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Solutions manual
to accompany
Auditing: a practical
approach
3rd
edition
by
Moroney, Campbell and Hamilton
Prepared by
Jane Hamilton
© John Wiley & Sons Australia, Ltd 2017

Solutions manual to accompany Auditing: a practical approach 3e
© John Wiley and Sons Australia, Ltd 2017 6.2
Chapter 6: Gaining an understanding of the client's system
of internal controls
Review questions
6.11 What is internal control? Why is an auditor interested in a client’s
internal control?
Internal control is defined as:
The process designed, implemented and maintained by those charged with
governance, management, and other personnel to provide reasonable assurance about
the achievement of the entity’s objectives with regard to reliability of financial
reporting, effectiveness and efficiency of operations, and compliance with applicable
laws and regulations. (AUASB Glossary).
Internal control is therefore the way that any entity organises itself to achieve its
objectives. It is how managers run the organisation and control the employees so that
they work towards achieving the organisation’s objectives and operate legally.
Auditors are interested in internal control because it is the system that managers use to
make sure transactions are recorded correctly and the accounting system is able to
produce financial reports that are reliable. The auditor has to provide an opinion on
the financial reports, so the auditor has to understand how well the internal control of
an organisation works to produce reliable financial records.
6.12 Explain each of the seven generally accepted objectives of internal control
activities.
Internal controls are designed and implemented to ensure that transactions are real,
recorded, correctly valued, classified, summarised and posted on a timely basis.
• Real – only genuine transactions are recorded.
• Recorded – all genuine transactions are recorded (none are omitted).
• Correctly valued – all transactions are at the correct amount.
• Classified – all transactions are allocated to the correct account.
• Summarised – all transactions are correctly totalled.
• Posted – all transactions, or transaction totals, are posted to the correct ledger
account.
• Timely – all transactions are recorded in the correct accounting period.

Chapter 6: Gaining an understanding of the client’s system of internal controls
6.13 If an auditor does not intend to rely on internal controls in the audit, does
the auditor need to obtain an understanding of the client’s internal
control? Explain.
ASA 315 requires the auditor to obtain an understanding of internal control on all
audit engagements. Therefore, even if the auditor intends to take an entirely
substantive approach to the audit and not rely on internal controls, the auditor must
obtain an understanding of internal control. This is because without gaining this
understanding, the auditor will not fully understand the risks of material misstatement
of the financial report. ASA 315 states that gaining an understanding of the entity and
its environment, including its internal control, establishes a frame of reference within
which the auditor plans the audit and exercises professional judgement throughout the
audit.
The standard allows the auditor to use professional judgement to determine the extent
of the understanding of internal controls required in each case.
6.14 Explain the difference between entity-level controls and transaction-level
controls. Is an auditor interested in both?
Entity-level controls are:
1. the control environment
2. the entity’s risk assessment process
3. the information system, including the related business processes, relevant to
financial reporting, and communication
4. control activities
5. monitoring of controls.
Each of these controls relates to the whole organisation.
Transaction-level controls are controls that impact a particular transaction or group of
transactions.
Therefore, the difference is that entity-level controls have the potential to impact all of
the processes in the organisation, including those that have a direct impact on the
financial report and others, while transaction-level controls impact only a specific
group of transactions. Transactions make up the financial report that the auditor is
auditing, and can be impacted by both entity-level and transaction-level controls. This
is why an auditor would be interested in both types of controls.

