ACT504 Auditing Assignment: Materiality, Independence, Controls

This auditing assignment, prepared for ACT504, delves into critical aspects of the auditing process. It begins by examining the evolution of materiality standards, specifically focusing on AASB 1031 and its revisions, and the shift towards a principles-based framework. The assignment defines materiality, differentiates between quantitative and qualitative guidelines, and explores the impact of misstatements on audit quality. The second part of the assignment focuses on auditor independence, differentiating between real and perceived independence, and analyzes ethical violations related to confidentiality and independence threats. The assignment provides case studies to illustrate these concepts. The third part identifies and analyzes internal control weaknesses at Everyday Supplies, covering segregation of duties, record-keeping practices, credit limits, and reconciliation procedures. The assignment highlights the importance of robust internal controls in mitigating risks and ensuring the reliability of financial information. This comprehensive analysis provides valuable insights into the practical application of auditing principles and the importance of ethical considerations and internal controls.

AUDITING
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AUDITING
Question 1
1. Australia first introduced an accounting standard dealing with materiality in 1969.The first
standard on materiality was issued by Australia’s Institute of Chartered Accountants as a
professional standard. The standard could notably not be enforced legally as it was a professional
standard that was only meant to provide guidance in the preparation of financial statements.
In1995, the AASB issued a legally enforceable standard; AASB 1031. The 1995 standard define
materiality, explained the role of materiality in making decisions relating to the preparation and
presentation of financial statements and required standards contained in other Accounting
standards to be effected if they had a material effect.
AASB 1031 was revised in 2004. There were no significant changes to the existing standard. The
revision was implemented on the backdrop of the adoption by the AASB of the International
Accounting Standards (IASs) issued by the International Accounting Standards Board (IASB). In
the adoption, IASs would be given priority over AAS if there were differences between the two
as the objective of the adoption was to ensure that AASB standards conform to international
standards. The revision implemented in 2004 involved reducing guidance on materiality as it was
noted that AASB had significantly more guidance on materiality compared to the international
Framework for Preparation of Financial Statements. However, the revision retained AASB
1031’s explanation of the meaning of materiality. AASB 1031 was further revised in 2013. The
revision removed guidance on materiality that was not contained in the IFRS. The revision also
directed constituents to other standards that provide guidance on materiality. The 2015 revision

of AASB 1031 completed the withdrawal of all references to the standard. The implication of the
2015 revision was that AASB 1031 was officially withdrawn.
2.
a. IAASB 1031 defined materiality as “ information which if omitted, misstated or undisclosed
could potentially adversely affect decisions relating to allocation of resources made by users
relying on financial reports or accountability of management or entity’s governing body”
(paragraph 5) With the adoption of IFRSs, AASB 1031 was revised and a new definition of
materiality was issued. The new definition defined omissions or misstatements as material if
“they could individually or collectively influence the economic decisions of users taken on
the basis of the financial statements. Materiality depends on the size and nature of the
omission or misstatement judged in the surrounding circumstances. The size or nature of
the item, or a combination of both, could be the determining factor.”(IASB 2007 p.5)
b. Under AASB 1031 materiality is determined based on two criteria: size and nature.
Quantitative guidelines provide guidance on how to determine materiality based on size while
qualitative guidelines relate to nature. The essence AASB’s quantitative guideline on materiality
is that an item or a collection of items is considered to be material if they are equal to or greater
than 10% of an appropriate base amount unless there is evidence to the contrary or a convincing
argument. Additional AASB 1031 quantitative guidance is that items that are individually or
collectively lest than 5% of a suitable base may be presumed not to be material unless there is
evidence to the contrary. Amounts greater than 10% are material while amounts less than 5% of
a base are immaterial. The standard is notably mum on the classification of items falling between
5% and 10% (PCAOB, 2007). Items or transactions may also be material if they are abnormal by

nature. Items that do not qualify to be classified as material under the quantitative guidelines may
be classified as material if their abnormality could affect the entity’s operating profit or loss after
tax.
c. Material misstatements and errors potentially affect the quality of work that auditors do.
Auditors should therefore plan their audits with the objective of detecting misstatements that
could lead to an incorrect audit opinion being reached. Auditors assess the risk that the clients
financial statements are false and based on this risk determine the level of materiality. If a
client’s level of risk is assessed to be high, then the auditor lowers materiality (Heiman-Hoffman,
Moser, and Joseph 2015 p.770). Conversely, if the level of risk is assessed to be low, then the
auditor responds by increasing materiality.
3. It is important to point out that IASs rely on a principles based framework. The implication of
this with regard to materiality is that whereas standards do not expressly state materiality levels,
the principles involved in determining materiality are well understood. The focus under the
principles based framework is on why materiality is set in the first place and not merely on
whether or not materiality should be 10%. Auditors and accountants should justify reasons for
using a low or high level of materiality. Withdrawal of AASB 1031 will not bring disparity in the
assessment of materiality. The reason is that auditors have to appreciate the reason why
materiality is important in the first place; the reason is to test whether there are misstatements or
omissions in the financial statements that could significantly affect the accuracy, truth and
fairness of financial statements. With this objective in mind, auditors are free to determine
materiality levels based on assessed levels of risk. The ultimate goal is to determine whether the
financial statements are reliable.

