Auditing Theory and Practice: Analysis of Three Case Studies

This report provides an analysis of three case studies in auditing, including inherent risks, preliminary materiality, debtor confirmation, ethical issues, and audit reporting options. The report also includes a table of contents, introduction, and references.

Running head: AUDITING THEORY AND PRACTICE
Auditing Theory and Practice
Name of the Student
Name of the University
Author’s Note

1AUDITING THEORY AND PRACTICE
Table of Contents
Introduction................................................................................................................................2
Case 1.........................................................................................................................................2
Requirement (a)......................................................................................................................2
Requirement (b).....................................................................................................................3
Case 2.........................................................................................................................................5
Requirement (a)......................................................................................................................5
Requirement (b).....................................................................................................................5
Case 3.........................................................................................................................................7
Requirement (a)......................................................................................................................7
Requirement (b).....................................................................................................................8
Requirement (c)......................................................................................................................8
References................................................................................................................................10

2AUDITING THEORY AND PRACTICE
Introduction
Auditing is considered as the process to undertake the financial statements and
records of the companies in order to make sure that they are accurate and have been prepared
in accordance with the required accounting rules and regulations. The main aim of this report
is to undertake the analysis of three provided situation in auditing. Analysis of the first case
study undertakes the analysis of involved inherent risks along with determining the factors to
consider for determining preliminary materiality. Analysis of the second case study
undertakes the valuation of the strengths and weaknesses of the debtor confirmation. Analysis
of the last case study undertakes the evaluation of ethical issues in auditing along with audit
report and recommended course of actions.
Case 1
Requirement (a)
Inherent risks are considered as those risks that cannot be protected by the internal
control of the companies (Ruhnke & Schmidt, 2014). It can be seen from the provided
information of MaxSecurity that there are certain factors that can lead inherent risks; these
are mentioned below:
I. As per the provided information, MaxSecurity operates in a highly specialized
manufacturing industry where they manufacture high-tech armour-plated personal
carriers. For this reason, the company has to maintain a highly secure environment
because of sensitive and confidential nature of the design of its vehicles. It implies
that business operations of MaxSecurity is complex in nature and this complexity in
the business operations can be connected to the complexity in the financial
transactions of the company where high accounting judgments as well as assumptions
can be involved. Complex nature of financial transactions can lead to material

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misstatements in the financial statements that can affect the company’s financial
reporting process (Coetzee & Lubbe, 2014).
II. According to the case, MaxSecurity has to face a competitive market tender process in
order to acquire large government contracts and this can be considered as a major
external environmental factor for inherent risk. This aspect can create pressure on
MaxSecurity in order to strengthen their financial statements in order to win the
contracts. This can lead to material misstatements in the financial statements of in
order to strengthen their financial position in manipulative manner. This can lead to
the development of inherent risk (Griffiths, 2016).
III. As per the provided information, MaxSecurity has recently installed an off-the-shelf
costing system in order to support their highly sophisticated as well as cost-sensitive
nature of product design. It can be seen that this manufacturing costing system is
highly dependent on the manufacturing unit inputs in order to calculate and produce a
database (Johnstone, Gramling & Rittenberg, 2013). In addition, this system is
integrated with the general ledger entries. Therefore, any error in the general ledger
can lead to wrong calculation as well as production of database of all product cost and
recommended sales price. This aspect can affect the financial statements of
MaxSecurity in major negative manner and this can be considered as a major inherent
risk of the audit of MaxSecurity (Botez, 2015).
Requirement (b)
At the time of audit planning, the auditors are needed to consider the aspects that can
make the financial statements materially misstated due to the fact that there is a relationship
between materiality and level of audit risk. The main aim of preliminary assessment of
materiality is the establishment of a suitable quantities materiality level in order to plan audit
procedures along with the selection strategies (auasb.gov.au, 2019). Therefore, it is needed

4AUDITING THEORY AND PRACTICE
for the auditors to take into consideration the quantitative threshold as guidance for the
determination of preliminary materialist level. The auditors of MaxSecurity can use the
following quantitative thresholds as guidance for the determination of preliminary materiality
level.
I. An amount that is greater than or equal to 10% of suitable base amount that may be
presumed to be material unless there is the presence of evidence or substantial
argument to the contrary; and
II. An amount which is less than or equal to 5% of the suitable base amount that can be
presumed not to be material unless there is evidence or substantial argument to the
contrary (auasb.gov.au, 2019).
At the time to establish the preliminary assessment of materiality, the auditors of
MaxSecurity is needed to take into favour three aspects; they are the reliability of the
information of management, qualitative factors and any factors that may indicate deviation
from normal business activities. Although quantitative factors are taken into consideration
when determining preliminary materiality, it is also needed for the auditors of MaxSecurity to
consider the outcome of audit and nature of misstatements.
Conclusion – As per the above discussion, the complex nature of business operation,
complex external business environment and competitive market tender process lead to the
complex financial reporting of MaxSecurity which can lead to the development of material
misstatements in the financial statements of the company. In addition, involvement of
extensive human judgment also leads to inherent risk of auditing as it can affect the
company’s financial statements (aasb.gov.au. 2019). Moreover, the auditors of MaxSecurity
is needed to take into consideration the quantitative threshold at the time to determine the
preliminary assessment.

