. (1992) ‘Identification of key financial ratios for going concern
decisions’, Charter, April, pp. 39–41.
Starke, J.G. (1991) ‘The protection of public service “whistleblowers”—part 1’, Australian
Law Journal, Vol. 65, No. 4, April, pp. 205–19.
Wright, M. (1999) Audit Guide No. 5: Auditing in an IT Systems Environment, Australian
Accounting Research Foundation, Melbourne.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Inherent risk
6.1 Define inherent risk and explain why it is important to evaluate inherent risk
as part of audit planning. LO 6.1
6.2 Outline the factors that may influence inherent risk at the financial report
level. LO 6.1
6.3 Outline the factors that may influence inherent risk at the assertion level.
LO 6.1

Risk of fraud
6.4 What are the ways in which fraudulent ﬁnancial reporting may be achieved?
LO 6.2
6.5 Describe three types of enquiry that an auditor will make of management
with regard to fraud. LO 6.2
6.6 What impact will advanced data analytics have on fraud detection?
LO 6.2

Related parties
6.7 Explain what is meant by the term ‘related parties’. LO 6.3
6.8 Provide four examples of transactions outside an entity’s normal course of
business that may indicate the existence of unidentiﬁed related
parties. LO 6.3
6.9 List three indicators of dominant inﬂuence being exerted by a related party.
LO 6.3

Appropriateness of going concern basis

6.10 Explain why the auditor’s assessment of the appropriateness of the going
concern assumption is so important. LO 6.4
6.11 Identify three factors that are relevant to management’s assessment of an
entity’s ability to continue as a going concern. LO 6.4
6.12 Provide three additional audit procedures that the auditor should perform
when events or conditions are identiﬁed that call into question the ability of
an entity to continue as a going concern. LO 6.4

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Page 258

Discussion problems and case studies

Inherent risk
6.13 EASY Megan Martin has been assigned to the audit of the inventory section
of two unrelated companies. The ﬁrst client, Ready Made Pty Ltd, sells
quality made-to-order cabinetry. Inventory comprises raw materials used to
manufacture its existing product range, partially completed cabinets and
cabinets which have just been ﬁnished and are awaiting delivery to
customers. The second client, Exclusive Boutique Pty Ltd, is a retailer of
exclusive and everyday wines. Its inventory is made up of bottles of wine,
including current vintages and aged bottles that are ready for drinking now.
REQUIRED
Explain which of the two clients you would expect Megan to assess as
having the higher inherent risk. LO 6.1

6.14 MEDIUM You are currently involved in planning for the audit of Curtains &
Blinds Ltd (CBL), a national company producing curtains and blinds. The
curtain and blind market is highly competitive, and CBL has been
experiencing declining sales over the past three years. Cost cutting has
proven very difficult, as the cost of materials used in the company’s
production lines has increased each year. CBL’s bank has continued to
provide CBL with loan facilities; however, it has indicated that it expects to
see improved results in the next financial report and has placed a number of
quite restrictive covenants in CBL’s lending agreements. Recent articles
appearing in the financial press concerning CBL’s expected financial results
have been very pessimistic about its likely performance.
REQUIRED
Based on the information provided:

(a) Discuss the overall impact on audit risk.

6.15 MEDIUM You are the audit senior responsible for the audit of Spectrum Ltd
for the year ended 30 June 2018. During your initial planning meeting with
Justin James, the chief financial officer (CFO), he informs you of the
following changes in the company’s operations.
(a) To help achieve budgeted sales for the year, Spectrum is about to
introduce bonuses for sales staff. The bonuses will be an increasing
percentage of the gross sales made by each salesperson above
certain monthly targets.
(b) Spectrum plans to close an inefficient factory in country Tasmania
before the end of 2018. It is expected that the redeployment and
disposal of the factory assets will not be completed until the end of
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the following year. However, Justin is confident that he will be able to
determine reasonably accurate closure provisions.
(c) The chief executive officer (CEO), Geoff Alderton, has just returned
from Italy, where he signed a contract to import a line of clothing that
has become the latest fashion fad there. The company has not
previously been engaged in the clothing industry.
(d) Due to Justin’s workload, the company recently employed a treasurer,
Alice Campbell. Justin is excited about the appointment, because in
the three months since Alice has been with the company she has
realised a small profit for the company through foreign exchange
transactions in US dollars.
REQUIRED
For each of the scenarios provided, outline how the information affects
inherent risk. LO 6.1