Question 2
a. Real independence or independence in fact relates to the way an auditor acts or reacts in
specific situations. A determination of real independence is inward looking. An auditor who has
real independence is capable of making independent decisions even if the circumstances
surrounding their decision may make them to be perceived as though they are not independent.
Perceived independence is determined from the point of view of a third party. An auditor has
perceived independence if a third party looking at their relationship with the client would
conclude that the auditor is independent (Libby and Frederick 2010 p.351). Real and perceived
independence both contribute to the credibility of the work an auditor does. Real independence
determines whether or not an auditor breaks relevant standards and regulations relating to
independence. If an auditor has real independence, they will act appropriately when placed in
compromising situations. Perceived independence relates to how third parties view the
relationship between the auditor and the client (Herda and Lavelle 2013 p.12). If third parties
that rely on financial statements perceive the auditor not to be independent, they are likely not to
going to give the audit report much credibility. Perceived independence is therefore important as
it can compel auditors to act or conduct themselves in a manner that exudes independence and
possibly to seek real independence from the auditor.
b.
(i) Bob has violated the principle of confidentiality in the Code of Ethics. This principle prohibits
auditors from disclosing outside the firm and from using information available to them as a result
of their role to their own advantage or to the advantage of a third party (Frederick 2011 p.243).
Bob has disclosed client information to a third party without the client’s consent. The fact that

Bob has removed all references to Club Casino does not mean that the information is not Club
Casino’s and therefore does not negate the obligation to observe confidentiality. Bob has used
the confidential information to his advantage. This is specifically prohibited by the Code of
Ethics. Bob should have sought express permission from Club Casino before using the
information.
(ii) Due to Wendy’s long term engagement as Ace Limited’s auditor, there is a threat that her
familiarity with the client will affect her independence. Wendy has developed a close
relationship with staff and directors of the client and as such may not be completely independent
of the client. Wendy’s appointment as the company’s secretary confirms that a familiarity threat
to independence exists. Wendy should either have declined the appointment to become a
company secretary or asked to be reassigned from her role as Ace Limited’s auditor in order to
safeguard independence.
(iii) There exists a close personal relationship between a member of the audit team and the client.
This close relationship is the source of a familiarity threat. Leo’s familiarity with the client could
potentially prevent him from performing his role independently. Leo should request to be
reassigned from the client due to the close personal relationship with the client.
(iv) The circumstances surrounding the relationship between Chan Associates and Classic
reproductions point to the existence of a self interest threat. First, the client has not paid audit
fees for the past three years. It is therefore in the best interests of the auditor to issues a favorable
audit report and opinion as issuing an adverse opinion would lower their chances of recovering
amounts owed. The fact that Chan Associates have an equity stake in Classic reproductions also
means that they have an interest in the financial performance of Classic Reproductions as it

affects the value of their shares. Chan and associates would therefore be hesitant to issue an audit
report that could adversely affect Classic Reproductions’ share price in the market. Chan
Associates should follow legal means to recover amounts owed to them. While accepting
furniture does not accept their independence, taking ownership of the client’s shares affects thir
independence.
Question 3
One of the internal control weaknesses at Everyday Supplies is that there is only person
responsible for opening the mail is also responsible for depositing the cheques. Like cash,
cheques are liquid resources that have a high level of risk attached. It is important therefore to
have a segregation of duties for those involved in handling cheques (Kopp and Bierstaker 2009
p.38). The person opening the mail should not be allowed to deposit the cheques without checks
and safeguards to ensure that all cheques received are actually banked. The ideal situation would
be to have two employees open the mail and have one of them record cheques received.
The second internal control weakness is that it seems that the cashier has a lot of room to record
transactions without supervision or independent checks to establish whether his records have
been kept appropriately and whether his records are complete and accurate. The cashier for
instance retains deposit slips after making payments therefore denying room for inspection of his
work.
The third internal control weakness is that subsidiary accounts receivables journals are updated
after the general ledger has been updated. This creates the likelihood of transactions to the
subsidiary ledger being missed or being inaccurate. If there are errors or omissions in posting the
subsidiary ledger then there will be a discrepancy between the general ledger receivables control

account and the ageing receivables balance which gives a total of individual customer balances
(Roybark 2010 p.138). This would be an audit issue.
The fourth internal control weakness is that there seems not to be credit limits for credit
customers. As long as the credit manager has approved a customer to take credit, there seem not
to be any limits on how much credit purchases the customer can make. This could potentially
result in a significant number of irrecoverable debts that could cripple the company’s operations
(Emby, 2015 p.112). A more proactive approach would involve granting limited access to credit
at the beginning of a credit relationship with a client and then gradually increasing a customer’s
credit limit based on the customer’s payment history (Messie, Chad and Smith 2013 p.151).
The fifth internal control weakness is that the process of writing off irrecoverable amounts seems
to place more emphasis on time lapsed rather than on making efforts to recover amounts owed.
Additionally, there is a significant time lapse between the time a customer fails to pay and the
time they are denied credit. The implication is that a customer can continue to take goods on
credit for up to six months from the point they lose their ability to pay.
A further internal control weakness is that regular reconciliations of the general ledger payables
control account and individual supplier balances are not performed. These reconciliations would
highlight any discrepancies and prompt quicker action.
Question 4.
One of the internal control weaknesses is that Retro does not have a basis for determining when
the stores department actually needs items to be purchased. The company should have critical
levels that inform those involved when new orders should be placed and the levels below which