6.15 Discuss the contention that the control environment is the most important
part of a system of internal controls because it provides the foundation for
the entire system.
The control environment sets the tone of the entity and influences the control
consciousness of its people. People, through their actions, determine the effectiveness
of internal controls. If the control environment does not encourage ethical behaviour
and high quality work, the people within an organisation could fail to implement
controls or override them when performing their duties. Even the best control system
is not 100% effective, and all systems are less effective if the people working with
them do not support the systems.
However, all components of an internal control system are important. Having a strong
control environment will not be sufficient by itself to ensure that an organisation is
able to achieve its objectives.
6.16 Why would an auditor be interested in a client’s control monitoring
processes?
A client should have processes for monitoring the effectiveness of its internal controls
because circumstances and conditions change over time and controls need to adjust
accordingly. An out-of-date control system may not be able to alert management to
new risks, or control new types of transactions. The monitoring process allows the
client to assess the need for changes to internal controls. As such, the auditor will be
interested in the effectiveness of the monitoring system and whether the client’s
management are able to be sure that internal controls remain current and valid. The
auditor will also be able to assess the client’s management attitude to internal control
systems through evaluation of the monitoring processes within the client.
6.17 What sort of risks would an entity’s risk assessment process consider?
Give some examples for a retailer. Which of these risks would be relevant
to financial reporting? Explain.
An entity’s risk assessment process would consider risks to its achievement of its
objectives at all levels. These would include: risks to revenue through product
competition, to attracting and retaining staff, exchange rate risks, transport
interruption risks (both freight and passenger transport delays affecting staff and
customers), climate change risk, financing risk (obtaining and servicing loans), supply
risks, and risks relating to protection of assets from theft and fraud etc.
A retailer would have a particular focus on the risk of not being able to buy the
appropriate products from reputable suppliers, product quality risks which would lead
to sales returns and/or warranty claims, exposure to exchange rate risks if suppliers
are located in other countries, transport risk affecting imports, competitive risks from
other retailers in the same location or servicing the same type of customer, staff risks
relating to attracting and retaining the right type of staff for all shifts, physical risks
including power interruption, shopping centre building issues, financing risks relating
to funding product purchases and paying expenses prior to receipt of cash from
customers, and protection of assets and the integrity of sales and other transactions in

the accounts. The retailer would be interested in identifying and controlling risks to its
ability to operate and achieve its objectives.
All uncontrolled risks for the entity could affect the ability of the entity to survive (i.e.
be a going concern). Therefore, all risks are of interest to the auditor. However, the
auditor is most directly concerned with risks relating to protection of assets and the
integrity of transactions in the accounts. The auditor must consider the risk to the
accounts so that the audit can be planned with appropriate consideration of the risk of
material misstatement
6.18 Explain the importance of segregation of incompatible duties. What sort
of duties would be segregated within the sales process? Why?
Segregation of incompatible duties is a part of the control activities of an organisation.
Control activities are policies and procedures that help make sure management’s
directives are carried out. The concept of segregation of incompatible duties is that no
one employee or group of employees should be in a position both to perpetrate and
hide errors or fraud in the normal course of their duties. If these duties are not
segregated, an employee could steal assets (such as cash or stock) and adjust the
records to conceal the theft. If the duties are segregated, the employee stealing the
assets would have to get the cooperation of another employee to adjust the records to
hide the theft.
Therefore, it is very important for the effective operation of a control system that
incompatible duties are split between different employees.
Within the sales process, the person making the sale is not responsible for recording
the sale, and should not be able to process a sales return or other adjustment to a
debtors account balance. If these duties were not segregated, the sales employee could
record a sale to a fictitious customer and take the goods for themselves. To conceal
the theft, the employee would later process a sales return or adjustment to eliminate
the balance in the fictitious debtor’s account.
6.19 In the sales transaction process, a key control affecting the accuracy
assertion for sales is ‘Credit committee review and approve all
applications for credit over $1000’. Explain the impact of this control on
the valuation assertion for sales receivable (debtors).
A control such as ‘Credit committee review and approve all applications for credit
over $1000’ will require applications for credit over the specified amount being
separately authorised. This control is related to the accuracy assertion for sales
because it prevents sales transactions being recorded that are incorrectly processed.
For example, if a data entry error is made so that a sale for $500 is incorrectly entered
as $5,000, the transaction would not be accepted until it had been authorised. Because
there is a data entry error, the person responsible for authorising the transaction
should notice that it is not for $5,000, but should be entered as $500. The control also
impacts on the valuation assertion for sales receivable because it would prevent the
incorrect sale being entered to the debtors account, and thus prevent it from being
overstated. In addition, if sales are genuinely being made for amounts over $1,000, the