6.16 HARD Caring for Kids Ltd (CFK) is listed on the Australian Securities
Exchange. The company provides childcare services for pre-school children.
CFK has undertaken significant expansion of its operations over the past
two years. This strategy has resulted in the acquisition of a total of 200 new
centres with childcare licences in Australia, New Zealand and the Page 259
United Kingdom. The expansion strategy has been funded mainly
from borrowings that have been sourced in both local and foreign currency.
CFK’s board consists of five directors: three non-executive directors, the
CEO and CFO. None of the three non-executive directors have any formal
qualifications or background in business.
The board has expressed concern about the pace of expansion, due to
CFK’s accounting system failing to effectively integrate the acquired
companies’ complex information systems.
REQUIRED
Based on the background information, identify four inherent risk factors for
CFK and explain their impact on the financial report. LO 6.1
Source: This question was adapted from the Chartered Accountants Program of Chartered
Accountants Australia and New Zealand, 2015 (2) audit and assurance module.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Risk of fraud

6.17 EASY Christopher Papadopoulos has been assigned to the audit of a new
client, Reality Loans Ltd, operating in the ﬁnance and banking sector. The
audit plan states that Reality Loans has an extensive information technology
(IT) system and therefore all auditors on the engagement should consider
the possibility of fraud. Christopher is confused by this comment, as he
believed that auditors did not concern themselves with fraud, and has asked
the audit manager to explain the comment.
REQUIRED
(a) As the audit manager, explain to Christopher why the audit plan
Gay, Grant E., and Roger Simnett. Auditing and Assurance Services in Australia, McGraw-Hill Australia, 2018. ProQuest Ebook Central,
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requires the audit team to consider the possibility of fraud.
(b) List six factors that may increase the susceptibility of IT systems to
fraud. LO 6.2

6.18 MEDIUM Modern Electricals Ltd oﬀers customers a range of payment

options. One increasingly popular method is interest-free finance. Generally,
such arrangements involve customers signing a consumer credit contract
with an interest-free term of up to two years from the date of purchase. The
growing demand for this financial arrangement has begun to stretch
Modern Electricals’ statement of financial position capacity, as it has had to
take on additional debt to fund the cash flow timing differential between its
receivables and payables. All interest-free finance contracts are held by
Interest Free Pty Ltd, a wholly owned subsidiary of Modern Electricals.
Modern Electricals must comply with various financial covenants for its debt
facilities with Australia Bank Ltd, and is close to breaching these covenants.
Modern Electricals obtained conditional approval for additional working
capital borrowings from Australia Bank in September 2017, subject to
meeting the debt to equity ratio at 30 June 2018 and meeting profit targets
for the year ended 30 June 2018. Australia Bank has requested a copy of
the 30 June 2018 audited financial report as soon as it is completed.
The significant growth in interest-free business is due in part to effective
incentive schemes that operate across all sections of the business. The
accountant at Interest Free, William Walters, obtains approximately 30 per
cent of his remuneration from monthly and year-end bonuses, based on
profit and the increase in finance receivable dollar value. Sales staff are paid
monthly bonuses made up of $50 per new finance contract signed and 1
per cent of the value of those contracts. At the end of each month, each
staff member emails the payroll department a log of contracts listing the
contract number and value. The payroll department processes the bonuses
based on this information.
Another reason for the growth in interest-free financing is a new initiative
that Modern Electricals has introduced whereby it does not run credit
checks on contracts of less than $1000, as the value of the contract is not
large and William has informed you that the hassle of the credit checks was
more than it was worth on that amount of money. Modern Electricals
promises customers easy finance and this has seen the number of contracts
for less than $1000 increase dramatically.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

REQUIRED
Identify three possible fraud risk factors and explain why each is a fraud
factor. LO 6.2

Page 260

6.19 MEDIUM You are undertaking the audit of Precious Metals Ltd (PML) for the
year ended 30 June 2018. During the audit planning process, the following
information is obtained:
PML management’s remuneration is heavily weighted towards incentive-
based payments that rely on optimistic sales targets.