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Case 2
Requirement (a)
Debtor confirmation is considered as a crucial aspect in the process of auditing the
financial statements of the companies and the same is applicable in case of MSMG. Debtor
confirmation is a crucial aspect that would provide the necessary evidence regarding the
existence assertion of accounts receivable at MSMG. In case an affirmative answer comes
from the debtors, it is an external evidence that they owe MSMG for rendered services
(Rokotyanskaya et al., 2018). The evidence of rights as well as obligation assertions can also
be obtained from debtor confirmation due to the fact that these assertions provide evidence
about whether they owned the amount to MSMG. Reliable evidence on valuation and
allocation assertion cannot be obtained from debtor confirmation. It can be seen from the
provided information of MSMG that the balance of receivable that is $3974569 is material. In
spite of the fact that 14 days is the payment term of the company, it can be seen that many of
the smaller debtor accounts are 60 days overview (Zakari, 2013). This can be considered as a
major weakness of the debtor confirmation of Shady Oaks because of ineffective approval of
credit and collection of debtors. At the same time, it needs to be mentioned that the debtor
confirmation of Shady Oaks does not provide any reliable information for the valuation and
allocation assertion of trade receivables. Since 60% of the debtors that is $2384741
approximately ($3974569 × 60%) is owned by five different medical practitioners, there is a
need for more evidence of valuation in order to proceed further which creates major doubts
about its recovery (Augustine et al., 2013). This can be considered as another major
weakness.
Requirement (b)
Chan and Partners can send debtor confirmation to the large accounts receivable
balances that is owned by five medical practitioners in order to obtain evidence about the

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existence of accounts receivable. However, there is need for further procedures in order to
gather reliable information or evidence about the valuation of these accounts receivables. It is
not mentioned that how long these accounts have been unsettled. It is less likely that there is
the presence of major doubt about the recovery of the debtors those are within 14 day.
However, it needs to be mentioned that in case there is an additional there is a review of
subsequent receipts, it would provide the auditors with certain additional evidence which
would be essential in the presence of the material nature of the accounts. This indicates
towards the crucial fact that debtor confirmation is not solely adequate as audit evidence in
case of large debtors (Rahman, 2015).
The smaller accounts of trade receivables that is 40% of total trade receivables
amounted to $1589828 ($3974569 × 40%) seems to be more likely to be in significant doubt
because of the fact that most of them are well over the allowed 14 days. Required evidence
on their existence can be acquired from debtor confirmation, but there is a need for other
procedures in case of the valuation assertion (Miculescu & Grui, 2018). Since the allowance
for doubtful debts is taken into consideration directly against the trade receivables account, it
would be needed for the auditors to review the transactions while assessing the rationality in
the presence of ineffective credit control. Along with these, it would be needed for the
auditors to consider subsequent review of receipts and analysis of the characteristics of the
debtors because of the fact that these procedures would provide the auditors with the
evidence about the valuation of these small debtors (Xu et al., 2013).
Conclusion – It can be seen from the above discussion that there are certain major
weaknesses in the debtor confirmation process of Shady Oaks. One of them is that the debtors
are not paying the due in the provided term of 14 days as they are due for more than 60 days.
In addition, it can also be seen from the above that only debtor confirmation is not adequate

7AUDITING THEORY AND PRACTICE
for the auditor to gain the required evidence as other relevant procedures need to be
performed by the auditors of Shady Oaks.
Case 3
Requirement (a)
As per APES 110, Code of Ethics and Professional Accountants, it is the
responsibility of Meg to adhere to five fundamental principles which are Integrity,
Objectivity, Professional competence and due care, Confidentiality and Professional
behaviour (apesb.org.au, 2019). According to APES 110, Section 100, certain circumstances
can create threat to these fundamental principles of APES 110; and can lead to the threats like
self-interest threat, familiarity threat, self-review threat, intimidation threat and advocacy
threat. In case of Meg, there are two threats of fundamental ethical principles and they are as
follows:
Self-interest Threat – This threat can arise when Meg may not wish to disappoint the CEO
and further, in case the audit firm loses the audit contract of Champion Securities (Kouakou,
Boiral & Gendron, 2013).
Intimidation Threat – This threat can arise when the CEO seems to threaten Meg for
making her agree on the valuation. The statement of the CEO can be considered as a threat to
Meg for replacing Meg and her audit firm. These threats can lead to the loss of audit
objectivity by Meg while adhering to the CEO’s request (Ojo, 2015).
Meg needs to do the following aspects to comply with APES 110:
I. She can request another audit engagement partner to join her for reviewing the case
with the aim to effectively deal with the CEO.
II. She can formally refer to this whole situation to the Audit Committee and Board of
Champion Securities.

