Auditing Theory and Practice

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Running head: AUDITING THEORY AND PRACTICE
Auditing Theory and Practice
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AUDITING THEORY AND PRACTICE
Contents
Introduction:....................................................................................................................................3
Answer 1:.........................................................................................................................................3
Part (a):........................................................................................................................................3
The reduction in inventory turnover is significant and indicates possible area of material
misstatement:...........................................................................................................................4
Risk of inventory mismanagement at the time of transfer:......................................................4
Part (b):........................................................................................................................................4
The risk of material misstatement as the turnover ratio of inventories have been reduced:....5
The risk of inventory mismanagement at the time of transferring inventories from central
warehouse to six regional warehouses:....................................................................................5
Part (c):........................................................................................................................................5
ASA 701 explaining key audit matters:...................................................................................5
Answer 2:.........................................................................................................................................8
Part (a):........................................................................................................................................8
Whether the item meets the criterions of intangible assets:....................................................8
Risk of measuring the cost of intellectual property reliably:...................................................9
Part (b):........................................................................................................................................9
In order to assess the risk of intellectual property not meeting the recognition criterion of
intangible assets:....................................................................................................................10

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Measuring cost of intellectual property reliably:...................................................................10
Part (c):......................................................................................................................................10
Key audit matters:..................................................................................................................11
Conclusion:....................................................................................................................................11
References:....................................................................................................................................13

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Introduction:
Appropriate auditing standards are to be followed in order to conduct an audit efficiently.
In case of entities and organizations operating in Australia the Australian Auditing Standards,
here in after to be referred to as ASA in this document, issued by the Australian Auditing and
Assurance Standards Board (AAUSB) shall be followed. In this document the explanations have
been provided in accordance with applicable ASA and accounting standards relevant to the facts
of the case.
Answer 1:
Part (a):
Valuation of inventories must be in accordance with AASB 102:
Entities operating in the country must follow AASB 102 in accounting for inventories in the
books of accounts. As per the standard on accounting inventories must be valued at lower of cost
and net realizable value. An auditor at the time of auditing the financial information of an
organization must verify that the inventories have been correctly valued and disclosed in the
financial statements. An auditor in Australia must follow the guidelines provided in ASA 501
while verifying the financial information in relation inventories of an organization. Necessary
audit evidence must be collected to come to a particular conclusion about the inventories
recorded by an organization (Soh and Martinov-Bennie, 2015).
Two key assertions at risk in relation to inventory:
Taking into consideration the information provided about the inventories of Computing
Solutions Limited, an entity operating in the country, for the financial year ending on June 30th,

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AUDITING THEORY AND PRACTICE
2018 two key assertions in relation to the risk in inventory valuation and recording in the books
of accounts of the company are enumerated below.
The reduction in inventory turnover is significant and indicates possible area of material
misstatement:
The inventory turnover ratio of the company for the financial year 2017 was 5.2 times
whereas in the current financial year, i.e. in 2018 the company has merely managed to turnover
its inventories by 3.8 times. This is a significant reduction in inventory turnover. There is a
possibility of material misstatement existing in the books of account in respect of inventory
valuation and disclosure (Nicoll, 2016). Also the fact that inventories have been moved from
central warehouse to regional offices in different parts of the country is another indication of
possible mistake in valuation of inventories as well as inventory.
Risk of inventory mismanagement at the time of transfer:
Moving the inventories from central warehouse to six different regional warehouses
could potentially have influenced the inventory management system. The risk of pilferage and
mismanagement of inventories at the time of transferring inventories from central warehouse to 6
different regional warehouses is a valid risk (Sadgrove, 2016). The auditor must evaluate this
aspect of inventory management. Inventory on hand has changed over the years and it is clear
from the fact that in 2014 it was around 14% of sales whereas in 2018 it is around 22% of sales.
The increase in inventory in hand over the 4 year period is not very significant but the reason for
such increase should also be checked and verified by the auditor (Beasley et. al. 2018).
Part (b):