authorising person has a chance to consider if the debtor has capacity to pay large
amounts. Procedures to check the credit-worthiness of debtors is likely to improve the
chances of the amounts being paid by the debtors (because only debtors that can and
will pay their debts are allowed to buy on credit), increasing the likelihood that
debtors are valued correctly.
6.20 Discuss the role of internal audit in an entity’s system of internal controls.
Is internal audit an essential element of a control system? Explain.
Internal audit is a part of an entity with responsibility for assessing the performance of
the entity’s control systems and making evaluations of client’s activities. Internal
auditors provide information about the functioning of the entity’s internal control
system, its strengths and weakness, and make recommendations’ for improvements, to
the entity’s management. Although internal audit departments are usually separate to
other functions within the client, they are not independent of the client.
Not all organisations have an internal audit department. Smaller organisations usually
do not have an internal audit function and many larger organisations outsource the
internal audit function to a third party. However, as organisations become larger, the
level of importance placed by an entity on its internal audit function can be a guide to
its overall commitment to internal control.
6.21 Several approaches to internal control documentation are discussed in the
chapter. Assess the advantages and disadvantages of each. How would
documentation assist the auditor to identify strengths and weaknesses of
an entity’s system of internal controls?
The four approaches to internal control documentation are:
1. Narratives; the advantage is that the process can be described in full; the
disadvantage is that it can take many words to describe a process in full.
2. Flowcharts or logic diagrams; the advantage is that the standardised graphics
allow a large amount of information to be presented on a single page to
represent complex flows of transactions and the key controls. If there is
common understanding of the symbols, it is easier to review and understand.
The disadvantage is that the reader may not understand the symbols or require
additional clarification.
3. Combinations of narratives and flow charts or logic diagrams; the advantage is
that complex systems can be described using standardised symbols, with
additional narrative to explain steps that are hard to chart. The disadvantage is
that both the diagram and narrative have to be prepared and checked for
consistency.
4. Checklists and preformatted questionnaires; the advantage is that it is helpful
to inexperienced auditors because the checklist guides the process and assists

in identifying critical controls. The disadvantage is that it can inhibit an
experienced auditor and slow down the process.
The documentation assists the auditor because the process of preparing the
documentation prompts the auditor to ask detailed questions in order to gain a full
understanding. An experienced auditor would be able to identify departures from the
systems used at similar organisations and the graphical forms of documentation reveal
quickly the destination of all copies of documents.
6.22 Why do auditors prepare management letters?
ASA 260 requires the auditor to communicate matters from the audit with those
charged with governance, and ASA 265 governs communicating deficiencies in
internal control to those charged with governance and management. To satisfy the
requirements in these standards, the auditor will prepare a management letter to those
charged with governance. The auditor will also communicate on a timely basis with
management of the entity, where appropriate, the deficiencies in internal control
revealed during the audit that are either being communicated to those in governance
or are not.
The auditor uses their professional expertise to inform management about deficiencies
in the internal control system which could affect the integrity of the financial report
either in the current financial period or in the future. The feedback is provided in
written form so that there is no confusion about the fact of the report or the
observations and recommendations being made. The management of the entity is able
to use the written report as a basis for a response. Sometimes, management is able to
use a letter written at an interim stage of the audit as a basis for a response before the
end of the audit.

Professional application questions
6.23 Understanding client controls
Abbott & Partners audit firm has audited Pretty Valley Shire council for
two years, performing both a statutory audit of the financial reports and
a compliance audit for the government department in charge of local
councils’ landfill waste disposal sites. In all previous control testing, no
exceptions were detected. The junior auditor on the engagement has
suggested that no work on internal controls is required because last year’s
evidence will be sufficient.
Required
Explain why the junior auditor’s suggestion is not appropriate.
The junior auditor’s suggestion is not appropriate because the auditor needs to have
sufficient appropriate evidence about the effectiveness of controls in the current year.
Any change in either the controls or the conditions would make last year’s evidence
not applicable to the current period. At a minimum, the auditor would need evidence
that the conditions remained the same and that the controls had not altered. The
auditor should also consider whether the controls are able to provide sufficient control
in the current circumstances. Even if there had been no changes since last period, the
auditor should evaluate the effectiveness of the controls and draw a conclusion on the
degree to which they can be relied upon.
In this particular case, the controls were assessed with respect to their ability to ensure
compliance with the regulations. It is likely that additional work is required for the
controls to be assessed for their effectiveness at preventing or detecting material
misstatements at the assertion level because this is a different objective.