8AUDITING THEORY AND PRACTICE
III. She can request for another independent valuation of the assets of the firm.
IV. She can ask to present this issue to the Annual General Meeting of the firm in front of
the company’s shareholders.
V. She can refers this matter to the Australian Securities and Investment Commission.
VI. She can resign from the audit of Champion Securities (apesb.org.au, 2019).
Requirement (b)
Meg has four types of audit report options and they are discussed below:
I. Meg can issue Unqualified Audit Opinion in case there is an agreement between her
and the CEO on the correct asset valuation (Tsipouridou & Spathis, 2014).
II. Meg can issue Disclaimer of Audit Opinion in case there is an agreement along with
the development of major going concern uncertainty which is sufficiently disclosed
(Pei & Hamill, 2013).
III. Meg can issue Qualified Audit Opinion in case the misstated asset valuation does not
widely affect the financial statements. This is improbable in the presence of the
critical nature of the valuation (Chen et al., 2016).
IV. Meg can issue Adverse Audit Opinion in case this asset valuation related
misstatement pervasively affect the financial statements. This is the most appropriate
option since the misstatement in asset valuation creates major doubts on the going
concern ability of the firm (Huang, Chang & Chiou, 2015).
Requirement (c)
It is recommended to Meg that she needs to resolve this issue with the assistance of
Champion Securities’ Board of Directors and other partners at the audit firm while ensuring
the fact that there is the disclosure of correct valuation of assets in the financial statements.
The most appropriate audit reporting option for Meg is the second option above where Meg

9AUDITING THEORY AND PRACTICE
needs to adequately disclose the uncertainty in going concern due to the valuation issue.
Providing adverse opinion while resigning as the auditor of Champion Securities are the last
options in case the relationship between the CEO and her is collapsed. Most important, Meg
must not agree with the request of the CEO for overvaluing the asset since this action would
breach the fundamental ethical principles of auditing.
Conclusion – It can be seen from the above discussion that there can be the creation of self-
interest threat and intimidation threat of audit indepdence due to the violation of the audit
ethical principle of APES 110. For this reason, Meg is needed to issue the disclaimer of audit
opinion while taking other initiatives like discussion with the Boards and others. These
actions would help Meg to continue the audit operations while complying with the required
ethical principles.

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References
Aasb.gov.au (2019). Materiality. Retrieved 7 August 2019, from
https://www.aasb.gov.au/admin/file/content102/c3/AASB1031_9-95.pdf
Apesb.org.au. (2019). APES 110 Code of Ethics for Professional Accountants. Retrieved 7
August 2019, from
https://www.apesb.org.au/uploads/standards/apesb_standards/23072019055710_APE
S_110_Code_of_Ethics_for_Professional_Accountants_December_2010_-_Final.pdf
Auasb.gov.au. (2019). Materiality and Audit Adjustments. Retrieved 7 August 2019, from
https://www.auasb.gov.au/admin/file/content102/c3/AUS_306.pdf
Augustine, O. E., Mgbame, C., Lucky, G. O., & Kuegbe, K. (2013). Impact of Audit
Evidence on Auditor’s Report. Research Journal of Finance and Accounting. ISSN,
2222-1697.
BOTEZ, D. (2015). Study Regarding the Need to Develop an Audit Risk Model. Audit
financiar, 13(125).
Chen, P. F., He, S., Ma, Z., & Stice, D. (2016). The information role of audit opinions in debt
contracting. Journal of Accounting and Economics, 61(1), 121-144.
Coetzee, P., & Lubbe, D. (2014). Improving the efficiency and effectiveness of risk‐based
internal audit engagements. International Journal of Auditing, 18(2), 115-125.
Griffiths, P. (2016). Risk-based auditing. Routledge.
Huang, T. C., Chang, H., & Chiou, J. R. (2015). Audit market concentration, audit fees, and
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121-145.

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Johnstone, K., Gramling, A., & Rittenberg, L. E. (2013). Auditing: a risk-based approach to
conducting a quality audit. Cengage learning.
Kouakou, D., Boiral, O., & Gendron, Y. (2013). ISO auditing and the construction of trust in
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Miculescu, M. N., & Grui, S. D. (2018). AUDIT OF TRADE RECEIVABLES. Quaestus,
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ROKOTYANSKAYA, V. V., MOSHCHENKO, O. V., VALUISKOV, N. V., OSTAEV, G.
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of Practice & Theory, 33(4), 247-269.

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