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Recently, the human resources department of PML has been short staffed
and has not been able to provide training to new staff responsible for
administrative and financial processing functions. Generally, new staff
members have experience within the industry.
One of the outputs produced by PML is a titanium bolt, which is small but
very valuable. There is a high demand for these bolts in the construction
industry.
Receivables are agreed to the sub-ledger, but there is no aging review
completed, and an increasing percentage of total receivables are falling
into the 90 days+ category.
REQUIRED
Identify and explain two key fraud risk factors within PML. LO 6.2
Source: This question was adapted from the Chartered Accountants Program of Chartered
Accountants Australia and New Zealand, 2015 (2) audit and assurance module.

6.20 HARD Bathroom Renovations Ltd (BRL) refinanced its existing loans with
State Bank and also obtained additional borrowings from them during the
year. State Bank has included covenants in the new loan agreements
stipulating that BRL must make a profit before tax in every financial year
and that it must maintain a net current asset position (i.e. that current assets
exceed current liabilities at all times).
You have been provided with an extract of BRL’s financial report for the
year ended 30 June 2018, which shows that BRL made a profit before tax
of $100 000 and had a net current asset position of $40 000.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

30 Jun. 2018 30 Jun. 2017

$000 $000

Cash and cash 204 206

equivalents

Trade and other 1 410 1 234

receivables

Inventories 684 688

Total current assets 2 298 2 128

Trade and other (604) (560)

payables

Deferred revenue (420) (602)

Loans and (1 202) (812)

borrowings

Employee beneﬁts (32) (28)

Total current (2 258) (2 002)

liabilities

Net current assets 40 126

EXTRACT FROM THE STATEMENT OF FINANCIAL PERFORMANCE

30 Jun. 2018 30 Jun. 2017

Revenue 4 281 4 270

REQUIRED
(a) Identify two key accounts that are at risk of material misstatement
due to fraud.
(b) For each account identiﬁed in (a), identify and explain one key
assertion at risk. LO 6.2
Source: This question was adapted from the Chartered Accountants Program of Chartered
Accountants Australia and New Zealand, 2015 (2) audit and assurance module.

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Page 261

Related parties
6.21 EASY You are the audit manager on the audit of Alpha Ltd for the year
ended 30 June 2018. Alberto Giovanni is a junior auditor in your audit team.
When Alberto read the audit strategy for Alpha, he noticed a paragraph
requiring the team to consider related parties when conducting the audit.
Alberto knows that the company must disclose related-party information to
comply with accounting standard AASB 124 (IAS 24), but does not
understand why the audit strategy has referred to related parties as a
‘special risk area’, and approaches you, as his manager, for an explanation.
REQUIRED
Explain to Alberto why it is necessary to consider related parties as part of
the audit planning process. LO 6.3

6.22 MEDIUM Golden Touch Ltd is a national fashion retail chain with stores
located throughout Australia. The major shareholders of Golden Touch are
the Campbell siblings Amos, Samantha and Terry. The remaining minority
shares are held by independent third parties. Both Samantha and Amos are
employees of Golden Touch, but only Amos, who is the CEO, is on the
board. All other board members are independent of the family.
Golden Touch specialises in expensive women’s swimwear and resort-wear
for summer use only, and designs its garments in Australia and
manufactures them in China from Italian-sourced fabrics. The only
exception is the material for Golden Touch’s resort-wear, which is
purchased at commercial rates from Kylie Campbell, the fourth Campbell
sibling, through her company Elite Fabrics Pty Ltd. The details of this
arrangement are contained in a note to the ﬁnancial report.
Samantha Campbell is in charge of purchases for the year ended 30 June
2018 and renegotiated Golden Touch’s contract with Elite Fabrics, so that
Golden Touch pays cash on delivery for all materials purchased from Elite
Fabrics, instead of the industry standard of 30 days. No one outside of the
purchasing department is aware of the renegotiation.
Golden Touch owns 75 per cent of its manufacturing operations in China,
with the remaining 25 per cent being owned by a Chinese company, Fung
Ltd. Amos Campbell’s wife is a clothing designer and has her fashion line
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