stocks should not go for each item. Determination of these critical levels would require
information on lead times, minimum order quantities, and rates of consumption for each item.
The second internal control weakness is that Retro does not issue a request for quotation from
suppliers. The risk involved in not issuing a request for quotation is that the company may end
up purchasing supplies at inflated rates. The ideal approach would be to request for quotations
from several suppliers and select suppliers with the most competitive prices with acceptable
quality (COSO 2009 p.19).
A further internal control weakness is that there are no checks to verify whether the purchase of
additional stocks is wasteful. Requisitions and approval of purchase orders should be checked
against budgets. Budgets are important as they determine whether expenditure on materials is
within acceptable levels given the levels of activity. The fact that requisitions are not checked
against budgets before approval means that Retro Pty could be incurring losses due to usage and
price variances.
Goods delivered by the supplier may be different in quantity, quality and price. Using the
purchase order to acknowledge receipt of goods could therefore hide discrepancies such as
delivery of fewer units by the supplier than the number of units supplied. The supplier’s goods
delivery not should be used and a goods received note generated by Retro to acknowledge
receipt of goods. Sending 2 copies of the purchase order to the receiving department so that one
of the copies can serve as a goods received note is therefore incorrect.
A further internal control weakness is that there are no cross references in the documents
prepared and issued in the purchasing process. Every subsequent documents should quote the
documents that gave rise to it (Brown-Liburd, Hussein and Lombardi 2015 p.466). A purchase

order for instance should have a slot where the order requisition number that necessitated the
purchase order is entered. This way, all transactions would be accounted for. The purchasing
process may for instance be suspended partway. Cross-referencing is important if one is to avoid
situations where a preceeding document is used more than once.
Question 5
One of the internal control weaknesses at MyPet is that the company uses a large number of
suppliers and contractors to produce a small range of products. The risk involved with
maintaining such a large number of suppliers is that it can be difficult to maintain quality
standards within a reasonable range (Roybark 2010 p.799). The fact that MyPet relies on many
subcontractors to manufacture products for third parties means that MyPet risks reputational
damage due because of relying on a variety of suppliers.
The second internal control weakness is that suppliers are selected based on their past reputation
and not on important and current factors such as current prices, current terms of delivery, current
work load and delivery time.
The third internal control weakness is that MyPet does not have in place procedures for handling
discrepancies between order and delivery dockets. It is not inconceivable to have errors in the
purchasing process. The description of the how the purchasing process should therefore
anticipate that errors will be detected at some point in the process and define how those
discrepancies are resolved (Bierstaker 2013 p.99). Once a discrepancy is identified, it should be
reviewed and approved by more than one person.
A further internal control weakness is that separate systems and staff are maintained for raw
materials and finished goods. The implication of this separation is that the company is unable to

determine efficiency in the use of raw materials to produce finished goods (Jennifer, Scott and
Yi-Jing 2017 p.90. If the two departments had a common system and perhaps common staff, it
would be easier to track raw materials to finished goods and identify instances where the
production process may have been inefficient or wasteful.
Using the previous month’s usage as a basis for determining the current month’s restock
quantities for raw materials and finished goods could lead to stock-outs or surplus stocks
(Anderson, Kaplan and Reckers 2012 p.12). Raw materials and finished goods consumption
instead follows seasonal patterns that often do not depend on the previous month’s consumption.
Raw materials and finished goods requirements are likely to be closely comparable at in the
same month every year with adjustments for inflation and other significant events having been
made. It is therefore important to prepare forecasts and have budgets that can then be used
alongside historical monthly consumption to determine more relevant restocking levels.
A further internal control weakness for MyPet is that quality checks do not seem to be a priority.
The process flow anticipates that all raw materials and finished goods received will be accepted
without any reservations. The process flow should anticipate that goods delivered may not meet
quality standards and after rejection, the purchase process may need to be terminated partway.
A further internal control weakness is that errors in posting in the nominal ledger or payables
ledger could go undetected as the payables control account is not reconciled regularly to
payables ageing (Luippold and Kida 2012 p.116)
b.
One of the tests of controls for the inventory system would be to obtain a list of all purchase
orders and check for completeness of records by checking whether there are serial numbers that

are missing in the pre-numbered sequence. These check should be extended to all pre-numbered
documents and discrepancies highlighted.
The second test would involve a list of all items in inventory along with their valuation and
comparing this value with the balance in the inventory control account (Pike, Curtis & and Chui
2013 p. 1420). The balances should match.

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