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AUDITING THEORY AND PRACTICE
Substantive audit procedures:
The risk of material misstatement as the turnover ratio of inventories have been reduced:
The auditor will have to evaluate the inventory management and valuation system.
Whether inventory management system is commensurate with the size of the inventory and the
quantum of turnover. It is important for an organization to have an effective inventory
management system to ensure that inventories are correctly managed and valued. The auditor
should also verify that the inventory valuation has been made in accordance with AASB 102.
Thus, the auditor should verify the inventory valuation system as well to evaluate whether proper
method and principles have been followed in valuation of inventories.
The risk of inventory mismanagement at the time of transferring inventories from central
warehouse to six regional warehouses:
The Computing Solutions Limited has transferred its inventories from the centralized
warehouse to six different regional warehouses in different parts of the country. The auditor must
very the process followed by the inventory management department at the time of transferring
the inventories to reduce the risk of inventory mismanagement and damage during the course of
transferring the inventories from one location to other. The auditor should also conduct physical
verification of inventories if possible. However, in case such physical verification is not possible
then at-least he should be physically present at-least once while the stock taking is taking place.
Part (c):
ASA 701 explaining key audit matters:
ASA 701 has expended the importance of key audit maters in an audit of financial
statements. Key audit matters are those matters that according to the professional judgment of
auditors are of very important to the overall financial performance and position of an

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AUDITING THEORY AND PRACTICE
organization. The importance of communicating key audit matters in an audit is of huge
significance and the relevant guidelines have been provided in ASA 701 that an auditor must
follow while conducting an audit of financial information.
While determining key audit maters (KAM) in an audit the following factors must be taken into
consideration by the auditor:
I. Areas in financial statements where the risk of misstatement is quite high. Such areas in an
audit of an organization are assessed after assessing the environment of the organization and
assessing the risk of material misstatements in such organization. ASA 315 must be followed
by the auditor to understand entity and its environment for assessing the risk of material
misstatements.
II. Areas in financial reports that require significant judgement of management and accountant
of the organization. Generally accounting estimates that have high amount of uncertainty with
regards to estimation (Knechel and Salterio, 2016).
III. Significant events and transactions that have happened during the period that expected to
have significant impact on financial performance and position of the organization.
After taking into consideration the above factors an auditor should determine the KAM and
communicate these in the independent audit report to ensure that the users of financial
statements can assess the impact of these mattes correctly on the financial performance and
financial position of the entity. An auditor must communicate KAM in independent audit
report as per the guidelines provided in ASA 701 (Bhattacharjee, Maletta and Moreno, 2015).
Key Audit Matters in relation to Computing Solutions Limited:

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AUDITING THEORY AND PRACTICE
High level of return owing suspected software problem: It is a key audit matter as the high
return experienced by the entity due to software problem if not communicated to the users of
financial statements via independent audit report then they would not understand the actual
financial performance of the entity. Hence, the matter should be communicated as KAM in
the independent audit report of Computing Solutions Limited (Brasel et. al. 2016).
Inventory turnover reduction:
The reduction of inventory turnover ratio from 5.2 times in 2017 to 3.8 times in 2018 is
important consideration for the auditor and is an indicative of possible area of misstatement
in the financial reports. However, this is part of analytical procedure finding for the auditor to
extend substantive procedures on certain matters and items but not a KAM to be
communicated in the independent audit report (Beck, Glendening and Hogan, 2016).
Moving inventory from central warehouse to regional warehouses:
Moving the inventory from a central warehouse to 6 regional warehouse of the company is
again an important consideration for the auditor to verify the inventory management system
before, after and during the time of transferring these inventories to the regional warehouses.
This is important for the auditor to conduct the audit effectively but not a KAM to be
communicated in the independent audit report (Wright, 2016).
Increase in inventory at hand:
Inventory at hand in 2018 is 22% of sales whereas in 2014 it was 18%. This is not a
significant factor for audit of the entity thus, need not be included as KAM in the auditor’s
report.

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AUDITING THEORY AND PRACTICE
Supplying products at 10% below cost:
In order to prevent competitors in the public sector from gaining foothold the company has
decided to supply products at 10% below the cost of production to a Government department.
This is a key policy decision affecting the financial performance and position of the
company. Hence, the matter must be communicated in independent audit report of the
company to highlight the matter and its impact on the financial reports clearly (Sirois, Bédard
and Bera, 2018).
Answer 2:
Part (a):
Two key assertions most at risk in relation to the intellectual property:
In Australia AASB 138, Intangible Assets, deals with valuation and disclosure of
intangible assets. The standard is in alignment with the one issued by the International
Accounting Standards Board, IAS 38. AASB 138 prescribes the accounting treatments to be
made for recording intangible assets in the books of account of an organization. According to the
standards only when the necessary criterions are met that an organization should recognize
intangible asset in the books of accounts. In order to recognize intangible assets in the books of
account the organization must demonstrate the item meets the definition of intangible asset and
met the recognition criterions (Kachelmeier, Schmidt and Valentine, 2017).
The two key assertions most at risk in relation to intellectual properties to be recognized as
intangible asset in the books of accounts of an organization are as following:

