SMU Classification: Restricted
SUGGESTED ANSWERS
Group Structure:
Fragrant Flowers
YYY Holdings
Poppy Ltd
19 other
companies
Shareholdings distribution:
Poppy Ltd (70%)
Mr Rose
(10%)
Mr
Carnation
(10%)
Ms Tulip
(10%)
Fragrant Flowers Pte Ltd
7.1 Audit risk
The following matters are relevant to planning Fragrant Flowers Pte Ltd's audit:
Inherent risks
Related party transactions
Fragrant Flowers Pte Ltd is part of a complicated group structure whereby YYY owns Poppy Ltd
and Poppy Ltd owns 70% of Fragrant Flowers.
 There is a risk of related party transactions existing (whereby Fragrant, subsidiary of Poppy,
regularly trades with another subsidiary of Poppy Ltd) which may lead to material
misstatements, unintentional or fraudulent. Specifically, misstatement of sales and
purchases transactions, either over or under, as a result of not transacting at market values.
 There is the concern of RPT transactions not being properly disclosed in Fragrant Flowers’
financial statements in accordance with FRS 24 Related Party Disclosures.
There is a potential risk of material misstatement at the assertion level, either sales or
purchase, due to regular business transactions with another subsidiary of Poppy Ltd.
Profit-driven management
Mr Rose is motivated by the performance incentive, as well as the benefits of being a
shareholder of FF:
 He receives a commission based on sales revenue.
 As dividends pay-out is dependent on profits made for the year, the higher the profits, the
more substantial his dividends will be.
There is a risk that the financial statements will be potentially affected by management
bias/manipulation, resulting in a risk of material misstatements at the financial statement
level. This is because Mr Rose has complete control over the business operations, as no other
shareholders are interfering in how he runs the business.
SMU Classification: Restricted
OR
RMM will be at the assertion level, specifically sales because he has absolute access to the
accounts ledger, making easy for him to manipulate sales figure to his benefit.
Control risks
Receivables
FF does not seem to have a strong policy of ensuring customers pay up on time, as it provides
extended credit period if they fail to pay up after the standard 60 days. This indicates that their
collection control is likely to be poor. Furthermore, the fact that “a number of accounts
appeared to be outstanding for a significant period” also indicate that their credit control is also
not effective. Possibly AR aging is not prepared.
This is likely to mean that trade receivables will be an account subjected to potential
overstatement as the provision for doubtful debt is likely to be insufficient. Key assertion of
VALUATION to be a concern to auditors.
Lack of segregation of duties
There appears to be a complete lack of segregation of duties on the three main ledgers,
whereby each individual is fully in charge of that section, e.g. purchases, sales and payroll.
The fact that there is no segregation on payroll is a key concern as this is an area where fraud
can easily be carried out, e.g. Mr Rose to create fictitious employees and pay himself through
these fictitious employees, as paying himself may be more profitable than receiving dividends
as a shareholder. Auditors can expect occurrence of payroll to be of concern.
Lack of segregation of duties can also lead to significant errors being made and not being
detected by the system. This problem means that control risk will have to be assessed as high
and significant substantive testing will need to be undertaken.
The potential RMM is likely to be at the assertion level as the misstatements are likely to be
found in payroll and sales.
Personal computer
A personal PC is used for the accounting system, which is unacceptable. This is likely to have
poor built-in controls and further exacerbate the problems caused by the lack of access
controls. The security over PCs is also often poor, as has been the case here, where a virus has
destroyed evidence about the sales ledger. Expect RMM at FS level due many more errors in
the other ledgers, not just sales records destroyed. There is also the lack of proper backup of
accounting information.
SMU Classification: Restricted
Audit risk and detection risk
Audit risk will be low as this is the first audit, so we have no prior understanding of the entity
to draw upon, e.g. no assurance over opening balances and prior audit opinion.
We must ask the client for permission to contact any previous auditors, in order to review
their working papers for any key audit concerns such as uncorrected misstatements,
modification of audit opinion or inconsistent accounting treatments. We must ensure that our
auditor's report is clear on this issue.
If there were no previous auditors due to the audit exemption, prior year figures are unaudited.
This means that we need to make sure that we exercise adequate professional skepticism when
reviewing the year on year figures.
Given a Low AR, High/Medium IR and High CR, the resultant DR will be LOW as we will want to
keep the risk of undetected misstatements to a minimum.