6.24 Importance of internal control
Elecnet is an electricity distribution company based in a large capital city.
Its business is to manage the electricity assets, including poles, wires and
other equipment, that are used to deliver electricity to more than 500 000
retail and business customers in the city. Pole, wire and substation
maintenance and improvements are a large part of the company’s
operations and teams of highly trained technicians are used for both
planned work and emergency response activities. Emergency response is
required when storms or fires bring down power lines, the power must be
turned off at the direction of police, or the electricity supply fails for any
reason.
Each team comprises several vehicles (vans and trucks) and uses
additional heavy equipment, such as cherry pickers, cranes and diggers,
as required. Each vehicle carries a core set of specialised parts and tools
and additional items are obtained as required from the stores, located in a
large warehouse in the northern suburbs. The warehouse is staffed on a
24-hour basis to assist night maintenance (designed to minimise
disruption to business customers) and emergency response.
Required
(a) Make a list of the potential problems that could occur in Elecnet’s
maintenance and improvements program.
(b) Suggest ways that good internal control over parts, equipment and
labour could help Elecnet avoid these problems.
(a) Potential problems include:
• Problems with communication systems stop emergency reports reaching the
response teams in a timely manner.
• Police or other emergency services are unable to contact Elecnet during an
emergency because they do not have the required contact information or staff
at Elecnet are not rostered on to respond to emergencies.
• Trained staff are not available to respond to emergencies through
mismanagement of leave or failure to recruit and train staff.
• Storms, fires or other emergencies are more extensive than anticipated and not
enough staff and equipment are available to respond.
• Equipment, such as vehicles, diggers and cherry pickers, are not operational
due to lack of suitable maintenance.
• Not sufficient supplies of specialised tools and parts are held in stores.
• The large warehouse is not accessible in an emergency because the key holder
is away sick or on leave.
• Too many staff are rostered onto normal maintenance and not enough
available for emergency response in a particular geographic location.
• Changes are made to the electricity distribution system so that different parts
are required for maintenance and these new parts are not ordered in time.

(b) Suggested internal controls include:
• responsibility for maintaining communication systems with emergency
services assigned to a senior staff member at Elecnet who also has information
about staff rosters.
• HR department is made aware of staffing requirements for emergency.
response and reports to senior management on achievement of staff targets
• HR department oversees policies and procedures for staff training to ensure
that sufficient staff within the organisation have the required skills and
qualifications.
• Scientific modelling of emergency situations, taking into account population
growth and climatic conditions.
• Schedule of maintenance for equipment coordinated with senior staff
responsible for emergency response.
• Stores report on holdings of various parts, with integration with new
equipment purchases.
• Stores maintain security systems and assign responsibility for staff member to
coordinate with emergency response teams.
• Staff schedules and rosters approved by senior management with consideration
of balance between maintenance and emergency response.