manufactured in Golden Touch’s Chinese plant at no charge, provided

members of the Campbell family are supplied with garments free of charge.
Golden Touch simply writes off the manufacturing costs incurred by Amos’
wife as a bad debt. Fung is not aware of this arrangement.
REQUIRED
Outline the issues in relation to the related-party transactions above that
may increase the risk of material misstatement in the financial statements
or prevent fair presentation of the financial report. LO 6.3
Source: This question was adapted from the Chartered Accountants Program of the Institute of
Chartered Accountants in Australia, 2011 (2) audit and assurance module.

HARD You are the audit manager on Highland Ltd, a property investment

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6.23 company owned by a small number of wealthy investors. Last year the
owners brought in new managers, who made substantial changes to the
organisational structure of Highland. The new management team acquired
a substantial parcel of shares in Highland and has also implemented a bold
acquisitions strategy, resulting in a number of new business interests
across the Asia–Pacific region.
A new staff member of the finance team, Kirsten Roberts, has been given
responsibility for liaising with the auditor in respect of related-party
transactions. Kirsten is responsible for identifying, recording, summarising
and disclosing related-party transactions. This responsibility, along with a
long list of other accounting responsibilities, has been delegated to her by
the new management team. Kirsten has given you a list of related-party
transactions that has not changed from previous years. However, given the
changes in the business and the new acquisitions, you believe there is a
risk of unidentified related parties. You meet with Kirsten to discuss this and
soon realise that Kirsten does not really know much about the Page 262
related-party framework in AASB 124 (IAS 24). Kirsten informs you
of the following information:
Highland provides management services to a company in Fiji called
Sunshine. However, no invoice has yet been processed and Kirsten is
unaware of the terms of the arrangement. It is Kirsten’s understanding that
Sunshine is owned by members of the new management team.
During the year Highland sold a property located in Singapore to a
company called Clayton, which was set up specifically for the purpose of
buying this particular property. Kirsten indicates that Clayton is not related
to Highland, as Clayton is owned 100 per cent by a Singaporean bank.
However, Kirsten does not understand why there are still property
management fees for this property in Highland’s accounts relating to the
period after the property was sold.
Since the new management team has come on board, Highland has done
a lot of business with a company called Diamond, in which one of the
directors of Highland has a substantial interest. Kirsten tells you that all
transactions with Diamond are on normal commercial terms, so she has
not included Diamond on her list of related parties.
REQUIRED
Based on the information given, list three factors that would increase the
risk of a material misstatement occurring due to fraud or error resulting
from the entity’s related parties or transactions. LO 6.3
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Source: This question was adapted from the Chartered Accountants Program of the Institute of
Chartered Accountants in Australia, 2011 (2) audit and assurance module.

Appropriateness of going concern basis

6.24 EASY Loretta Quick, a junior auditor with Nathan & Hansen (N&H), has
noticed that the audit strategy for Overlander Ltd for the year ended 30
June 2018 includes a paragraph specifically requiring N&H to consider
possible going concern problems. Loretta quickly looked at the interim
financial report attached and noted that Overlander does not appear to
have any going concern problems. She is not sure why specific comment
Gay, Grant E., and Roger Simnett. Auditing and Assurance Services in Australia, McGraw-Hill Australia, 2018. ProQuest Ebook Central,
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has been made in the audit strategy and asks the audit senior for an
explanation.
REQUIRED
As the audit senior for Overlander, explain to Loretta why it is necessary to
assess the risk of going concern problems as part of the audit planning
process. LO 6.4