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AUDITING THEORY AND PRACTICE
Whether the item meets the criterions of intangible assets:
In order to recognize intellectual properties as intangible asset an organization, Beautiful
Hair in this case, must show that the property meets the recognition criterion of intangible asset.
The intangible asset shall be recognized as intangible asset only when the following conditions
are satisfied:
I. The entity will received future economic benefits from the use of such intellectual property and
II. The cost of acquiring intellectual property can be measured reliably (Parr, 2018).
In this case thus, one of the two key asserts at risk is whether the Beautiful Hair will be able to
make use of the intellectual property held by Shimmer’s solicitors to gain economic benefits in
the future (Cordoş and Fülöp, 2015).
Risk of measuring the cost of intellectual property reliably:
Since the intellectual property is the property of Shimmer’s solicitors thus, the ability of
Beautiful Hair to use it for earning future economic benefits is not certain. Also the fact that
how the cost of intellectual property will be measured reliably. Any error in determining the cost
of intellectual property at the time of recognition of the property as intangible asset would impact
the financial statements of the company (Brasel et. al. 2016).
Part (b):
Substantive audit procedures:
The substantive audit procedures help the auditors to corroborate necessary audit
evidence to come to a particular conclusion about an item of financial statements. An auditor is
responsible to conduct all necessary procedures and collect audit evidences to express an
accurate opinion on the financial statements. Substantive procedures help an auditor to collect

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AUDITING THEORY AND PRACTICE
necessary audit evidence to make assertion on items of financial reports. In case of the two key
risk assertions mentioned about recognizing intellectual property as intangible assets in the books
of accounts of the company the auditor should conduct appropriate substantive audit procedures
to response to these risks (Christensen, Glover and Wolfe, 2014).
In order to assess the risk of intellectual property not meeting the recognition criterion of
intangible assets:
The auditor should conduct extensive audit procedure to verify whether the intellectual
property of Shimmer’s solicitor will continue to provide economic benefit to the Beautiful Hair
even after the acquisition of the former by the later. Often intellectual properties of a transferee
company does not yield similar benefits for the transferor company due to number of reasons
such as change in management, different approach of management, change in employee and
working staffs and other such reasons (Zambon, 2017). In this case the auditor will have to
assess whether the acquisition of Shimmer by Beautiful Hair will have any adverse impact on the
intellectual property and its value to the Beautiful Hair. In case the auditor determines that the
intellectual property will keep on producing economic benefits for Beautiful Hair than the
property shall be recognized as intangible asset in the books of accounts of the company
(Bianchi, 2017).
Measuring cost of intellectual property reliably:
Once the intellectual property meets the recognition criterion the auditor will have to
verify the information available about the property to ensure that the cost of the property can be
measured reliably. The auditor if determines there is significant information available to
determine the cost of the property reliably then he shall evaluate whether the intellectual property

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AUDITING THEORY AND PRACTICE
has been valued at such cost in the books of accounts of Beautiful Hair (Castilla-Polo and
Gallardo-Vázquez, 2016).
Part (c):
Key audit matters:
As already mentioned an auditor in Australia must communicate key audit matter (KAM)
in the independent audit report of an organization as per the prescription given in ASA 701. ASA
701 is the standard in disclosing key audit matters in an audit of financial statements issued by
the AAUSB. The auditor and his professional judgment plays the most important role in
determining the KAM to be disclosed in the independent report of the auditor on the verification
of financial reports of an organization (Sinclair and Keller, 2014).
The intellectual property and its recognition in the books of accounts of Beautiful Hair is a
matter to be verified and checked by the auditor but whether the item is KAM or not to be
determined on the basis of the quantum of value of such intellectual property. In case the cost of
intellectual property is huge and recognition of such will have a significant impact on the
financial position as well as performance of Beautiful hair significantly then, the matter could be
reported as KAM in the independent audit report of the company (Dumay, 2016).
Conclusion:
Accounting standards (AASBs) and auditing standards (ASAs) in Australia clearly
explain that the responsibility of an auditor extend much beyond that simple verification of few
vouchers and supporting documents. In fact an auditor must have all necessary knowledge about
AASBs and ASAs to efficiently discharge the responsibilities of an auditor. In this document the

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AUDITING THEORY AND PRACTICE
risk of material misstatement in the audit of two separate entities evaluated from prism of the
AASBs and ASAs applicable in the country. The discussion clearly revealed that the auditor
must provide a detailed information in the independent audit report of key audit matters to attract
the attention of the users of financial statements. The information regarding inventories of
Computing Solutions Limited and intellectual properties of Beautiful Hair are certainly
significant for the auditor but not always part of key audit matters in the independent audit report
of the two companies.