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6.25 Control environment
Cheetah Airways became a client of an audit firm for the first time this
year. Soon after taking the engagement in September last year, Cheetah
Airways was under investigation by the Australian Competition and
Consumer Commission (ACCC) for allegedly fixing prices on some routes
in collusion with another airline. The two airlines made an illegal
arrangement to not compete with each other so that they both benefited
by sharing the business and maintaining prices that would allow them to
make profits. After the ACCC investigation became public, several of
Cheetah Airways’ key corporate customers decided that they did not wish
to associate themselves with the airline and severed their exclusive travel
dealings with Cheetah Airways.
Required
How does the above information affect your understanding of the control
system at Cheetah Airways?
The information available to the auditor raises questions over the tone at the top of
Cheetah Airways because it is alleged to have engaged in activities to rig the market
by agreeing with a competitor not to undercut each other. Specifically, is there a
commitment to integrity and ethical values in the organisation? What is
management’s philosophy and operating style? Is there a win at all costs attitude and
lack of respect for laws that affect the business?
At the time of the audit there is an investigation by the ACCC, but no prosecution
against the client. However, several customers of the audit client have taken their
business elsewhere. This fact also raises questions for the auditor because it suggests
that the client’s revenue has been adversely affected, and could be more adversely
affected if other customers also take this action. In the extreme case, there could be
questions about the audit client’s ability to continue as a going concern (although this
would require many more customers to also leave), and could impact on the auditor’s
opinion.
If there is a poor ethics/tone at the top, or evidence of fraudulent or illegal activities,
the auditor should consider whether the client is one that they wish to continue to
audit. The auditor should reconsider the information it gathered at the time of taking
over the client – what did the prior auditor disclose, what did the auditor’s
investigations disclose etc. Ultimately, the auditor will have to document the action
taken to investigate the matter and consider the integrity of the client, and any impact
on the auditor’s ability to perform the audit. For example, has the auditor had any
difficulties in getting access to records and personnel it requires in order to do the
audit? Has the client been able to offer the auditor any assurances about their
integrity? The auditor may conclude that the bad publicity is unwarranted and the
departure of several customers is more related to activities by the client’s competitors.
Alternatively, the auditor may decide to resign from the audit engagement if the client
is unable to provide the assurances required.

6.26 Expense transaction risk
Bear Transport’s accounting policy for maintenance on its fleet of cargo
planes is to capitalise the cost of major airframe and engine maintenance
checks and depreciate over the shorter of the scheduled usage period to
the next major inspection or the remaining life of the aircraft. The latest
data shows the aircraft and engines at cost (including major maintenance
costs) to be at a similar level as last year while depreciation costs have
decreased by 5 per cent.
Required
Discuss the risk of misstatement for depreciation costs. What could go
wrong?
The main risk for depreciation costs is that they are understated. ‘What could go
wrong’ is that it will overstate profits and overstate the written down value for assets.
Capitalising expenditure on maintenance that should be a cost of the period by
designating it as improvements would understate expenses. Depreciation expense
could also be understated if the rate is reduced or new additions to assets are not
depreciated.
Auditors should determine if the accounting policy to capitalise maintenance and
amortisation over the maintenance period is reasonable under the accounting
standards.
Depreciation costs have decreased even though the cost of ships and engines has not
changed. This suggests that the scheduled period for maintenance is greater (a longer
period before the next major maintenance is scheduled). This would be justified if the
ships are traveling fewer kilometres each year (e.g. as a result of economic downturn
and reduced international trade) Auditors should investigate the schedules for ships to
determine if the distances travelled are lower.

6.27 Segregation of duties in small business
North State Computers has premises in the main street of a large regional
city. The business is owned by Bob and Mary Winters, who purchased it
three years ago. Mary has an extensive background in IT and has a talent
for diagnosing and solving problems with computers that are brought in
for repair. Bob also has an IT background and oversees the sales and
administration staff. There are three staff in the business: a computer
technician who assists Mary, a part-timer who helps with sales and a
junior trainee, Cara, who does other tasks such as banking. Cara is also
responsible for issuing invoices and statements to clients who have a
service contract with the business. These clients are generally other
businesses that ask Mary to visit their premises for routine and
emergency repairs and that purchase software and hardware from the
business.
Bob and Mary have worked very hard over the last three years but they
have cash-flow problems. Their bank manager has requested a meeting to
discuss the business’s growing overdraft. The bank manager asks Bob
and Mary to prepare for the meeting by analysing their accounts
receivable and customer receipts. Bob and Mary review the accounts
receivable ledger and find that it is not up to date. They also discover that
client statements have not been issued for four months. They are also
unable to identify from the cash receipts journal which clients have paid
their accounts.
Required
(a) Discuss the attitude and control consciousness of North State
Computers’ management.
(b) Which duties should be segregated in this business? Recommend an
appropriate allocation of duties for the staff at north State Computers.
(a) The accounts show that the controls over sales, debtors and cash receipts are not
good. The accounts are not up to date and client statements have not been issued for
four months. These tasks were apparently the responsibility of the junior trainee,
Sally, under the supervision of Bob. Bob appears to have been unaware of the
problems, suggesting that he is not monitoring the processes very closely. Overall,
this means that the management’s attitudes towards internal controls in general, and
the accounts in particular, are not good. The fact that the bank has asked them to meet
to discuss their worsening cash position also suggests that they are not managing their
cash flow adequately.
Although Mary is responsible for technical issues, such as repairing computers, rather
than the administration side of the business, she is also an owner of the business and
as such should be involved in setting the tone of the organisation. Bob and Mary
appear to have failed to establish good internal controls and to communicate and
enforce the importance of the systems to their staff. There is no evidence of any
unethical behaviour by the staff, but they do not appear to have been adequately
trained and/or appropriately selected for the positions they hold.

