Guide of Case Study Assignment- Audit Planning- Cloud 9 Pty Ltd
W&S Partners commenced the planning phase of the Cloud 9 audit with procedures to gain an understanding of the client's structure and its business environment. You have completed your research on the key market forces, as they relate to Cloud 9's operations. The topics you researched included the general and industry-specific economic trends and conditions; the competitive environment; product; customer and supplier information; technological advances and the effect of the internet; and laws and regulatory requirements. The purpose of this research is to identify the inherent risks. The auditor needs to indentify which financial report assertions may be affected by these inherent risks. Identifying these risks will help determine the nature of the audit procedures to be performed.
Management implicitly or explicitly makes assertions regarding the recognition, measurement, presentation and disclosure of the various elements of a financial report. Auditors use assertions for account balances to form a basis for the assessment of risks of material misstatement. That is, assertions are used to identify the types of errors that could occur in transactions that result in the account balance. Consequently, further breaking down the account into these assertions will direct the audit effort to those areas of higher risk. The auditors broadly classifies assertions as existence or occurrence; completeness; valuation or allocation; rights and obligations; and presentation and disclosure.
An additional task during the planning phase is to consider the concept of materiality as it applies to the client. The auditor will design procedures in order to identify and correct errors or irregularities that would have a material effect on the financial report and affect the decision making of the users of the financial report. Materiality is used in determining audit procedures and sample selections, and evaluating differences from client records to audit results. It is the maximum amount of misstatement, individually or an aggregate, that can be accepted in the financial report. In selecting the base figure to be used to calculate materiality, an auditor should consider the key drivers of the business. They should ask, "what are the end users (that is, shareholders, banks etc) of the accounts going to be looking at?" For example, will shareholders be interested in profit figures that can be used to pay dividends and increase share price?
W&S Partners' audit methodology dictates that one planning materiality (PM) amount is to be used for the financial report as a whole (that is, rather than separate PMs for the income statement and the balance sheet). Further, only one basis should be selected- a blended approach or average should not be used. The basis selected is the one determined to be the key driver of the business.
W&S Partners use the following percentages as starting points for the various bases:
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BASE
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THRESHOLD (%)
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Profit before tax
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5.0
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Turnover
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5.0
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Total assets
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0.5
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Equity
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1.0
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These starting points can be increased or decreased by taking into account qualitative client factors, which could be:
- the nature of the client's business and industry (for example, rapidly changing, either through growth or downsizing, or an unstable environment)
- if the client is a listed entity (or subsidiary of) subject to regulations
- the knowledge of or high risk of fraud.
Typically, profit before tax is used; however, it cannot be used if reporting a loss for the year or if profitability is not consistent.
When calculating PM based on interim figures, it may be necessary to annualise the results. This allows the auditor to plan the audit properly based on an approximate projected year-end balance. Then at year-end the figure is adjusted, if necessary, to reflect the actual results.
Part 1- Materiality
Required
Answer the following question based on the information presented for Cloud 9 in the appendix to this case study.
(a) Using the 30 September 2011 trial balance (appendix to this case study) calculate planning materiality and include the justification for the basis that you have used for your calculation.
1. Planning Materiality (PM)
The students' PM worksheet should be as follows. However, that there may be alternate formats:
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Planning Materialty
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Base amount
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$
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PM
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Profit before tax
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Turnover
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Turnover
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Total assets
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Equity
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Students should select Revenues or Turnover as the basis for calculating PM.
Note: The students can select any answer from the three options given above except net loss. The planning materiality can be computed out of Revenue (Turnover) or total assets. They need to write about two paragraphs justifying their answer.
Part 2- Analytical Procedures
Required
Answer the following questions based on the information presented for Cloud 9 in the appendix to case study.
(a) Using analytical procedures and the information provided in the appendix, perform an analysis of Cloud 9's financial position and its business risks. Discuss the ratios indicating a significant or an unexpectedfluctuation.
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Analytical Review
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Year ending 30 Sept
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Year ending 31 Dec
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Description
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Formula
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2011
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2010
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Liquidity ratios
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Current ratio
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Quick Ratio
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Inventory turnover
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Accounts receivable
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Solvency ratios
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Debt to equity
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Times interest earned
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Profitability ratio
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Gross profit ratio
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Net profit ratio
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ROA or ROEC
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Retrun on equity
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You need to add explanations.
Note: 6 marks to be given for the above worksheet. The students need to compute a minimum of 6 ratios out of 10 ratios given above. 4 marks should be given for the above comments.
(b) Prepare a common-size statement for the balance sheet of Cloud 9, use total assets as the basis for the balance sheet.
Please google examples of common-size statement for the balance sheet.
https://www.youtube.com/watch?v=S4L49s9Q5b
You also need to add comments and analysis of Common size statements.
Notes: 1. 6 marks should be given for the above worksheet. The student answers may be different because they might classify current and non current liabilities in different ways for the interest bearing loans and long service leave provisions.
(c) Which specific areas do you believe should receive special emphasis during your audit? Consider your discussion of the analytical procedures results, comments on the common-size statement and as well as your preliminary estimate of materiality. Prepare a memorandum to Suzie Pickering, Audit Senior outlining potential problems areas (that is, where possible material misstatements in the financial report exist) and any other special concerns (for example, going concern). Specify the accounts and related assertions that would require particular attention.
Memo to include the following:
The major areas to be considered by the audit are as follows:
1. The total revenue change
2. Advertising expenses, sales and promotional expenses
3. The Insurance expenses
4. Current and quick ratio
5. Accounts receivable turnover
6. Overall liquidity and solvency and profitability
7. Inventory balance
8. PPE
9. Increase in payables
10. Special disclosures
Note: 1 mark for each of above points. The students need to write only 10 points to get the total marks