Case: Far East Plastics Ltd.

You are the audit manager in charge of the audit of Far East Plastics ("FEP") Ltd., for the year ended 31 December 2016. Your CPA firm, Au & Au, has been the auditors for FEP for ten years from the time it only produced two products to today when it is a successful diverse company. FEP was started by Joe Lee who owns 51% of the shares with the balance held by about ten silent partners with no operational responsibilities.

Historically, the company presented no unusual audit problems and Au & Au had issued an unmodified report every year. The audit approach used has always been a "substantive" audit approach. Under this approach, the in-charge auditor obtained an understanding of internal controls as part of the risk assessment procedures, but control risk was assessed at the maximum (100%). Extensive analytical procedures were done on the income statement and unusual fluctuations were investigated. Detailed audit procedures emphasized statement of financial position accounts. The theory was that if the statement of financial position accounts were correct at year-end and had been audited as of the beginning of the year, then retained earnings and the income statement must be correct.

In evaluating the audit approach for FEP for the current year's audit, you considered that a substantive approach was really only appropriate for the audits of small non-public companies. In your judgement, FEP with sales of HK$200 million and 75 employees, had reached the size where it was not economical, and probably not wise, to concentrate all the testing on the statement of financial position. Therefore, you designed an audit program that emphasized identifying internal controls in all major transaction cycles and included tests of controls. The intended economic benefit of this "reliance"/"compliance" approach was that the time spent testing controls will be more than offset by reduced tests of details of balances on the statement of financial position accounts.

In planning tests of inventories, you used the audit risk model to determine the number of inventory items you should test at year-end. FEP maintains 2,450 items in its perpetual inventory management system.

You determined that overall audit risk should be low (say 5%). For inherent risk, you determined that it is high because inventory, by its nature, is subject to many types of misstatements. Based on your understanding of the relevant transaction cycles, you believed that internal controls are effective. Therefore, you assess control risk as moderate before performing tests of controls. Of course, you also plan to use analytical procedures for tests of inventory. These planned tests include comparing gross profit margins by month and reviewing for slow-moving items. Substantive tests of details will include tests of inventory quantities, costs and net realizable values at an interim date 2 months before year-end. Cut-off tests will be done at year-end. Inquiries and analytical procedures will be relied on for assurance about events between the interim audit date and year-end date.

Required:

(a) Discuss whether you need to perform the following steps(1-5) if you are using (a) a compliance/reliance audit approach and (b) a substantive audit approach.

1) Assess inherent risk

2) Obtain an understanding of internal control

3) Perform tests of control

4) Perform analytical procedures

5) Assess planned detection risk

(b) Discuss the advantages that you foresee in using the reliance/compliance approach versus the substantive approach previously used in the audit of FEP.

(c) What advantages did the substantive approach have over the reliance/compliance approach? (6 marks)

(d) Assume the audit partner agrees with your recommended approach. Using the audit risk model in the planning the audit evidence for detailed inventory tests, the conclusion is that detection risk should be moderate/low. Discuss what this means in this audit.

(e) Now assume(only for this part) that instead of your original control risk assessment of moderate, you assessed control risk at high and all other risks as they are stated, explain the impact on the planned audit procedures and sample size in the audit of inventory as compared to your procedures in step (d) above.

(f) Although the planning went well, the actual testing yielded some surprises. When conducting tests of controls over acquisition and additions to the perpetual inventory, the audit staff found deviations/exceptions for several key controls that were higher than expected. Discuss the actions you should take in relation to arriving at the appropriate audit opinion.

(g) Regarding (f) above, describe one other action you should take in relation to the completion of the audit. (Hint: Audit committee)