In a small business, such as this, management involvement is a substitute for a large
system of formal controls. This means that Bob and Mary must be personally
involved in authorising and supervising transactions to a greater extent than if there
were more staff.
(b) Segregation of duties should follow the broad principle that the following duties
are segregated:
• Authorisation or approval of transactions affecting assets
• Custody of assets
• Recording or reporting of transactions
• Control over processing of a transaction should be separated from recording or
reporting a transaction
Cara is employed to help with administration. The other staff is a computer technician
and a sales part-timer. This means that Cara and Bob are the only two staff currently
with administrative responsibilities. It will be difficult to adequately segregate duties
with only two staff in the area. Therefore, Bob and Mary must perform additional
review tasks, such as separately reviewing all transactions over a certain limit,
monthly reports of debtor’s balances and transactions, bank reconciliations etc.
In addition, if Cara retains the task of banking, she should not be involved in
recording transactions, particularly cash receipts. An alternative would be for Bob to
do the banking and leave Cara responsible for transaction processing. Mary could take
responsibility for stock control, so that the sales staff are not involved in maintaining
stock records as well as having access to the stock for making sales.

6.28 Control environment
Red Minerals is being audited by your firm for the first time in 2015. In
2010, Red Minerals invested in a mining joint venture in Bangaloo, a
country which recently experienced significant currency devaluation. In
December 2013, there was a large chemical spill in the area surrounding
the main centre of Red Minerals’ operations in Bangaloo, and the
government is seeking compensation and asking for restoration work to
be done. The story has been covered in the Australian press. In a review
of documents you discover that in 2014, there was a raid on the homes of
several Red Minerals’ employees, following a tip-off to police. The tip-off
alleged that over several years, four members of Red Minerals mechanical
staff had been stealing small tools from Red Minerals and re-selling them.
To date, four members of Red Minerals’ staff have been charged with
fraud and theft. You are aware that the Chief Operations Officer (COO)
of Red Minerals resigned at the start of 2015 and a suitable replacement
has not yet been found.
Required
Discuss the impact of the background material for Red Minerals on your
likely assessment of entity-wide controls at Red Minerals.
The information suggests that there are problems with the client’s control
environment surrounding the chemical spill incident. What are the circumstances of
the spill? Was there evidence of suitable precautions being taken or was management
treating the potential problem lightly because the country is poor (currency
devaluation issues suggest economic problems in Bangaloo)? Was there evidence of
appropriate consideration of the risks of a chemical spill and the impact of the cost of
clean-up on the company? What action has management taken to repair the damage?
Is the company’s failure to repair the damage evidence of financial problems at the
client?
The petty theft could be simply a problem isolated to several dishonest employees, or
could be further evidence of poor control procedures at the client. Is the resignation of
the COO related to either the chemical spill or the theft? Does it signify that there are
further problems at the client which the client has not provided information about to
the auditor? What procedures have been adopted to find a replacement?
The auditor should consider whether those charged with governance (board of
directors) are aware of the problems and taking action. Has the board established
suitable policies for dealing with the risk of operating in Bangaloo?
What evidence can the auditor gather about Red Minerals’ management’ philosophy
and operating style? What approach has management taken to establishing procedures
to implement policies around the risk of chemical spills and control over company
assets? How have the policies and procedures, as well as the ethical values of the
organization, been communicated from the board to management and more widely in
the organization?

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