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References:
Beasley, M.S., Blay, A.D., Lewellen, C. and McAllister, M., 2018. The Association Between
Board Risk Oversight and the Risk of Material Misstatement.
Beck, M.J., Glendening, M. and Hogan, C.E., 2016. Financial Statement Disaggregation,
Auditor Effort and Financial Reporting Quality. working paper, Michigan State University.
Bhattacharjee, S., Maletta, M.J. and Moreno, K.K., 2015. The role of account subjectivity and
risk of material misstatement on auditors' internal audit reliance judgments. Accounting
Horizons, 30(2), pp.225-238.
Bianchi, P., 2017. The economic importance of intangible assets. Routledge.
Brasel, K., Doxey, M.M., Grenier, J.H. and Reffett, A., 2016. Risk disclosure preceding negative
outcomes: The effects of reporting critical audit matters on judgments of auditor liability. The
Accounting Review, 91(5), pp.1345-1362. [Online] Available at:
http://www.aaajournals.org/doi/abs/10.2308/accr-51380 [Accessed 19 September 2018]
Brasel, K., Doxey, M.M., Grenier, J.H. and Reffett, A., 2016. Risk disclosure preceding negative
outcomes: The effects of reporting critical audit matters on judgments of auditor liability. The
Accounting Review, 91(5), pp.1345-1362.
Castilla-Polo, F. and Gallardo-Vázquez, D., 2016. The main topics of research on disclosures of
intangible assets: a critical review. Accounting, Auditing & Accountability Journal, 29(2),
pp.323-356. [Online] Available at: https://www.emeraldinsight.com/doi/abs/10.1108/AAAJ-11-
2014-1864 [Accessed 19 September 2018]

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Christensen, B.E., Glover, S.M. and Wolfe, C.J., 2014. Do critical audit matter paragraphs in the
audit report change nonprofessional investors' decision to invest?. Auditing: A Journal of
Practice & Theory, 33(4), pp.71-93. [Online] Available at:
http://www.aaajournals.org/doi/abs/10.2308/ajpt-50793 [Accessed 19 September 2018]
Cordoş, G.S. and Fülöp, M.T., 2015. Understanding audit reporting changes: introduction of Key
Audit Matters. Accounting & Management Information Systems/Contabilitate si Informatica de
Gestiune, 14(1).
Dumay, J., 2016. A critical reflection on the future of intellectual capital: from reporting to
disclosure. Journal of Intellectual capital, 17(1), pp.168-184.
Kachelmeier, S.J., Schmidt, J.J. and Valentine, K., 2017. The disclaimer effect of disclosing
critical audit matters in the auditor’s report.
Knechel, W.R. and Salterio, S.E., 2016. Auditing: Assurance and risk. Routledge.
Nicoll, P., 2016. Audit in a democracy: the Australian model of public sector audit and its
application to emerging markets. Routledge.
Parr, R.L., 2018. Intellectual property: valuation, exploitation, and infringement damages. John
Wiley & Sons. [Online] Available at: https://books.google.co.in/books?
hl=en&lr=&id=04NTDwAAQBAJ&oi=fnd&pg=PP2&dq=Valuing+intellectual+properties+as+I
ntangible+assets+&ots=HDGRtA1YBr&sig=zZZIDIzyPdR3HNOrv706WZMSUyM#v=onepage
&q=Valuing%20intellectual%20properties%20as%20Intangible%20assets&f=false [Accessed
19 September 2018]
Sadgrove, K., 2016. The complete guide to business risk management. Routledge.

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Sinclair, R.N. and Keller, K.L., 2014. A case for brands as assets: Acquired and internally
developed. Journal of Brand Management, 21(4), pp.286-302.
Sirois, L.P., Bédard, J. and Bera, P., 2018. The informational value of key audit matters in the
auditor's report: evidence from an Eye-tracking study. Accounting Horizons. [Online] Available
at: http://www.aaajournals.org/doi/abs/10.2308/acch-52047 [Accessed 19 September 2018]
Soh, D.S. and Martinov-Bennie, N., 2015. Internal auditors’ perceptions of their role in
environmental, social and governance assurance and consulting. Managerial Auditing
Journal, 30(1), pp.80-111. [Online] Available at:
https://www.emeraldinsight.com/doi/abs/10.1108/MAJ-08-2014-1075 [Accessed 19 September
2018]
Wright, W.F., 2016. Client business models, process business risks and the risk of material
misstatement of revenue. Accounting, Organizations and Society, 48, pp.43-55.
Zambon, S., 2017. Intangibles and intellectual capital: an overview of the reporting issues and
some measurement models. In The economic importance of intangible assets (pp. 165-196).
Routledge.