6.25 MEDIUM Mitchell Hazlewood is an audit senior with Lyon & Associates.

Mitchell is involved in planning the audit for the year ended 30 June 2018
of Blue Water Ltd, a manufacturer of engines for luxury leisure boats. Blue
Water’s operations are financed by a combination of long-term debt and
short-term loans from a financial institution, My Bank Ltd.
As part of the planning process Mitchell has noted the following matters:
Blue Water has been profitable for several years and has recently
successfully expanded its operations to manufacture a new type of
engine for export to New Zealand.
One of Blue Water’s major customers, Bob’s Boats, which represents 35
per cent of Blue Water’s annual sales, has indicated that it has started to
manufacture its own engines.
The strength of the Australian dollar against foreign currencies has had an
adverse effect on demand for locally produced engines. Competition in
the industry is becoming more intense, with some other customers of
Blue Water indicating they may now purchase their engines from Korean
suppliers at a much lower cost.
My Bank has requested cash flow forecasts for the coming year to
support the financing arrangements that are currently in place. Blue
Water’s level of debt has remained constant in recent years and it had a
positive working cash flow position to 30 June 2018.
REQUIRED
(a) Identify whether there are events or conditions that may indicate
material going concern uncertainties.
(b) Identify any mitigating factors. LO 6.4
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Page 263

6.26 HARD You are the auditor of Cool Air Ltd (CAL), a listed company that
manufactures and installs large commercial air-conditioning systems. CAL
typically has two or three large contracts (ranging from $6 million to $10
million each) in progress at any one time. The contracts usually take up to
six months to complete, although unexpected on-site difficulties can result
in lengthy delays in completion (of up to 12 months). CAL finances its
operations with a mixture of equity, long-term debt (secured by fixed
assets) and short-term bank loans.
It is now May 2018 and your planning of the audit of CAL for the year ended
30 June 2018 is nearing completion. You have met with the management of
CAL and, from those discussions and a review of the preliminary
information provided by CAL, you have identified several issues that may
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have implications for the company’s ability to continue as a going concern.
The relevant issues are as follows:
Competition in the industry is becoming more intense, with some
customers now installing their own systems.
CAL’s bank has requested cash flow forecasts for the coming year to
support the short-term loans. It has indicated that it may need to withdraw
funding or restructure debt if the forecasts are not adequate.
The review of work-in-progress indicates that all the contracts in progress
at year end are due for completion within six months of the balance date.
There are no new contracts in place for the coming year, although
management has indicated that there are orders currently being
negotiated. The nature of the business is such that sales will fluctuate
considerably from year to year depending on the timing of one or two
large contracts.
Assets consist chiefly of plant and equipment, some of which is
specialised to the industry. Debtors are significant, but recoverability is
not considered an issue as the ongoing projects are with reputable
customers and management is not aware of any problems. Creditor
balances are at normal levels, and the company is in a positive working
capital position.
Included in provisions is a large provision for warranty for one of CAL’s
jobs completed at a hotel two years ago. It appears that the air-
conditioning system is still not working and the hotel is now requesting a
substantial refund of the contract price.
REQUIRED
Explain whether you believe the area of going concern should be assessed
as high risk for CAL’s audit for the year ended 30 June 2018. LO 6.4

6.27 MEDIUM You are the auditor of Apple Pie Ltd, a frozen foods
manufacturer. Using the company’s ﬁnancial report, its budget for the year
under review and industry benchmarks, as well as your understanding of
the entity, you have compiled the following information:
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

Current ratio 1.57 1.32 1.33 1.84

Quick asset 0.82 0.79 0.79 1.05

ratio

Times 5.34 8.12 6.51 6.27

interest
earned ratio

Debt to 0.52 0.35 0.43 0.40

equity ratio

Days in 33.46 30.87 32.15 30.18

inventory

Days in 50.12 48.01 49.39 45.02

receivables

Gross proﬁt 8.50 9.56 8.98 9.04

ratio %

Admin. 1.67 1.68 1.81 2.02

expenses/sal
es %

Marketing 2.64 1.84 2.05 2.21

expenses/sal
es %

Return on 13.18 16.89 14.94 15.62

shareholders
’ equity %

Return on 10.83 14.36 13.42 14.71

total assets
%

Apple Pie operates in a low gross margin environment, meaning that large
volumes are required to cover overhead costs and generate proﬁts. It also
means that overheads need to be kept under control to ensure that Page 264
a net proﬁt results from its operations. Financial gearing also plays

