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Audit and Risk Assessment of Pakatan Harapan Pty. Ltd and Karkun Slack Assessment Answer

SCHOOL OF ACCOUNTING

Part A (20 Marks Total)


The managing director of Pakatan Harapan Pty. Ltd asked the company’ auditor: Tom Hardy to complete the audit in time to submit audited financial statements to a financial institution as part of a loan application. Hardy immediately accepted the engagement and agreed to provide a auditor’s report within one month. The client agreed to pay the normal audit fees plus a percentage of the loan if it was granted. 

Hardy hired two recent accounting graduates to conduct the audit and spent several hours telling them exactly what to do. He told the new assistants not to spend time reviewing the internal control but instead to concentrate on proving the mathematical accuracy of the general and subsidiary ledgers and summarizing the data in the accounting records that supported the company’s financial statements. The new assistants following Hardy’s instructions, and after two weeks gave Hardy the financial statements excluding the notes to the financial statements. Hardy reviewed the statements and prepared an unqualified auditor’s report. The report, however, did not, refer to approved accounting standards. 

Required: 

Identify and briefly describe how the actions of Hardy have resulted in failure to comply with approved standards on auditing. 

Part B (45 marks total)

You are auditing the financial statements of a new audit client: Karkun Slack, a health-food chain that has a June 30 year-end. The company is privately held and has just obtained some long-term financing that includes various restrictive covenants. In order to obtain debt financing, companies often agree to certain conditions, some of which may restrict the way in which they conduct their business. If the borrower fails to comply with the stated conditions, it may be considered in default, which would give the lender the right to accelerate the due of the debt, add other restrictions, wave the default for a stated period, or revise the covenants. Usually, there is a grace period during which the borrower can default. 

You believe that it is possible that at August 31, Karkun Slack was in violation of the debt covenant restrictions, which became effective on that date. The debt covenants require the company to maintain a certain debt equity ratio. You are not certain, however, because of the accounting records, including period-end cutoffs for sales and purchases, have not been well maintained. Nevertheless, Karkun Slack’s executives assure you that if they were in violation, the company will be able to obtain a waiver or modification of the covenants. 

Required: 

Discuss the audit procedures that you would conduct if Karkun Slack violated the debt covenants. How would you determine whether Karkun Slack would be able to obtain a waiver, assuming that the company was in violation of the debt covenants? 

Based on the case scenario, should Karkun Slack continue to class this liability as non-current? 

Answer

Auditing and Risk Assessment

Part 1- Audit of Pakatan Harapan Pty. Ltd.

On the basis of particular provided in relation to audit engagement and by Tom Hardy, it can be said that rules and regulations are not followed by Tom Hardy while conducting order to for Pakatan Harapan Pty. Ltd.   Following are the audit deficiencies that can be identified in the audit engagement undertaken by Tom Hardy-

Accepting audit fees as a percentage of the loan- According to rules and regulations developed by auditing authorities, it is not permissible for an auditor to take audit fees as a percentage of revenue or any other kind of factor in a business organization. It can be said that to the auditor is guilty of professional misconduct in accordance with rules and regulations developed by accounting and auditing authorities (Cohen and Simnett, 2014). There should always be a fixed price of audit engagement and such audit prices should be mentioned in the contract between auditor and client before starting the process of audit.

Over-dependence on accounting graduates- Auditing of financial statements requires specialized knowledge and experience in the field of auditing. It is important that an effective and efficient audit team is developed by the auditor before starting the process of audit. In the given scenario Tom Hardy has hired accounting graduates for evaluating relevancy and accuracy of financial statements for financial statements prepared by the organization. There is a high probability that to 20 accounting graduates might not have knowledge about accounting standards that are specifically applicable to business organizations (William Jr, Glover and Prawitt, 2016). In addition to that, they also might not be able to identify material misstatement due to lack of experience.

Ignoring internal controls- Primary function of that is undertaken by Auditor in an External Audit engagement is the identification of material misstatement in financial statements as well as internal controls. In the given scenario auditor of the organization has clearly instructed accounting graduate to not check internal controls employed by the organization to protect any kind of negative impact of external factors. It can be said that this is a clear violation of rules and regulations are developed by accounting authorities for the auditing process.

Accounting standards- Auditor of the organization has provided an unqualified report on financial statements but does not provide any kind of opinion on whether the organization has followed applicable accounting standards or not. One of the basic function to be performed by the auditor is to examine whether financial statements are prepared in accordance with accounting standards (Knechel and Salterio, 2016).

Part B- Audit of Karkun Slack

A. Audit procedures

Audit procedures that will help in evaluating whether management of the organization mission of debt covenants is as follows-

  • First of all audit of the organization is required to understand the terms and conditions of the contract entered into by financial institution and business organization. This will help in understanding the restriction forced by financial institutions on a business organization that is specifically required to be checked in the auditing process.
  • Auditor of the organization is required to analyse debt to equity ratio at the end of every month in the accounting period under consideration.
  • This will help in understanding whether management has maintained prescribed debt to equity ratio throughout the financial year or not (Messier Jr., 2016).
  • The auditor should also identify whether there are any conditions mentioned in the contract entered into between business organization and financial institution regarding any kind of waiver to be provided by the financial institution. If yes then conditions of such people should also be analysed and compare it with the practices of business organization.

These audit procedures will help in identifying whether there is any violation on part of client i.e. Karkun Slack or not.

Karkun Slack has informed auditor that in case of any violation he would be able to extract waiver from the financial institution irrespective of the nature of the violation. It is important for the order to analyse whether management will be able to extract such from a financial institute or not. For this purpose auditor of the organization can contact a representative of financial institution. the written confirmation can be taken from this financial institute on whether they will be providing a waiver in case of violation of debt covenants to Karkun Slack or not.

Irrespective of the waiver, auditor of the organization is required to mention in the audit report that management of the company has not complied with the debt covenant applied by the financial institution on business organization according to terms and conditions of the loan (Byrnes et.al, 2018). One of the primary objectives of the auditor is to make sure that all the relevant and accurate information is available to investors and stakeholders. This can be considered as material misstatement as according to 2000 conditions financial institution will accelerate the recovery of a principal amount of loan if there is a violation of debt covenant.

B. Classification of non-current assets

According to accounting standards and reporting framework, every business organization is required to categorize its liabilities into equity, non-current liability, and current liabilities. Current liabilities are liabilities that are expected to be measured in the next financial year i.e. next 12 months whereas non-current liabilities will be measured after 12 months on the date of balance sheet. If the management of the organization has not violated any kind of debt covenants then the loan taken from a financial institution can be considered as a non-current liability as management will not be required to make payments immediately in next 12 months (Kafka, 2014).

Whereas if there is any violation of conditions presented by financial institution then the financial institution has a power to speed the recovery process of the principal amount. In such a scenario there is a possibility that the principal amount will be recovered by a financial institution in next 12 months financial year 2018-2019. In such case, it is important that Karkun Slack should classify this liability as a current liability rather than non-current liability as management is not aware of the timing of recovery in relation to this liability. 

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