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a role in keeping interest costs down and maintaining a margin for solvency
in downturns.
Apple Pie did not reach industry benchmarks with regard to profitability in
the previous year, and budgeted to better this in the current year. Apple
Pie’s intended strategy was to keep its costs down in relation to sales, while
allowing its gross profit ratio to drop, and to plan to generate a larger
volume of sales.
Apple Pie also planned to improve its working capital management by
reducing levels of inventory and accounts receivable. It budgeted for a
drop in gearing levels, thus indicating that it expected to produce a healthy
cash flow to enable it to do so.
REQUIRED
(a) Given all the information provided, including the results of your
preliminary analytical procedures, identify the key factors that
suggest Apple Pie may have a going concern problem.
(b) Given your answer to (a), identify four audit procedures that you
would conduct to assess the appropriateness of management’s use
of the going concern assumption in the preparation of the financial
report. LO 6.4
Source: This question was adapted from the Chartered Accountants Program of Chartered
Accountants Australia and New Zealand, 2015 (2) audit and assurance module.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

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Continuous case study
Background information for the continuous case study, Reliable Printers Ltd (RPL), is
contained in the Appendix to this book.

6.28 EASY You are conducting your risk assessment of RPL, as part of the
planning for your audit for the year ended 30 June 2018.
REQUIRED
Based on the background information for RPL contained in the
Appendix , identify two inherent risk factors that arise from the nature of
RPL’s business operations. Explain why each of these is a risk and how it
may aﬀect the risk of material misstatement in the ﬁnancial report. LO 6.1

Source: This question was adapted from the Chartered Accountants Program of the Institute of
Chartered Accountants in Australia, 2012 (3) audit and assurance module.

6.29 MEDIUM As part of your audit of RPL for the year ended 30 June 2018,
you are considering the risk that fraud may have occurred.
REQUIRED
(a) Based on the background information for RPL contained in the
Appendix , identify and explain two key fraud risk factors relating
to misstatements arising from fraudulent financial reporting to which
RPL may be susceptible.
(b) Explain how the risk factors identified in (a) would affect the conduct
of the audit. LO 6.2
Source: This question was adapted from the Chartered Accountants Program of the Institute of
Chartered Accountants in Australia, 2012 (3) audit and assurance module.
Copyright © 2018. McGraw-Hill Australia. All rights reserved.

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Page 229

CHAPTER 6
Assessing inherent risk and other speciﬁc business risks
LEARNING OBJECTIVES (LO)
6.1
Explain the fact

Page 230
RELEVANT GUIDANCE
ASA 200/ISA 200
Overall Objectives of the Independent Auditor and the
Conduct of an Audit in Accor

FIGURE 6.1 Flowchart of planning and risk-assessment stage of a financial report audit
Gay, Grant E., and Roger Simnett. Audi

LO 6.1 Inherent risk
ASA 315.25(a) (ISA 315.25(a)) requires the auditor to address the assessed risks of materi
al misstatem

Page 231
ASA 200.A42 (ISA 200.A42) points out that the auditing standards no longer ordinarily
refer to inherent and control

GLOBAL EXAMPLE 6.1 Inherent risk assessment
H Ltd is a construction company. Control of the company is in the hands of
the H

The incorrect reconciliation of debtors statements and the lack of
segregation of duties for the warehouse manager aﬀect cont

may be taken. When important operating and financing decisions are reviewed and
approved by the entity’s board of directors o

As indicated in an AUASB Bulletin (2012), economic downturns also often produce
uncertainty regarding the ability of an entit

There are three major categories of risk arising from the use of e-commerce (discussed in
Chapter 13
) that could increase in

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